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U.S. bank derivatives books larger since rescue of Bear Stearns

Section: Daily Dispatches

By Ben McLannahan
Financial Times
Saturday, March 16, 2018

At the end of January 2008, in what would turn out to be its final annual report, Bear Stearns went into some detail about its big book of derivatives. The book had a notional value of $13.4 trillion at the end of November, Bear said, up more than 50 percent from a year earlier. A two-notch downgrade in the firm's credit ratings, it added, would require it to come up with an extra $353m in collateral.

This huge cluster of financial instruments -- swaps, futures, forwards, and options -- may not have been the main cause of Bear's collapse, about six weeks later. The firm was stuffed with mortgage assets at a time when the housing market was sinking, and had a tiny sliver of equity to absorb losses. But the dense web of interlocking claims in the derivatives book certainly did not help, as hedge funds and other counterparties scrambled to get their money out.

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Shares in Wall Street's fifth biggest investment bank went from $62 on Monday March 10 to $30 on Friday March 14, when Moody's -- yes -- announced a two-notch downgrade. Bear was sold to JPMorgan Chase for $2 a share on the Sunday, a price that was subsequently revised to $10.

"It was the definition of a run on the bank," says Steve Abrahams, a former senior managing director now running Milepost Capital Management.

Derivatives have never really gone away in the ensuing decade. The total value of the books at five of the biggest U.S. banks has dropped about one-quarter since tougher capital rules kicked in, from 2013. Even so, there were $157 trillion of derivatives out there at the end of last year, according to data prepared for the Financial Times by Aite Group, a Boston-based research firm. That's about 12 percent more than the amount these banks had, entering the crisis.

At Citigroup, the derivatives book of $44 trillion is about 50 percent bigger than it was back then. That should make people uncomfortable, says Javier Paz, senior analyst at Aite. Citi "seems to have forgotten the time when they were a buck a share," he says, alluding to the trough in March 2009.

The banks say these huge numbers -- $157 trillion is more than twice global GDP -- do not tell the whole story. And they are right: headline figures say nothing about the counterparties, the collateral, the offsetting positions, or whether the trades are centrally cleared. ...

Still, these huge books are worrying. At a futures-industry conference in Boca Raton this week, Tom Russo argued that contracts like these just cannot be relied upon. Mr. Russo should know: as chief legal officer of Lehman Brothers for 15 years, right up until the last rites in September 2008, he found that a lot of counterparties simply refused to pay when it came to the crunch. ...

Even in non-crisis situations, derivatives contracts have proven unenforceable. In the UK in the early 1990s a court ruling voided all interest-rate swap agreements between banks and local governments. Lawmakers in Milan reached a similar verdict five years ago.

So if a bank's counterparty balks, claiming it was duped, or an entire class of contracts is declared illegal, is an auditor really going to say these things are worth 100 cents on the dollar?

"When you owe a little bit of money, you call your banker to pay it," says Mr. Russo. "When you owe a lot of money, you call your lawyer to get out of it."

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