Why Another Financial Crisis Is Inevitable – Part Two

The world’s scariest story: trading in derivatives

Bad as these scandals are and vast as the money involved in them is by any normal standard, they are mere blips on the screen, compared to the risk that is still staring us in the face: the lack of transparency in derivative trading that now totals in notional amount more than $700 trillion. That is more than ten times the size of the entire world economy. Yet incredibly, we have little information about it or its implications for the financial strength of any of the big banks.

Moreover the derivatives market is steadily growing. “The total notional value, or face value, of the global derivatives market when the housing bubble popped in 2007 stood at around $500 trillion… The Over-The-Counter derivatives market alone had grown to a notional value of at least $648 trillion as of the end of 2011… the market is likely worth closer to $707 trillion and perhaps more,” writes analyst Jenny Walsh in The Paper Boat.

“The market has grown so unfathomably vast, the global economy is at risk of massive damage should even a small percentage of contracts go sour. Its size and potential influence are difficult just to comprehend, let alone assess.”

The bulk of this derivative trading is conducted by the big banks. Bankers generally assume that the likely risk of gain or loss on derivatives is much smaller than their “notional amount.” Wells Fargo for instance says the concept “is not, when viewed in isolation, a meaningful measure of the risk profile of the instruments” and “many of its derivatives offset each other”.

However as we learned in 2008, it is possible to lose a large portion of the “notional amount” of a derivatives trade if the bet goes terribly wrong, particularly if the bet is linked to other bets, resulting in losses by other organizations occurring at the same time. The ripple effects can be massive and unpredictable.

Banks don’t tell investors how much of the “notional amount” that they could lose in a worst-case scenario, nor are they required to. Even a savvy investor who reads the footnotes can only guess at what a bank’s potential risk exposure from the complicated interactions of derivatives might be. And when experts can’t assess risk, and large bets go wrong simultaneously, the whole financial system can freeze and lead to a global financial meltdown.

In 2008, governments had enough resources to avert total calamity. Today’s cash-strapped governments are in no position to cope with another massive bailout.

Wells Fargo: is this good bank “extremely safe”?

The article in The Atlantic clarifies what’s going on by exploring what’s going on inside what is arguably the safest and most conservative bank: Wells Fargo [WFC].

Last year, I had written an article about the case for considering Wells Fargo as a “a good bank”.

Wells does what banks are supposed to do: take deposits and then lend the money back out. Interest margin drives half its revenues. Fees from mortgages, investment accounts and credit cards generate the other half. ‘I couldn’t care less about league tables,’ says Wells CEO Stumpf. ‘I’m more interested in kitchen tables and conference room tables.’ By operating a bank like a bank, the article says, Stumpf has at once made Wells exceedingly profitable—for 2011 the bank’s net income jumped 28% to $15.9 billion, on $81 billion in revenue—and extremely safe. The value of Wells Fargo’s shares is now the highest of any U.S. bank: $173 billion as of early December 2012.
Wells Fargo: large scale trading in derivatives

But among the startling disclosures in the article in The Atlantic from examining the footnotes in its most recent annual report are:

The sheer volume of proprietary trading at Wells Fargo suggests that this bank is not what it seems.
A large part of that trading is not in safe conservative things like equities or bonds but in derivatives—the things that almost blew up the economy in 2008.
These derivatives are hidden under seemingly the benign headings.
The scale of this trading is breath-taking.
The benignly labeled activity “customer accommodations” has derivatives on its books with notional risk of $2 trillion. That number, assuming it is accurate, can make any particular trading loss appear minuscule.

A lower circle of financial hell: “special purpose entities” redux

Ever heard of “variable interest entities” aka VIEs? If not, you are not alone. They are phenomena that reside in what The Atlantic calls “an even lower circle of financial hell” than proprietary trading. They are basically a new label for “special-purpose entities” i.e. the infamous accounting devices that Enron employed to hide its debts. These deals were called ‘off-balance-sheet’ transactions, because they did not appear on Enron’s balance sheet.

The article likens variable interest entities to “a horror film, which the special-purpose entity has been reanimated… The problem is especially worrisome at banks: every major bank has substantial positions in VIEs.”

As of the end of 2011, Wells Fargo, the “extremely safe bank”, reported “significant continuing involvement” with variable-interest entities that had total assets of about $1.5 trillion. The ‘maximum exposure to loss’ that it reports is much smaller, but still substantial: just over $60 billion, more than 40 percent of its capital reserves. The bank says the likelihood of such a loss is ‘extremely remote.’ As The Atlantic comments: “We can hope.”

Worse: “Wells Fargo… excludes some VIEs from consideration, for many of the same reasons Enron excluded its special-purpose entities: the bank says that its continuing involvement is not significant, that its investment is temporary or small, or that it did not design or operate these deals. (Wells Fargo isn’t alone; other major banks also follow this Enron-like approach to disclosure.)… The presence of VIEs on Wells Fargo’s balance sheet ‘is a signal that there is $1.5 trillion of exposure to complete unknowns.’”