We posted a blog earlier this week about Bank of America moving their Derivatives contracts over to a FDIC insured subsidiary, potentially transferring massive risk to tax payers without congressional approval. A Bloomberg article also implies that this move has the support of the Federal Reserve and is not supported by the FDIC. I did a bit more digging and a review of the current report from the Office of the Comptroller of the Currency, and it shows a much bigger picture, and not one that is particularly pretty.

First let’s review what a derivative is. Warren Buffet calls it “financial weapons of mass destruction” once entered into, almost impossible to unravel. Most derivative contracts are private, so no one really knows how many actually exist, but according to the BIS (Bank of International Settlements), the notional value or face amount of all OTC (Over the counter) derivatives total somewhere around $1.48 Quadrillion dollars. Global GDP is approximately $75 Trillion dollars, according to the IMF, therefore the known derivatives are almost 20 times larger then the global GDP. The problem is that they are big bets with no asset underneath in case of default and those betting do not have to have a vested interest on the outcome. Information about the risks being taken is generally well hidden.

The derivative market is a relatively new beast, having been born in 1996, only 15 years ago, and has grown from a notional value of approximately $18 trillion to over $249 trillion (amount in the insured banking system), accounting for a substantial portion of many banks income. The following illustration shows you how the derivative system works.

That last statement in the illustration about trading information being not freely available is accurate. In fact, when I was checking with the BIS and requested information on the number of gold derivative contracts, they replied that the information was not available (to me). But the OCC (Office of the Comptroller of the Currency) does publish a quarterly report on known derivatives in the FDIC insured banking system. Here’s the link if you’d like to read the entire report http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq211.pdf

According to the OCC’s quarterly report, insured U.S. commercial banks reported that trading revenues were the fourth highest on record. They further stated that trading risk exposure increased at the 5 largest banks and that the notional amount of those derivatives increased $5.3 trillion just from the first quarter of 2011 to $249 trillion, 11.6% higher than a year ago.

There are a total of 1,071 insured U.S. banks that reported derivative activities, an increase of 24 banks from just the prior quarter, though it continues to be dominated by the 5 largest banks which represent 96% of the total banking industry notional amounts. So what were they saying about “Too big to fail?” Let’s take a deeper look.

The following chart is very telling. First of all, you can see that the banks first created derivative contracts in 1996, at roughly $18 trillion. In 1999 the Glass-Steagall Act was repealed. Glass-Steagall had been enacted in 1933 in response to the 1929 Stock market crash and was designed to curb speculation. This act kept commercial banks (that accepted deposits) and investment banks (that issued securities) activities separate. Once that barrier was removed, the creation of many types of derivatives grew, as did the bank income and bonuses from these activities. In fact you can see that between 1996 and 2007, the derivatives in the “Insured” banking system grew 900%. Remember, these are all big bets between banks and/or insurance companies, with nothing to support them. When the derivatives on sub-prime began to implode in 2007, this caused almost an immediate freeze in the credit markets, and that was just a tiny percentage of the derivative market.

Look at 2008 (3rd line) as the Federal Reserve and Treasury got congress to approve the first round of “bailouts” aka TARP, TALF etc.  These programs injected massive amounts of liquidity into the banking system as the Federal Reserve took some of the illiquid derivative contracts off those “Too big to fail” bank’s books.

After that round of stimulus into the banking system, you can notice flat derivative activity until the 2nd round of stimulus (4th line called quantitative easing) and then whoosh, even faster growth. In fact, now they have 35% more derivative exposure than they did before!

This next table will show you what is at risk in the US Insured Banking system. This does not include any insurance companies or global banks, so it is only a percentage of the global derivative market which according to the BIS, totals 1.48 quadrillion. The top 5 banks control 96% of US banking derivative contracts. The table below is showing you VAR (value at risk). Let me explain. Take for example JP Morgan Chase, which has total assets (includes deposits) of roughly $1.7 trillion, but has VAR of roughly $79 trillion, that means that if all of their derivative contracts defaulted, they would be on the hook for 4,610% MORE than every asset they have, including your deposits! Look at Goldman Sachs, which became a commercial bank during the crisis in order to have access to the Federal Reserves discount window and is now an FDIC insured bank; they have assets of $84 billion but value at risk of almost $45 trillion!

In fact, the top 25 insured commercial banks have total assets of roughly $8 trillion but have put at risk almost $244 trillion. And as we saw at the start of the current crisis, if even a small player defaults, because of the incestuous nature of the system and the contracts, the entire system could be in jeopardy of imploding. This is what they are worried about with a Greek default. If the European banks do not agree, it could trigger a CDS (Credit Default Swap) implosion and global banking crisis. What a mess.

Now you might say, “My money is safe, its FDIC insured.” Good, but according to the most current FDIC balance sheet report, the insurance fund to support your deposit totals $3.9 billion. So if there is a systemic financial melt down, how far will $3.9 billion go against potential derivative losses of $244 trillion? Can you see the problem here?

It’s a catch 22, if they allow a failure, it is likely to bring down the entire system, so instead they transfer your wealth the banks way via “bailouts” and currency devaluation. They can talk all they want about “Too big to fail” but every action that has been taken makes these behemoths even bigger. Pay attention to what happens in Greece; can a safe room really be created? Can they unwind this default without global impact? We shall see my friends, we shall see.

We’ve been taught to believe that banks are safe, bonds are safe, and our dollar is money and represents wealth. We are suppose to “Have Faith” but my faith has been eroded by the truth. Banks have been given permission to take risks with our wealth and as witnessed by the data above, it has only gotten worse since the beginning of the crisis.

Bonds are pure debt and it is probable that by Friday, the US debt to GDP ratio will hit 100% making it even more challenging to grow more debt. The bottom line is that there are simply too many risk balls being juggled, heaven help us all when the first one falls. So much for derivatives.