Derivative Dangers
The Quarterly Derivatives Fact Sheet from the Office of the Comptroller of the Currency (OCC) is a collection of derivative activity information from all U.S. banks. Each bank must prepare a "Condition and Income" report from which the OCC gathers its data. The most recent report available is currently the 1998 Q4 report from which the data herein was obtained.
What is a derivative? The OCC glossary contains the following definition: a derivative is a "...financial contract whose value is derived from the performance of assets, interest rates, currency exchange rates, or indexes. Derivative transactions include a wide assortment of financial contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards, and various combinations thereof...". In other words, a swap is really nothing more than a "bet" made between two parties and the result of which is a cash paid settlement from one party to the other.
Perhaps the most striking single piece of information in the report is the fact that the total amount of derivatives held by U.S. banks is $32,999,490,000,000  in case you did not count the zeroes, that's $33 trillion!! If you were to include the additional derivative transactions performed by the holding companies of these banks, the total would be closer to $37 trillion. In a report from the Bank For International Settlements, global overthecounter (OTC) derivatives total $70 trillion (in U.S. Dollars), and this figure only includes OTC transactions, exchange traded transactions were not available which could present a worldwide figure closer to $80 trillion.
This staggering sum for U.S. banks is comprised of $10.9 trillion in futures and forwards, $14.3 trillion in swaps, and $7.6 trillion in options. $24.8 trillion is concentrated in interest rates and $7.4 trillion is in foreign exchange derivatives.
The top 7 U.S. banks hold 94% ($30.9 trillion) of all reported derivatives. These top banks include the following (with stock symbol): Chase (CMB) includes Chemical from merger, J.P.Morgan (JPM), Citibank (CCI), NationsBank (NB), Bankers Trust (BT) in proposed merger with Deutsche Bank AG, Bank of America (BAC), and First Chicago (FCN). The top 25 U.S. banks account for 99% of all reported derivatives.
To be upfront, not all of the $33 trillion exposure is currently at risk. Actually, when looking at only interest rate and foreign exchange derivatives, only $12.6 trillion is at risk with an expiration horizon of less than one year and another $8.1 trillion exposure for a 15 year expiration horizon. It should also be pointed out that only $122 billion in derivatives is held for less than 1 year for equities (stock market). Commodities (including gold and precious metals) are only $70 Billion for less than one year to expiration.
The following table demonstrates the derivative positions held, by bank, for the 7 highest positions. The columns have the following meanings: Assets is the total assets of each bank, Derivs is the total derivative exposure (all expirations), <1 Year is the total derivative exposure that expires in less than one year, Assets:1Yr is the percentage of assets relative to derivatives that expire within 1 year, Equity is the banks exposure to the stock markets.

** Deutsche Bank has proposed a takeover of Bankers Trust Corp by April 22, 1999.
Granted, not all derivative positions are at direct risk. Most positions have been countered with offsetting derivative positions with other couterparties. But, because of the extreme overextension of their use, Chase Manhattan Bank only needs to suffer a loss of less than 7% of its 1year derivative positions to wipe out their entire asset base. When looking at all derivative maturities, a loss of only 3% would wipe out all of Chase's assets, and only 2% is needed to wipe out the assets of JPMorgan.
The odds of a catastrophe of sufficient magnitude to wipe out more than a few percent of their derivative positions is perhaps remote. But one only has to investigate the nearcollapse of the LTCM hedge fund to see how easily losses can snowball into significance.
Many of these banks participated in investing in the LTCM hedge fund, in addition to directly holding derivatives, which magnified their exposure to market fluctuations. An outright collapse of LTCM would have been a disaster for many of these banks. First, the forced liquidation of the derivatives held by LTCM would have certainly caused the markets to fall even further. Second, the leveraged exposure these banks had to the markets directly though their own derivative positions, would certainly have added to their losses. Third, with a portion of derivatives expiring on October 16, 1998, it is no wonder that the FED stepped in to assist in a multiparticipation bank bailout of LTCM and announced an emergency rate reduction on the day before many derivatives were set to expire.
Since most of the banks derivative positions are hedged with offsetting positions with other counterparties (called "netting"), one would be lead to assume that any real risk of loss is almost insignificant. However, there are many different kinds of exposure to derivativeloss risk, and credit and systemic risk is perhaps the most likely to occur. Systemic risk is when the failure of one party fails to meet their obligations to the other party when the derivative agreement becomes due. If LTCM had been a party for which the banks were relying on for counterparty netting, then the subsequent failure of LTCM could have caused a huge backlash and disrupted the entire global banking infrastructure.
In early 1998, LTCM had an equity to balance sheet asset ratio of 25:1. Apparently, LTCM assumed that their portfolio was quite diversified since crosscorrelation between the various markets appeared to be low. However, the article Banks' Interactions with Highly Leveraged Institutions (see link below) said that following the Russian currency devaluation and announced moratorium on their debt, "… global markets simultaneously moved in the same direction, with credit spreads widening, equity markets declining and volatility increasing in various equity and interest rate markets… the confluence of these events, together with a reduction in liquidity in many markets, ultimately produced the large losses experienced by LTCM…".
The article also disclosed that of the OTC derivatives held by LTCM there were 50 counterparties involved.
LTCM was only one counterparty that was used by some of these banks. Some of the banks are counterparties with each other. There may have been other hedge funds in a similar situation as LTCM. In a world where very little information is available about the unregulated holdings of international hedge funds, one only has to wonder what would have happened if LTCM was allowed to fail. Because of a cascade of systemic risk failures, perhaps banks such as Chase or JPMorgan would have been handed their 79% shortterm derivative losses.
©1999, Steven J. Williams
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