Banking Derivative Risk Questions

K

kowboy

I would like to learn from someone who has knowledge of the topic, how they view the current banking sector risk for a longer term investment hold, in light of the rapidly expanding derivative risk situation. Reading the online Fdic and Occ literature I do not easily understand the assessment in laymen's terms.

For example, several larger banks pay solid dividend yields at current stock prices. But the total value of their derivatives appears to be a significant portion of their bank's shareholder equity.

The risk associated with derivatives depends on the ability of the counter party to fulfill the underlying contract.

Are these derivative risks significant? How does the individual investor get a handle on the downside risk for purposes of investing in the banking sector? What would be a guess as to the credit worthiness of various counterparties' ability to perform on the underlying contracts-ie any hedge funds involved, who are in fact the counterparties? How would one assess the actual risk or downside potential?

Thanks for sharing any knowledge.

http://www.fdic.gov/bank/analytical/fyi/2003/032603fyi.html

(old data)
 
You hit the nail on the head:

"The risk associated with derivatives depends on the ability of the counter party to fulfill the underlying contract."

Therein lies the problem, and why the derivatives market should have been regulated long ago by the bumbling bureacrats, and made more transparent. It wasn't. LTCM was a warning shot across the bow, and the Fed and Wall Street rescued the entire system from a potential meltdown.

Q) Are these derivative risks significant?

A) Yes - the "notional" dollar amount dwarfs whatever you might guess it is.

Q) How does the individual investor get a handle on the downside risk for purposes of investing in the banking sector?

A) You don't, they are, for the most part, off-balance-sheet, and that's why its so hard to calculate the real risk.

Q) What would be a guess as to the credit worthiness of various counterparties' ability to perform on the underlying contracts-ie any hedge funds involved, who are in fact the counterparties?

A) Uh, let's see, how can I put this in professional terms...shit

Q) How would one assess the actual risk or downside potential?

A) This risk goes way beyond individual institutions - we are talking the big picture here - we may yet learn what the meaning of systemic risk is

Then again, what do I know, I'm an idiot :D
 
Thanks Sponger for your input. Much appreciated.

Reading the year end Sec 10k filing for one of the Broker Dealer banks in the OP list.

Interesting to note this bank increased the total derivatives portfolio 30% in 2006 over 2005.

The total credit derivative portfolio exposure was 27 trillion while the share holder equity was 135 billion, a 200 to one ratio. And the bank only assigned a .11% credit risk to the total derivatives portfolio. BTW this credit risk reserve amounts to 24% of shareholder equity.

As a side note, an actual across the board incurred credit risk loss of .46% would totally wipe out the total share holder equity. Not likely to happen since some of the derivatives are offsetting.

Hmmm, gets one thinking. Under what circumstances would the process possibly unwind enough to effect a long term hold in the banking sector?
 
Quote from kowboy:


Hmmm, gets one thinking. Under what circumstances would the process possibly unwind enough to effect a long term hold in the banking sector?
More...

When people are exiting from insurance companies; etc. huge put options on these stocks.
 
You raise a good point as on the surface the exposure really stands out. However, you have to view this in context of the overall operations of a bank and why these positions are put on.

I am basing my reply on the time I spent working in these departments (specifically in FX and fixed income, not equities although the principles hold) from the back office, middle (P&L) to on the desk itself.

The vast majority of derivative transactions in my experience, were for hedging purposes with strong counterparties i.e. other large international banks or sometimes within the bank itself to another trading group. So the counterparty risk was low, not zero but low.

There was real initial risk if we were dealing with the "retail" groups where they would deal with a corporation or individuals and kick the risk back to us. However we would look to offset that with our contacts (other banks) or take on futures. It was amazing sometimes to see how a big position from those guys could get whittled down by our group so the risk was manageable. Also, in the case of futures we settled trades daily and either received or paid out P&L daily.

Keep in mind that unlike an individual trader or even a hedge fund or prop desk a bank can simply pass on losses to it's clients through increased interest rates, fees etc. For if we blew it on an interest rate trade the retail mortgage,commercial lending groups will be adjusting their rates and the bank's loss will start to be recouped let alone what we were trying to get back. Bad for our group minimal to the bank.

I guess the point is that while there are huge transactions that go on, you have many people working to get the effective risk down and the true p&l impact may be minimal. I personally did FX trades that were huge in dollar value (1-2 billion) the net p&l was only the spread.
 
Good points helo...

Banks may not be making outright bets and directional plays like hedge funds, pooled money, IB's etc.

However, they are in the game - if counterparties fail to perform their end on swaps and other derivatives trades anywhere in the system, a dominoe effect will harm all involved.

We haven't really tested that theory yet - LTCM was rescued. And Amaranth was a hedge fund that bet the wrong way on commodities trades. I'm worried about the derivatives markets effects on systemic risk to the whole financial game.

Someone had a good post about value-at-risk models not pricing in enough "outlier events" - and how everyone is using the same darn models. You can model all you want - when things go crazy, models go kaput. And then the real fun begins:p
 
You guys are over my head, but I wanted to throw in my 2 cents.

Not that long ago, the oldest bank in England, Barings Bank, went bankrupt through it's derivatives operation (futures trading to be exact) in Asia.

I'm aware limits have been set on position size when it comes to putting on options trades, but I have no idea about other derivatives.

On a sidenote, how would a big wirehouse firm whittle away the risk it has assumed by participating in the mortgage arena over the last couple years?? Sell it off at a loss?? I don't know. The carry-trade that I'm sure these firms have played out that everyone is talking about - how do you whittle away the risk of BoJ raising their interest rate?? Do they just blow up like Amaranth or do they have a better, safer setup??

Thanks,
G.

[I apologize if it's too off-topic]
 
Quote from Sponger:

'm worried about the derivatives markets effects on systemic risk to the whole financial game.

Someone had a good post about value-at-risk models not pricing in enough "outlier events" - and how everyone is using the same darn models. You can model all you want - when things go crazy, models go kaput. And then the real fun begins:p
More...

http://www.gladwell.com/2002/2002_04_29_a_blowingup.htm

Have a look at the above link. Perhaps people/hedge funders who think like Taleb will be the least worried about systemic risk. He looks for the outliers, because history does repeat itself. I guess the questions he deals with concern "targets" and market areas susceptible to outlier events.

To the OP: Is the derivatives concern you have such an event?? Or are you still figuring it out??
 
Quote from G-Boa:

You guys are over my head, but I wanted to throw in my 2 cents.

Not that long ago, the oldest bank in England, Barings Bank, went bankrupt through it's derivatives operation (futures trading to be exact) in Asia.

I'm aware limits have been set on position size ... Do they just blow up like Amaranth or do they have a better, safer setup??

Thanks,
G.

[I apologize if it's too off-topic]
More...
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Its on topic,.
Big behemoth ,huge risk to to bank stock prices;
dont worry about bank runs or failures. The overexposure amoung US bank is so huge BB /fed probably will not let them fail.:D
So yes, comercial banks are safe;
bank stock price isnt safe at all:cool:
Bank stock dividends;dont have an opinion on that one
 
Quote from G-Boa:



To the OP: Is the derivatives concern you have such an event?? Or are you still figuring it out??
More...

Here's the proposition. I've had this sector on buy alert for months waiting for a pull back, namely the higher dividend yielding banks, Bac, Wfc, Wb.

From old Fdic and Occ information, The top five dealer banks have about 90% of the entire banking derivatives exposure.

But still don't have enough knowledge to evaluate the long term downside risk to enter a long term (1 year+) hold in this sector for the purposes of receiving dividend and price appreciation.

It seems like when the sector is strong or weak, the entire sector follows the pack, including the smaller regionals. So regardless of a specific bank's derivative exposure, they all seem to follow the major banks lead.
 
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