the most recent (Q4 2008) report from the Office of the Comptroller of the Currency, which among
, discussed the $9.2 billion bank trading loss in cash and derivatives in Q4. That itself was not news to anyone who follows the major commercial banks' operations, however should make for an interesting contrast when the OCC reports Q1 results, especially in the context of the plausible scenario that
Now focusing on the other things side of the equation, there were several charts in the OCC report that caught my eye. The first relevant item is the insane propagation of derivative contracts over the past 10 years, not merely CDS, which those foaming in the mouth claim is the sign of the beast.
A little background: the OCC has five categories of derivative products: 1) interest rate , 2) foreign exchange, 3) equities, 4) commodities and, of course, 5) credit default swaps. And, yes, while CDS have grown as holdings by commercial banks from $144 billion in 1998 to $15.9 trillion in 2008, it is not this that is of interest. More notable, while the total derivatives basket has grown at an astounding rate, from $33 trillion to over $200 trillion over the same period, it is the interest rate (specifically swaps but also futures and forwards) category that is the biggest culprit here: growing from $24.8 trillion to $164.4 trillion! This represents over 80% of the total underlying derivative notional currently in existence according to the OCC (and about 10x Obama's optimistic projections for U.S. GDP).
Focusing a little more on the Interest Rate derivative category, the two critical subcategories here are the Interest Rate swaps maturing in under a year, and the IR swaps with a 1-to-5 year duration.
So what are interest rate swaps: in their simplest definition, they are merely contracts exchanging a stream of interest payments for another party's stream of cash flows. Interest rate swaps are often used by hedgers to manage their fixed or floating assets and liabilities. They can also be used by speculators to replicate unfunded bond exposures to profit from changes in interest rates. The underlying key variable is, as the name implies, the interest rate, which derives from the Fed's policy decisions and subsequent spillovers into monetary markets. As interest rates fluctuate substantially less than corporate (and even sovereign) credit risk, and, one may argue, have better predictive visibility, the notional outstanding is so staggering. Specifically (and this is an oversimplification) to generate profits on a, i.e., 0.25% move in rates, the notional outstanding has to be a huge amount.
