"What the 2008 crisis and the J.P. Morgan fiasco show is that derivative strategies might have become so complex that even the best, most experienced derivatives managers cannot always predict what will happen. They are at times like the sorcerer's apprentice: The magic wands (derivatives) are in control, not the apprentices." -- Pensions & Investments
Last week, according to a Wall Street Journal editorial, the Treasury Department's Financial Stability Oversight Council quietly designated a handful of derivative's clearinghouses as "too big to fail." The move opens the door to a potentially massive federal bailout of derivatives insurers whose principle clients are the major banks.
"We're told," says the Wall Street Journal, "that the clearinghouses of Chicago's CME Group and Atlanta-based Intercontinental Exchange (ICE) were voted systemic this week, and rumor has it that the council may even designate London-based LCH Clearnet as critical to the U.S. financial system." In other words, the new "too big to fail" doctrine will extend not just to U.S.- based derivative clearing houses but to their counterparts overseas -- a convenient inclusion when you consider that much of the trading in derivatives by American banks now occurs in the opaque London over-the-counter market. The highly publicized JP Morgan losses for example occurred in its London trading unit. Atlanta-based ICE alone, says Dow Jones Newswires in a separate report, carries about $914 billion of open credit default swaps (CDS) that it guarantees for the big commercial banks. The designation open is important in that it refers to positions against which there is no corresponding or off-setting trade -- a speculation as opposed to a hedge.
Such revelations beg a question: Does the United States government fully understand the level of exposure it assumes by including derivatives clearinghouses on its 'too big to fail" list?
$220 trillion in top bank derivative exposure
Four large American banks have a combined derivatives exposure of of more than $220 trillion -- that's trillion, not billion. JP Morgan leads the pack at over $70 trillion. Citibank ranks second at $52 trillion; Bank of America, third at $50 trillion; and Goldman Sachs, fourth at $44 trillion. As we found out with the recent JP Morgan debacle centering around its trading unit in London not all of these positions are hedged despite the claims to the contrary, and it is the speculative positions that are a cause for worry. Losses can mount quickly, and because the banks' positions are so huge, as is the case with JP Morgan's precarious London book, the banks have nowhere to go to unload a losing trade. In other words, once the bleeding starts, it is very difficult to stanch, and that perhaps is where the new backstop comes into play.
(Interesting graphic representation of banks' derivatives exposure)
Polling tells us that the American people are opposed to bailouts, yet here we have a vast expansion of the bailout doctrine to the dangerous, highly leveraged world of derivatives that stands as the polar opposite of the what the Volcker Rule intends. That same Wall Street Journal editorial ends with a warning: "If there's one truth we've learned about government financial backstops, it's that sooner or later they will be used. So eventually taxpayers will have to bail out one derivatives clearinghouse or another. It promises to be quite a mess."
JP Morgan as a study in derivatives exposure
Let's examine, for a moment, the derivatives situation at JP Morgan as a case in point. One of the largest and best run banks in the United States -- and one with a reputation for skilled risk management -- JPM suddenly was plunged into a state of upheaval on soured bets placed at its London trading office. At first Jamie Dimon, the bank's president, put the loss at $2 billion. It quickly went to $3 billion and now reports are filtering through the markets that it could run as high as $5 billion or more. That is the customary way with derivatives bets gone bad -- the first announced losses turn out to be no where near the final outcome.
The Financial Times reports that "The unit at the centre of JPMorgan Chase's $2 billion trading loss has built up positions totalling more than $100 billion in asset-backed securities and structured products -- the complex, risky bonds at the centre of the financial crisis in 2008." That $100 billion position is listed by the Federal Reserve as open, meaning it is a speculative trade, not a hedge as claimed by the bank -- a circumstance that opens the door to questioning what portion of the $70 trillion derivatives position is hedged and what portion is really speculative bets.
JPM has about $2.2 trillion in assets, and it has about $190 billion in shareholder equity. Certainly, when you see potential loss of $2 billion, or even $5 billion, against assets and shareholder equity that large, it seems digestible. However, when you consider that JP Morgan's full notional exposure to the derivatives' market is on the order of $70 trillion, the situation begins to take on a more ominous tone. A meager 3% loss in JPM's derivatives position would wipe out its assets; a loss of less than .3% would wipe out its shareholder equity -- and that would be interpreted by the market as catastrophic. The bank may have a "fortress balance sheet," as CEO Jamie Dimon describes it, but it manages a derivative book substantial enough to materially threaten it.
Now consider that similar problems might exist at the other banks and you get a sense about just how bad it could get. Much of that loss will roll into the clearinghouses as the banks line up to cash in on their derivatives insurance, and, once again the federal government and the Federal Reserve under a threatening cloud would be called upon to save the banks, and by doing so, keep the economy from going over a cliff.
So, what does all this mean to the gold market?
All of this, of course, circles back to the proven safety of gold as a financial hedge. If such bailouts were to occur, they would almost a certainly be underwritten by the Federal Reserve in much the same manner as the 2008-2009 bailouts. In other words, the Fed would print what the government could not raise on its own. In the end such activity, when it isn't filling some rather large holes in the financial system (and thus underwriting more moral hazard), it generally wends its way through the economy in the form of inflation or even runaway inflation.
On the other side of the coin, if the baliouts fail, the financial system implodes -- banks and brokerages close down -- and chaos ensues. In either case, you will have been well served with a few ounces of the yellow metal stashed away for safekeeping. It is troubling to say the least that nothing has been done to overturn the kind of bad behavior that got us into a fix in 2008 in the first place. The Obama administration's quiet underwriting of the bailout mentality even as it publicly endorses the Volcker rule is not just a failure in economic policy, but at its heart a moral failure as well. If in the end we have learned nothing as a society from our past travail, it may be the best argument that can be made in favor of the gold ownership as simply good defense against recurring systemic risks.
In the context of derivatives and their dangers, Sheila Bair, who formerly chaired the FDIC, told the Huffington Post, "The potential sources of shock that now confront the system are greater than we saw in 2008. I don't want to alarm people, but I don't think we have a good sense of what would happen here if there were a large banking failure in Europe. We don't have a handle on what will happen if the eurozone breaks up and there are bank runs." Bair, like Volcker believes the banks should play a more traditional role in the economy and get away from the risky trading business.
Beyond gold's utility in this respect, there is another aspect to the derivatives situation that could have a positive impact on the gold market. As more and more people inside and outside the financial business begin to understand the problem the banks have created for themselves with their uncontrolled derivatives' exposure, the pressure will mount to enforce the Volcker rule, which is aimed at separating speculative trading at the banks from normal commercial banking activity.
JP Morgan and gold derivatives
At the moment JP Morgan and Hong Kong Shanghai Bank (HSBC) are the predominant players in the gold derivatives market. Since it is impossible to know the nature and extent of their gold derivatives positions, it follows that it would be difficult to get a handle on precisely what might occur in the wake of Volcker rule implementation, which is scheduled to begin in July and phased-in over the next two years. At the same time, for a good many years the gold market has operated under the belief that the major banks are net short the gold market, although, as I say, it is difficult to prove outright. It follows then, that if they are forced to cease their activities in the derivatives markets, those short positions will need to be squared, or bought back -- a situation which could set off a major short-covering rally.
Alternatively, as some have suggested, gold derivatives trading operations could be moved out of the banks and off-shore or to special, separate hedge funds with the banks intimately involved. However, the minute that happens the bailout backstop is removed and losses will have to be claimed as losses -- unless, of course, the list of institutions "too big to fail" is made even longer. Hedge funds not under the wing of the Federal Reserve might be hard-pressed to take the short side of the gold market at a time when central banks, funds of every description (see "Institutional demand" below) and private investors are loading up on the metal in record volume. All in all, it could add up over time to a sea change in the way the gold market operates.
