Of the many issues that I have been warning about concerning banks, their balance sheets and the risks that they take, one of the (and there are a few) most underappreciated is the currency risk of the "mother of all carry trades". See Roubini Not Alone in Fearing Dollar Carry Trade and Roubini Sees `Huge' Asset Bubbles Growing in `Mother of All Carry Trades'.
Investors worldwide are borrowing dollars to buy assets including equities and commodities, fueling “huge” bubbles that may spark another financial crisis, said New York University professor Nouriel Roubini.
“We have the mother of all carry trades,” Roubini, who predicted the banking crisis that spurred more than $1.6 trillion of asset writedowns and credit losses at financial companies worldwide since 2007, said via satellite to a conference in Cape Town, South Africa. “Everybody’s playing the same game and this game is becoming dangerous.”
The dollar has dropped 12 percent in the past year against a basket of six major currencies as the Federal Reserve, led by Chairman Ben S. Bernanke, cut interest rates to near zero in an effort to lift the U.S. economy out of its worst recession since the 1930s. Roubini said the dollar will eventually “bottom out” as the Fed raises borrowing costs and withdraws stimulus measures including purchases of government debt. That may force investors to reverse carry trades and “rush to the exit,” he said.
“The risk is that we are planting the seeds of the next financial crisis,” said Roubini, chairman of New York-based research and advisory service Roubini Global Economics. “This asset bubble is totally inconsistent with a weaker recovery of economic and financial fundamentals.”
As has been the case at least twice in the past, I am in agreement with the man. The amount of bubbliciousness, overvaluation and risk in the market is outrageous, particularly considering the fact that we haven't even come close to deflating the bubble from earlier this year and last year! Even more alarming is some of the largest banks in the world, and some of the most respected (and disrespected) banks are heavily leveraged into this trade one way or the other. The alleged swap hedges that these guys allegedly have will be put to the test, and put to the test relatively soon. As I have alleged in previous posts (As the markets climb on top of one big, incestuous pool of concentrated risk... ), you cannot truly hedge multi-billion risks in a closed circle of only 4 counterparties, all of whom are in the same businesses taking the same risks.
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See the following for a backgrounder on my opinion before we move on to the risks of currency volatility and interest rate swaps in the "Too Big To Fail, but Too Big to Let Survive Intact" club:
- The Fed Believes Secrecy is in Our Best Interests. Here are Some of the Secrets
- Why Doesn't the Media Take a Truly Independent, Unbiased Look at the Big Banks in the US?
- As the markets climb on top of one big, incestuous pool of concentrated risk...
- Any objective review shows that the big banks are simply too big for the safety of this country
- The ARE trying to kick the bad mortgages down the road, here's proof!
- Why hasn't anybody questioned those rosy stress test results now that the facts have played out?
- If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It?
- If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It?: Pt 2 - JP Morgan
- If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It?: Pt 3 - BAC (the bank
- If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It? Pt 4 - Wells Fargo
- If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It? Pt 5 - PNC Bank
- A Must Read: An Independent Look into JP Morgan. This contains the "public preview" document (JPM Public Excerpt of Forensic Analysis Subscription), which is free to download.
So, How are Banks Entangled in the Mother of All Carry Trades?
Trading revenues for U.S Commercial banks have witnessed robust growth since 4Q08 on back of higher (although of late declining) bid-ask spreads and fewer write-downs on investment portfolios. According to the Office of the Comptroller of the Currency, commercial banks' reported trading revenues rose to a record $5.2 bn in 2Q09, which is extreme (to say the least) compared to $1.6 bn in 2Q08 and average of $802 mn in past 8 quarters.
High dependency on Forex and interest rate contracts
Continued growth in trading revenues on back of growth in overall derivative contracts, (especially for interest rate and foreign exchange contracts) has raised doubt on the sustainability of revenues over hear at the BoomBustBlog analyst lab. According to the Office of the Comptroller of the Currency, notional amount of derivatives contracts of U.S Commercial banks grew at a CAGR of 20.5% to $203 trillion by 2Q-09 from $87.9 trillion in 2004 with interest rate contracts and foreign exchange contracts comprising a substantial 84.5% and 7.5% of total notional value of derivatives, respectively. Interest rate contracts have grown at a CAGR of 20.1% to $171.9 trillion between 4Q-04 to 2Q-09 while Forex contracts have grown at a CAGR of 13.4% to $15.2 trillion between 4Q-04 to 2Q-09.
In terms of absolute dollar exposure, JP Morgan has the largest exposure towards both Interest rate and Forex contracts with notional value of interest rate contracts at $64.6 trillion and Forex contracts at $6.2 trillion exposing itself to volatile changes in both interest rates and currency movements (non-subscribers should reference An Independent Look into JP Morgan, while subscribers should reference JPM Report (Subscription-only) Final - Professional, and JPM Forensic Report (Subscription-only) Final- Retail). However, Goldman Sachs with interest rate contracts to total assets at 318.x and Forex contracts to total assets at 11.2x has the largest relative exposure (see Goldman Sachs Q2 2009 Pre-announcement opinion, Goldman Sachs Stress Test Professional, Goldman Sachs Stress Test Retail). As subscribers can see from the afore-linked analysis, Goldman is trading at an extreme premium from a risk adjusted book value perspective.
As a result of a surge in interest rate and Forex contracts, dependency on revenues from these products has increased substantially and has in turn been a source of considerable volatility to total revenues. As of 2Q-09 combined trading revenues (cash and off balance sheet exposure) from Interest rate and Forex for JP Morgan stood at $2.4 trillion, or 9.5% of the total revenues while the same for GS and BAC (subscribers, see BAC Swap exposure_011009) stood at $(196) million and $433 million, respectively. As can be seen, Goldman's trading teams are not nearly as infallible as urban myth makes them out to be.
Although JP Morgan's exposure to interest rate contracts has declined to $64.5 trillion as of 2Q09 from $75.2 trillion as of 3Q07, trading revenues from Interest rate contracts (cash and off balance sheet position) have witnessed a significant volatility spike and have increased marginally to $1,512 in 2Q09 compared with $1,496 in 3Q07. Although JPM's Forex exposure has decreased from its peak of $8.2 trillion in 3Q08, at $3.2 trillion in 2Q09 the exposure is still is higher than 3Q07 levels. Even for Bank of America and Citi , the revenues from Interest rate and forex products have been volatile despite a moderate reduction in overall exposure. With top 5 banks having about 97% market share of the total banking industry notional amounts as of June 30, 2009, the revenues from trading activities for these banks are practically guaranteed to be highly volatile in the event of significant market disruption - a disruption aptly described by the esteemed Professor Roubini as a rush to the exit in the "Mother of All Carry Trades" as the largest macro experiment in the history of this country starts to unwind, or even if the participants in this carry trade think it is about to start to unwind.
The table below shows the trend in trading revenues from Interest rate and Forex positions for top banks in U.S.
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Banks exposure to interest rate and foreign exchange contracts
With volatility in currency markets exploding to astounding levels (with average EUR-USD volatility of 16.5% over the past year (September 2008-09) compared to 8.9% over the previous year), commercial and investment banks trading revenues are expected to remain highly unpredictable. This, coupled with huge Forex and Interest rate derivative exposure for major commercial banks, could trigger a wave of losses in the event of significant market disruptions - or a race to the exit door of this speculative carry trade. Additionally most of these Forex and Interest rate contracts are over-the-contract (OTC) contracts with 96.2% of total derivative contracts being traded as OTC. This means no central clearing, no standardization in contracts, the potential for extreme opacity in pricing, diversity in valuation as well as a dearth of liquidity when it is most needed - at the time when everyone is looking to exit. Goldman Sachs has the largest OTC traded contracts with 98.5% of its derivative contracts traded over the counter. With the 5 largest banks representing 97% of the total banking industry notional amount of derivatives and most of these contracts being traded off exchange, the effectiveness of derivatives as a hedging instrument raises serious questions since most of these banks are counterparty to one another in one very small, very tight circle (see the free article, "As the markets climb on top of one big, incestuous pool of concentrated risk... ").
The table below compares interest rate contracts and foreign exchange contracts for JPM, GS, Citi, BAC and WFC.
JP Morgan has the largest exposure in terms of notional value with $64,604 trillion of notional value of interest rate contracts and $6,977 trillion of notional value of foreign exchange contracts. In terms of actual risk exposure measured by gross derivative exposure before netting of counterparties, JP Morgan with $1,798 bn of gross derivative receivable, or 21.7x of tangible equity, has the largest gross derivative risk exposure followed by Bank of America ($1,760 bn, or 18.1x). Bank of America with $1,393 bn of gross derivatives relating to interest rate has the highest exposure towards interest rate sensitivity while JP Morgan with $154 bn of Foreign exchange contracts has the highest exposure from currency volatility. We have explored this in forensic detail for subscribers, and have offered a free preview for visitors to the blog: (JPM Public Excerpt of Forensic Analysis Subscription), which is free to download, and JPM Report (Subscription-only) Final - Professional, or JPM Forensic Report (Subscription-only) Final- Retail as well as a free blog article on BAC off balance sheet exposure If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It?: Pt 3 - BAC).
Subscribers, see WFC Research Note Sep 2009, ~ WFC Off Balance Sheet Exposure ~ WFC Investment Note 22 May 09 - Retail ~ WFC Investment Note 22 May 09 - Pro ~ Wells Fargo ABS Inventory to expound on our opinions of Wells Fargo, below.
Factors contributing to record trading revenues in 1H09
In 1H09 trading revenues were positively impacted by strong activity in interest-rate and money-market products, steep yield curves and declining short-term rates which usually help banks generate mark-to-market gains on their investment portfolio. As per the OCC 2Q2009 report, one of the major factors that contributed to record trading revenues was the changes in the value of derivatives payables and receivables. During 2Q09, following results of the stress tests for large banks, credit spreads had narrowed down sharply. The net effect of these changes to the fair values of derivatives payables and receivables, which contribute to trading revenues, had a material impact during 2Q09. In addition, the banks also benefited from wider margins (bid-ask spreads) due to lower competition and reduced risk appetite amongst existing players.
Are record Fixed Income Currency and Commodities (FICC) revenues sustainable in the long run......?
The record trading revenues reported by commercial banks were on back of low investment write-downs and higher bid ask spread. After reporting record trading revenues of $9.8 bn in 1Q09, the revenues from this segment is under pressure. In 2Q09, the trading revenues declined to $5.2 bn and further the declining trend continued in 3Q09 as well, with banks reporting further deterioration in the trading revenues growth q-o-q. For example, Goldman Sachs' (GS) trading and principal investment revenues declined by 7.0% q-o-q to $10.0 bn in 3Q09 as compared to $10.8 bn in 2Q09, while Bank of Americas' trading revenues fell 5.6% q-o-q to $1.8 bn.
If we look at the actual fundamentals for the previous quarters, specifically from Q42008 through 3Q2009, we could hardly witness any significant improvement or sign of economic recovery. Unemployment levels continue to rise, consumer spending is dismal, retail sales are declining and bankruptcies across industries are still being witnessed while CRE losses have yet to peak and we feel residential real estate losses have reached a faux peak through a combination of governmental bubble blowing and seasonality. Foreclosures and shadow inventory are building at a record pace while interest rates are as low as they can effectively get, and the main value drivers for consumption of residential real estate: availability of credit, wealth, employment, and income, have been beaten severely and are still on the downturn at a time when supply is STILL being introduced into the market at a dizzying pace in the form of foreclosures and soon to be finished construction projects tailing off from the end of the credit boom. Eighteen to 24 month construction cycles are dumping 2007 projects in our laps right about now, see - "Who are ya gonna believe, the pundits or your lying eyes?"and Who are you going to believe, the pundits or your lying eyes, part 2 . Here, a picture is worth a thousand words...
There ain't nuthin like building thousands of extra condo and apartment rental units next to empty condo/rental to be lots, as condo/rental prices plunge amid a glut of condo/rental supply - all funded by banks leveraging FDIC guaranteed consumer monies!
We may (or may not) have seen the worse, but chances are there is a lot of pain is still left. This should be witnessed in terms of higher investment write downs (than in past couple of quarters) in the coming periods and lower trading revenues which spiralled up off temporary highly favorable, yet quite unsustainable factors. The bid-ask spreads (which currently are at high levels by historical standards) have been beginning to show signs of narrowing of late. This should pull down the phenomenal growth we have witnessed in recent quarters in the trading revenues of said banking institutions.