There are over $640,442,000,000,000USD (yes, that’s $640 Trillion) in derivatives outstanding (notional value) as of the most recent numbers of the Bank of International Settlements. Where are they? Who holds them? And who is receiving margin calls given the recent extraordinary market events and record volatility?
To put it in perspective, the massive $2 Trillion-dollar stimulus plan in the U.S. is only 0.3% of the derivatives market, close to a rounding error.
As the COVID-19 crisis has deepened, many have considered the impact on the economy. But there is a larger set of dominos to consider, and we cannot see all the pieces right now.
The Cascade:
- Workers are sick or feel getting sick and stay home;
- A renter fails to pay their rent because their business or work is shuttered;
- The Landlord is unable to pay their mortgage or loan;
- This impacts REITs and other real estate investors;
- Real estate impacts the larger bond and fixed income market;
- And corporate loans made by banks are impacted;
- Suddenly. we have an expanding financial crisis that has ensnared the banking system with non-performing loans and other exposures.
But more importantly we are missing an important link to the financial markets: derivatives. Derivatives can amplify (or reduce) the economic damage.
Suddenly, we recall the cascade of defaults from 2008–2009. The distress of mortgages lead to the distress of mortgage-backed securities (MBS) which, in turn, impacted investment banks and commercial banks, and ultimately lead to the bankruptcy of Lehman Brothers.
Lehman Brothers was a storied, but smaller investment bank, albeit a major one, which held a variety of risky investments. The banks investments turned bad, and a run on Lehman by its creditors and counterparties pushed the highly levered firm into bankruptcy in New York. This unexpectedly triggered a cascade of bankruptcies in London and around the world.
But Lehman Brothers had a secret. It was not widely known that Lehman had a very large derivatives book. In fact, it was approximately $35 Trillion USD in notional value. This was more than ten times the derivatives book of Bear Stearns, the investment bank which was acquired in March 2008 with financing from the Fed. Once the market figured out the size of Lehman’s derivatives book, the race was on to find out who was in trouble. Luckily, Lehman, a highly levered investment bank, which was holding billions in distressed real estate, mortgages, structured products and other asset-backed securities, did not have massive losses from its derivative book, as it had managed it quite well. Lehman sought to have its derivative contracts enforced later when they were in the money, albeit unsuccessfully. Other parties appeared to owe Lehman huge sums from these derivative positions. However, the contracts were voided in the Lehman bankruptcy and Lehman could not collect.
The very size of the derivatives portfolio and the unknown counterparties and exposures created uncertainty at a time when Lehman needed to show transparency and security. And like a self-fulfilling prophecy, when an entity appears to be heading into distress, its creditors may push you them into distress. They make it happen with prudent risk management. It is not intentional, but distressed creditors act like a heard of gazelle avoiding a predator. Fear makes them move as one. This herd mentality pushes creditors and trading partners to de-risk, and pull back, cut ties and cease trading. This is a death knell for a financial trading firm. You can understand trading partners wanting to de-risk. Why would you take the chance on a struggling firm when the implications could be deadly for your own business?
Today we have a slightly different issue. The market volatility in oil, currencies, interest rates and a host of other economic indicators are all the subject (or “underlyings”) of the massive OTC derivatives markets. The change in value of an underlying can turn and asset into a liability and vice versa. The OTC derivatives market operates largely silently to allow sophisticated traders for governments, financial institutions and investment managers to trade risks and assets. Silent, that is, until there is a problem. When there is a problem, everyone tries to understand these strange derivatives and the daisy chain of linkages between parties all over the world. This problem is not without precedent.
In 1998, the hedge fund, Long-Term Capital Management (LTCM) had an issue with its global trading, excessive leverage, and exposure to OTC derivatives in another “unprecedented” financial crisis, the 1998 Russian default on its international debt. Ironically, the debt was in Russian rubles. All Russia had to do was print money to pay its debts. Unexpectedly, they did not print, but instead defaulted.
In 2008, investment banks, insurance companies and other firms blew up due to their exposure to credit default swaps, collateralized debt obligations (CDOs), MBS, and other structured products and derivatives. The initial spark of a small investment bank failure triggered a set of events that nearly toppled the global financial system. As Hank Paulson described in detail in his excellent retrospective book, the global financial system was “On the brink”. Derivatives played an important role in that story in spreading the impact globally and creating additional uncertainty in the market.
Today we likely have yet another derivatives problem. In derivatives trades, there are certain dates that are important for payments between parties. The end of the month or the end of a quarter tend to be payment dates. Thus, amounts owing on derivatives can build until these dates, when the bill becomes due. March 31st is this kind of date. It is not clear who is offside their derivatives trades, but we know that many corporations, firms, banks, asset managers or governments are likely receiving margin calls now. The question in who, where and how much? We will likely find out in short order who has a problem or a major set of problems. This problem may be the hidden domino which turns the COVID-19 health crisis into a full-blown financial crisis.
The problem is that the OTC derivatives market is currently invisible to us. For how long this problem remains unseen is anyone’s guess. However, it is likely that sometime soon., we will find out where the derivatives are. who is holding them, and how much is owed. Let’s hope this is not the invisible domino that spreads our horrific health and humanitarian crisis into yet another global financial or sovereign crisis.