In one of the threads running at the moment it was mentioned that derivatives gambling by the banks was the hidden problem.
The following was sent to me and makes interesting reading and explains a bit;
The Global Financial Crisis Explained
There is a lot of misunderstanding and confusion relating to the current world financial crisis
The main problem is massive derivative exposure
The main problem is that banks around the world, including Australian banks, have been gambling on a massive scale in derivative markets.
Derivative markets are where participants can bet on where they think a currency, exchange rate or any one of a number of markets will be at a future date.
Derivatives can be useful to hedge (or insure) where there is a risk to a bank. For example if an Australian bank borrows money from the US, in $US to use the money in Australia, it can be prudent for the borrowing Australian bank to hedge (insure) against the currency risk when the money needs to be repaid. If the $A rises in value against the $US in between borrowing and repayment, then the borrowing bank will make a windfall profit on the deal because it will not have to pay as many Australian dollars to repay the principle. Conversely, if the Australian Dollar falls in between borrowing and repayment, the borrowing bank will suffer an exchange rate loss on the deal. To remove this risk, of both a profit and loss, the bank can hedge its position in the derivatives market.
The problem is that banks around the world haven’t just been hedging (insuring) in this market. They have been gambling.
The scale of the problem
Australian Banks have a combined exposure of $13,785 Billion (or $13.785 Trillion) to derivatives and other “off balance sheet business” as at 30 June 2008. These are the most recent figures publicly available. Readers can verify these figures by getting a copy of the Reserve Bank Bulletin, September 2008, and look at Table B4, and it is the last figure on the page. The source is credited to APRA or the Australian Prudential Regulatory Authority.
This is their exposure, not their turnover.
It is unfortunate that the banks’ combined exposure has been increasing, even in the past year.
To get this figure into perspective the total shareholder equity of the banks at the same date was a mere $129 Billion (or $0.129 Trillion) The total shareholder equity in our banks is less than 1% of the banks’ combined ‘off balance sheet’ exposure.
In Australia the banks may claim that they are hedging however the size of their derivative positions dwarfs their total assets ($2T table B2) so this argument doesn’t hold water.
‘Counter party failure’If there is counter party failure (this is where the bank, hedge fund etc at the other end of the deal goes broke) of even 1% of these positions, then the whole equity of our banks is gone. The reason that governments around the world are preventing banks failing is that if one bank folds, the counter party failure will ensure the domino effect around the world causing most banks to fail. The ironic thing is that it is the banks with severe exposure that are being saved. ie the ones that have gambled the most.
Bet the wrong way
A ‘significant bet’ that goes the wrong way, that results in a loss of 1% of the total exposure, will have the same result.
Public awareness and the markets
People who know about these issues
Some senior bank people and government people certainly know about this exposure as do well-informed market traders. More and more trading people have been finding out and when they understand the problem they have been dumping shares, especially bank shares. With the exception of two articles in The Australian earlier this year, the public don’t appear to be aware of this risk to their investments. The main articles in the Australian were:
“Bomb ticking for off-balance banks” by Adele Ferguson, Monday 18 February 2008 on page 36
“Gambles in the balance” by Adele Ferguson, Week End Australian 8-9 March 2008 page 26 of the Inquirer section
Other articles have included updates since then.
Public awareness is very low
Most financial commentators have no idea of the problem. Similarly, most members of the public have no idea of the issues. It is unfortunate that many financial advisers and commentators who don’t understand the situation are advising members of the public to buy shares, especially bank shares. Some commentators are claiming that the markets are in panic and are not acting rationally. Many commentators are also advising the public to buy shares because they say the markets can’t go much lower. Some commentators also refer to yields on shares based on previous earnings, whereas astute investors realise that future earnings are going to be very different.
The market is rational
Once readers understand the above they will see that the financial markets are reacting in a rational way. The banks aren’t lending to each other because they don’t know what ‘unrealised losses’ (losses that haven’t been declared) lie within other banks and they also don’t want to get further exposure to banks that may fail if a counter party fails.
Exposure of individual banks
The public do not know which Australian banks belong to which parts of the $13.7T of exposure. The ASX should immediately suspend all bank share trading until the public knows what the exposure is of each bank and what losses lie hidden in these enormous positions. If the ASX doesn’t suspend trading in bank shares then this price sensitive information will only be known to insiders. The public needs to know this information.
How did the banks get to this position?
Essentially their mindset is that the government won’t allow the big banks to fail so the banks keep punting recklessly. If the banks bet and win, they get to keep the profits, and if they lose then the governments of the world will step in and rescue them. This is what is happening now.
How did the government let this happen?
Government regulators have been asleep at the wheel and used totally inadequate risk modelling.
Government action required
A lot of money will be wasted and opportunities lost unless the bank exposure to derivatives is quarantined.
The government must:
Force the banks to disclose their full exposure to the public
The markets get more spooked by not knowing than knowing. The public need to know the extent of the problem. There is nothing in the disclosure rules that says if the news is really bad then the public shouldn’t be told. Also, small investors are getting burnt by buying when larger investors know what the problems are and are selling to the smaller investors.
Ban banks from paying any bonuses or dividends until their exposure is known
Banks should be banned from paying bonuses and dividends until all of the losses and exposure is known. No bank should be allowed to distribute a reward to employees or shareholders until the bank can demonstrate that there are no hidden losses or exposure in their derivative positions.
Ban banks from further gambling in these markets
The banks must not be allowed to gamble in these markets. It is this gambling that got the banks into this position.
Set an orderly plan to wind back the banks’ positions
The positions must be wound back in a prompt and orderly manner and the losses realised.
Any banks found to be insolvent must have the boards and ceo removed immediately
Einstein said that you cannot solve a problem with the same thinking that caused the problem.
Any banks found to be insolvent must have shareholder value removed
Unless shareholder value is removed from any insolvent banks, governments will be effectively guaranteeing bank losses and encouraging the same risk taking that got us to this position.
Split insolvent banks in two
Insolvent banks should be split into two with the gambling side of the business made insolvent, and, the ‘borrowing and lending’ part of the bank nationalised. Unless the ‘borrowing and lending’ part of insolvent banks are nationalised, with deposits guaranteed, then depositors would lose their money and people would not put money in banks for a generation. This would not be acceptable to any country including Australia.
Only assist banks AFTER risks are known
The banks must not be assisted, except for guaranteeing deposits, until all risks and unrealised losses are known. Governments are spending many billions of dollars when the problem may be in the trillions. Any money spent on banks with huge exposure may be totally wasted and disappear without solving any problem. This is why it is vital to know what the problem is and quarantine the gambling side of the business before throwing taxpayer money at the banks. The federal government will not be able to help Australian banks if they have run up trillion dollar losses gambling derivatives because the total federal budget is only $300 Billion pa (or $0.3 Trillion)
In addition to the derivative exposure, which is the largest problem, there are some other issues that we can cover in subsequent articles including:
1. The asset bubble and implications for Australia and our banks plus how governments should be handling the situation
2. Bad loans on the books of our banks
3. The debt problem and deleveraging explained
4. Exchange rates and the rise and fall of the Australian dollar. Why it happened and consequences for Australia.
5. Why our credit squeeze didn’t happen when the rest of the western world had one and why it is happening now
6. Who is going to finish up paying for the economic problems of the world