The top 4 commercial banks in the United States (JPMorgan Chase, Citi Bank, Goldman Sachs, and Bank of America) have an impressive $5,124,040,000,000 in assets (that is over $5.1 Trillion!). With assets like that our great leaders in Washington have been putting them through “stress tests” to makes sure our financial system remains healthy should we ever have a “Black Swan” financial crisis.
According to the latest data from the Office of the Comptroller of the Currency these 4 banks with $5.1 Trillion in assets have a staggering $194.3 Trillion in Derivatives exposure! (For those that like to see the number that is $194,339,235,000,000!). When you account for all the exposure of the top 25 banks it weighs in at over $220 Trillion.
So what is a Derivative, what does it do, and why does it matter to me? Derivatives can be very complicated, probably the one that comes to mind are all those credit default swaps the media made a big deal out of during the financial crisis. In a very simple explanation a Derivative is not an investment in anything. When you buy a stock you are purchasing ownership in the company, and when you buy a bond you are purchasing debt. However with a Derivative it is simply a bet on what will happen in the future. So with a Derivative you can “bet” on things like where the DOW will be, the price of commodities, and the value of currencies, and the future interest rates. In a nutshell, we have turned Wall Street into the biggest casino in the history of the world.
Let’s put this in numbers that may make it easier to understand. Let’s take some 5th grade math and scale this down to your household. Let’s say that your net worth of your family adds up to $510,000 when you take the equity in your house, your retirement, and all your other assets. To understand the exposure it would be like taking that $510k to Vegas and betting $1,943,000 in a casino everyday! Sure some days you would win, but some days you would lose. Not only would you lose, but you could lose almost 40 times the total wealth that you have accumulated over your total lifetime with a few poorly placed bets!
That is the thing about betting, for someone to win, someone has to lose. Granted there will be offsetting wins and losses among this $220 Trillion in “bets,” but someone is going to go home empty handed.
Jamie Dimon, the CEO of the #1 Bank and Derivative holder wrote to his shareholders…”Some things never change — there will be another crisis, and its impact will be felt by the financial market. The trigger to the next crisis will not be the same as the trigger to the last one – but there will be another crisis. Triggering events could be geopolitical (the 1973 Middle East crisis), a recession where the Fed rapidly increases interest rates (the 1980-1982 recession), a commodities price collapse (oil in the late 1980s), the commercial real estate crisis (in the early 1990s), the Asian crisis (in 1997), so-called “bubbles” (the 2000 Internet bubble and the 2008 mortgage/housing bubble), etc. While the past crises had different roots (you could spend a lot of time arguing the degree to which geopolitical, economic or purely financial factors caused each crisis), they generally had a strong effect across the financial markets.”
We are in the midst of a historic bubble with global issues around the world pointing to unsustainable financial activity. Derivatives will play a major role in the chain of events that will cause the system to unravel before we can build it back again. At the end of the day some will be big winners, some will be big losers, and some with walk away from the table with a few free drinks and a good story about how they almost won, almost lost, but was able to make it out flat. Put your hedges in now and make sure that you are on the winning side, or that you at least escape alive.