The Trouble with Bubbles It was about the time that the Fed Chairman made his famous quote regarding irrational exuberance that I published a short cautionary tale in comic form "The Trouble with Bubbles" (available Fraserbooks.com or Amazon.com). Jim Grant thanked me for an advance copy and included a note that "the trouble with bubbles is they keep on expanding". At the time I thought the turn of phrase cute, in retrospect astute. Now bubbles are part of our everyday lexicon, with legions of gainfully employed individuals gleefully quitting their jobs to become day traders. Not as impressed by the bull hysteria was Warren Buffet who voiced a word of caution on the ABC News Nightline program saying that the US equity market was in a "dangerous phase that could see value drop sharply. After a while the very act of stocks going up starts drawing in other people who get excited about the fact that their neighbor is making money and that's when you get in to the dangerous periods."
Neighbors seem to be a pretty all encompassing category. On Monday March 1st the Swiss National Bank reported it was thinking about shifting some of its assets into stocks and shares. Apparently the Swiss central bank is no more immune to envy than ordinary mortals and has been eyeing its colleagues in the Netherlands where fully 28% of that bank's capital was invested in equities as of the end of 1997. Norway took the plunge in 1996 and now has a portfolio worth $20-25 billion. The Swiss, assuming their referendum is not voted down by the populace next month, will sever their link to gold. This will allow the Central Bank to sell 1,300 tons of gold and give them at current price $2 billion to play the market with.
Not to be left out our own Administration seeks to "save" social security by investing a portion of the trust fund in equities. At this point it is clear that several assumptions have clearly permeated the collective consciousness of both politicians and central bankers; specifically that equities will always increase over time. It is also clear that there is ample evidence to the contrary but it takes a cursory knowledge of history to remember this. Secondly that Central Banks are now seen not as stewards of financial stability but as potential profit centers. We say this despite that fact that at their Feb 24th meeting the G7 finance ministers proposed the creation of a "Stability Forum". This august body is to be charged with sounding the alarm in the event of financial instability. However the body will meet only twice a year which makes the probability of their meeting coinciding with financial instability fairly remote.
In reality this was a victory for the American position in managing financial crises. Namely that it should be left to the free market. The free market being the US and its proxies the World Bank and IMF. Their success at handling global financial crises has been well demonstrated in the past year in regions as diverse as Russia and Brazil. The later however, now has put its central bank in the capable hands of former Soros' aide Armenio Fraga.
The lasting effect of LTCM was to demonstrate how incestuous the world of hedge funds, and banks, both commercial and investment, really is. On Wednesday March 3rd the House Banking Subcommittee on Capital Markets, Securities and Government -Sponsored Enterprises took testimony from the President's Working Group on Financial Markets. While allowing that their work was not complete, Treasury Deputy Assistant Secretary Lewis Sachs said in reference to LTCM: "That a single firm with a relatively modest capital base could finance positions so large that their unwinding might have significantly disrupted financial markets around the globe is disturbing." Sachs continued, "It is excessive leverage of this nature, and the practices which allowed the accumulation of such leverage, which has the potential lead or contribute to systemic risk in the future."
In this context it is interesting to study the derivative positions reported by US Banks to the comptroller of the currency.
Notional Amount of Off Balance Sheet Derivative Contracts (in millions, except for %)
The notional amount of derivatives in insured commercial bank portfolios increased by $4.5 trillion (almost sixteen percent) in the third quarter, to $32.6 trillion. Seven commercial banks account for 94 percent of the total notional amount of derivatives in the banking system. Over the counter contracts comprise 84 percent of the total with exchange-traded contracts 16 percent. As the Comptroller of the Currency puts it: "OTC contracts tend to be more popular with banks and bank customers because they can be tailored to meet firm-specific risk management needs. However, OTC contracts expose participants to greater risks and tend to be less liquid than exchange traded contracts, which are standardized and fungible."
Quarterly charge-offs from derivatives rose to 445.4 million In the third quarter of '97 the figure was $57 mln. The third quarter of 1996 was $18 mln. The first quarter of 1996 was $2 mln. There was a $58.9 billion increase in third quarter total credit exposure from off balance sheet contracts to $400.9 billion. Relative to risk-based capital, total credit exposure for the top seven banks in creased to 318 percent of aggregated risk based capital in the third quarter of 1998 from 277 percent in the second quarter. This takes into account the benefit of netting. Banks have the option of approximating their netted potential future credit exposure on an aggregate basis. The exposure reduced through netting is estimated at 60%. All the above data is taken, much of it verbatim, from the OCC Bank Derivatives Report third quarter 1998 published by the Comptroller of the Currency. For readers interested in further detail the web site is http://www.occ.treas.gov/
The table above illustrates that the difference between a hedge fund and a bank is that the latter are public enterprises and so must report the incredible extent to which they are leveraged. Even with netting approximate exposure we are still talking about over 300 percent of total bank capital. As anyone with a brief introduction to commodities will know, leverage works both ways.
When, not if, the bubble bursts this will be amply demonstrated. And when will the bubble burst? The oracle of Omaha replied "you never know…valuations are high, by historic standards. You know speculation is high by any historic standards, and you know that it doesn't go on forever. But you don't know when it ends."
I couldn't put it better myself.
Greg Pickup
Gpickup@ix.netcom.com13 March 1999
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