Background: What I will talk about is the so called derivative space in I/commercial banking, a particular member of this derivative space : credit default swaps (CDS) is now being accused of being the villain that brought down the financial sector.
The CDS for the layman is essentially an insurance against something (usually company bonds/debt etc). An underwriter (AIG) like your local auto insurer charges the insuree a monthly payment (coupon) determined by the CDS rate and if something bad happens to the insuree's holdings the underwriter ponies up the insured money just like an auto insurer pays for your wrecked car in case of accidents. Of course when all these CDSes started defaulting simultaneously (primarily because they were junk grade to start with, for example a pizza delivery boy in orange county,CA ,offered a 350k house loan on zero down, underwritten by AIG, packaged as CDS instrument by Lehmann... u get the picture), the insurer (AIG) was called upon by a myriad of insurees for the lumpsump payments causing the meltdown.
Now the derivative space has some more members besides the CDS notably :
- interest rate
- foreign echange
However another silent player in this dreaded derivatives basket seems to have risen in a more alarming fashion. It is the interest rate (1, in the list above, specifically swaps but also futures and forwards) that has grown from $24.8 trillion to $164.4 trillion!
In simple terms an interest rate swap (IRS) are merely contracts exchanging a stream of interest payments for another party's stream of cash flows, the underlying interest rate is often the Fed rate. Now associated with the IRS and derivatives is something called Total Credit exposure (TCE) which is essentially a metric that measures a bank's risky credit/risk eposure. Higher the number worse the bank.
Now for the bad news:
The Office of the comptroller of currency released a chart last week for the top 5 banks and the percentage of their total credit in relation to the potential toxic risky credits/derivatives arising from interest rate swaps (item 1 in the derivative basket above).
Table reproduced for better visibility:
Total credit exposure to risk based capital (%)
JPmorgan: 400(Q4 03), 384 (Q4 08)
Bank of America: 178(Q03,08), 179 (Q4 08)
Citi 260: (Q3), 278(Q4)
Goldman: 4(Q3), 1056(Q4)
HSBC : 664 (Q3), 550(Q4)
And drum-rolls please we have a winner. IT IS OUR OLD I-BANK PAL GOLDMAN SACHS WITH A STAGGERING 1056% % ratio of their total credit in terms of interest rate swaps.
The ramifications of this I leave to the readers, but just for fun imagine GS defaulting on these, ah wouldnt that make the AIG collapse look like peanuts. For those getting ready to join Goldman Sachs be sure to ask your bosses about these charts, Id love to have an explanation for their immense love of interest rate swaps. Also those in the class rooms do me a favor ask your fin-profs about these numbers, either way I'd love to know whats going on with this epic GS and IRS love saga. And a true love saga always needs a tragic ending, right ;-)
Charts Source :
http://www.occ.treas.gov/ftp/release/2009-34a.pdf:zerohedge :Office of comptroller of currency's quarterly report for bank trading and derivative activies