Will Derivatives Be The Next Black Swan?

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"It's déjà vu all over again." - Yogi Berra

The stock market has long been classified by economists as a leading indicator of the economy. It tracks and reflects the nation’s economy and industry fundamentals. The market often seems able to anticipate positive or negative change before it happens. Since the beginning of the bear market in August of 2015, the prices of many bank stocks, especially European and Japanese banks, have declined steadily and precipitously. Deutsche Bank has lead the way by dropping below the level it reached in 2009. Shares of HSBC, Citibank, Bank of America, Credit Suisse, Goldman Sachs as well many other big banks have also taken a beating of 25-45%.

What are bank stocks trying to tell us?

Some analysts suggest low interest rates are a problem for the banks along with flattening yield curves that suppress their profitability; or slow economic growth together with the sharp decline in oil prices and drilling activities are placing pressure on the credit quality of banks’ loan portfolios. Upon closer examination, we think neither of these issues is creating monumental problems for banks. As a matter of fact, the banks are doing just fine at the moment. Earnings are coming in above expectations and anecdotal evidence suggests that all is well on Wall Street. Young bankers who live in the tri-state area continue to drive luxurious European cars, live in multi-million dollar houses, and earn high salaries and huge bonuses. There are no recent layoffs by banks and not even a scent of trouble being detected.

We think the banks are faced with two fundamental problems; both need to be fixed immediately. The first problem is philosophical: if the banks continue to treat their customers unjustly and unfairly by not paying out interest on deposits, they will surely lose their customers and hurt their businesses. Common sense dictates that they must follow the basic business principle of placing clients first and employees second. After all, over the last eight years, the banks have made billions of dollars on credit card loans, mortgages, consumer installment loans, commercial and industrial loans plus government bailouts. Why don't banks start paying interest to their depositors? The banks in the U.S. alone withheld $1 trillion of interest payments from their customers. What‘s their excuse? None whatsoever.

Derivatives are extremely risky to the whole system

While no one knows exactly what bothers investors, we worry that something dastardly is lurking around the corner. The dreaded and misunderstood D word: Derivatives.

Fifteen years ago, Warren Buffett warned everyone about derivatives in the banking system:

The derivatives genie is now well out of the bottle and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control or even monitor the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that now latent are potentially lethal.

Those words turned out to be prophetic. Derivatives almost destroyed financial markets with the collapse of Long Term Capital in 1999 and subprime/CDS in 2008. One would think that the industry would learn from its mistakes; however, the exact opposite occurred. Derivatives have multiplied in variety and number. Today, the derivatives bubble is much larger than it was before the 2008 financial crisis. During a recent interview, Buffett was asked if he is still convinced that derivatives are “weapons of mass destruction." He answered that he believes that they are and that "at some point they are likely to cause big trouble." In normal times when business cycles are in an upturn, the major banks can make lots of money trading derivatives; but when a black swan emerges, sudden and massive shifts in the market place can bring huge negative surprises that present significant counter-party risks (solvency of trading partners.)

There are more than $250 trillion dollars of exposure to derivatives contracts with the major US banks. Globally, there are $550 trillion dollars of derivatives. The bankers assure regulators that these financial instruments are not as risky as they sound and that they are spreading the risk adequately as not to bring chaos to the entire financial system.

What is bizarre is that the leadership of most major banks don’t know much about derivatives. The same can be said for a majority of commercial bankers and traders. It is a major problem when neither Wall Street experts nor regulators understand these complex instruments. As the world learned in 2008, it is difficult to know where, when, why and what will cause a major problem but the consquences can be huge. Major institutions can suddenly implode. Those that were previously “too big to fail” are now bigger than ever with the total quantity of derivatives. Deutsche Bank has a derivatives book of over 55 trillion Euro, which is almost 20x the size of Germany's GDP and roughly 5x the GDP of the entire Eurozone!

There is absolutely no centralized regulatory agency or self-policing organization to monitor them and literally, no one truly understands the risks. If a black swan event hits, there will neither be enough money in the United States nor in the whole world to bail out today's global banks of massive scale. The banks have not heeded Warren Buffett’s warning and are taking no steps to fix the problem. Should the stock market be worried when the banking industry takes the attitude that “ignorance is bliss?”

How do you feel about your bank's financial health? Should banks pay out higher interest to its customers? Please share your thoughts in the comments.

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About the Author: Samson Wang

Samson Wang

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