Looking through the Byzantine maze of accounting interpretations and black box calculations that compose Bank of America's latest quarterly balance sheet presentation, you get the idea that the company has increased its exposure to derivative positions in the first three quarters of 2011 by about $6 billion on the asset side. In the context of these dangerous and volatile times, knowing what happened in 2008, that may not seem like a very good thing for the bank. There was also an increase in derivative liabilities, about $4 billion, so at least most of that increase was funded in the same arena (banks always want to match risks or net them out somehow).
A $6 billion increase for a bank that has $2.219 trillion in assets seems rather trivial, however. Even looking at the derivative "exposure" in total, $79 billion, it does not appear to be anything out of the ordinary. That $79 billion cumulative position only takes up 3.5% of the entire bank's portfolio.
Moving further into the financial notes, conversely, and you begin to see just how the bank arrives at that critical $79 billion calculation. That $79 billion figure comes from a "Gross Derivative Asset" summation of total contract exposures across various derivative products: $2.172 trillion. From there, the company subtracts $2.027 trillion in "legally enforceable master netting agreements" and then further subtracts $65.6 billion of "cash collateral applied" to whittle that $2.172 trillion all the way down to the balance sheet presentation of $79 billion.
The tricky part here is the "legally enforceable master netting agreements", which essentially transforms what would be some other financial risk (interest rate risk, default risk, etc.) into counterparty risk. In other words, Bank of America gets to redefine its riskiness simply because it has a contract from someone else that says such counterparty will pay Bank of America if Bank of America gets something wrong in its calculations and ends up on the wrong side of a trade or, more likely, trades. It seems that these derivative contracts are designed for exactly this kind of risk transformation, especially since financial statements were created to measure typical financial risks. Operating outside the bounds of traditional risk measurements then, it is easy to see why derivatives are so attractive, especially in light of the real cash flows that they can produce.
By now most people are pretty well acquainted with the idea of a Shadow Banking system. It was the off-balance sheet arrangements that brought the system to near collapse in 2008, primarily consisting of securitized mortgage bonds of subprime mortgages. The financing for the Shadow Banking system was accomplished through repo deals and commercial paper. At the most basic level, these structured finance products only sought to quantify and disperse default risk.
The Shadow Banking system was really a cross between the traditional banking system and something newer and more complex. In many ways this hybrid system increasingly relied on synthetically derived exposures, so the Shadow Banking system, in historical terms, acted as a bridge between the traditional bank model and the derivative model that has largely taken up the marginal attention of the system.
The synthetic, derivative exposures at these huge banks have created brand new risks that are not even accounted for correctly. Counterparty risk is still more of an emotional consideration than financial disclosure. By allowing such a state to grow, regulators have allowed the creation and establishment of a Synthetic Banking system. Bank of America has $2.172 trillion in gross exposure, but that only measures the contract values of each individual position.
For example, an interest rate swap is in many ways a synthetic bond position. Currently the 30-year U.S. treasury swap rate is 2.77%, meaning that you agree to swap paying 2.77% in order to receive 3-month LIBOR from some financial counterparty (you would do so because you speculate that interest rates are going to be much higher over the life of the swap, and so your floating LIBOR receipts will rise much higher than the 2.77% fixed you continually pay out). These positions replicate the cash flows that you would have received by investing directly in bonds of some form (a U.S. treasury for the fixed rate receiver, or a eurodollar loan for the floating rate receiver).
At the inception of the swap, you and the counterparty specify the "notional" amount of the contract. That is, you agree how big of a synthetic bond you want to replicate. The attraction here is that these cash flows take place without ever having to come up with the full principal amount of that theoretical bond - the notional amount is simply a phantom calculation - leading to an important form of financial leverage.
In terms of accounting for this contract, Bank of America in its "Gross Derivative Asset" total only counts the contract values, disregarding the notional amount entirely. That contract value is a function of whether the particular derivative is at a profit or loss, and by how much. This is a much smaller calculation, intentionally, than accounting for the notional values. This makes some sense because neither counterparty will ever lose the full notional amount of the derivative because that notional amount simply does not exist. So a lot of the excitement about notional exposures is misplaced.
The total "notional" amount of derivatives contracts that Bank of America is involved with, on both the asset and liability side of its balance sheet, is about $74 trillion. That number means there is a lot of potential counterparty risk here, but what I believe is equally or more important is how Bank of America has transformed itself in terms of intermediation.
In the old days of boring banking (all the way back to the 1970's and 1980's), Bank of America would have had to "invest" $74 trillion into some economy somewhere, creating real credit of that amount, just to create these financial cash flows. If we look at this Synthetic Banking system as a means of avoiding the complications arising from actually having to lend out money, in some form or another, Bank of America has actively engaged in synthesizing the cash flows from $74 trillion in financial assets. These assets don't exist, only the derived cash flows do. But that means that Bank of America has dedicated resources to engaging in lending activities that never lend money to anyone in the real economy.
If the banking system as a whole performs a vital economic function, the only argument in favor of the Synthetic Banking system is price discovery. But do we need to conjure $74 trillion from nothing to discover the real price of U.S. treasury rates or U.S. equities (through futures contracts) or even U.S. dollars? Are currency trades not liquid enough that we need to have $64.6 trillion in synthetic arrangements? Anyone paying attention to markets as they operate in 2011 (and have for several years) knows that the synthetic money now drives the cash money. In other words, the futures and derivative markets lead the cash markets in a fit of the theoretical tail wagging the very real dog. That is not price discovery, it is dysfunction and disconnect.
The use of derivatives, especially interest rate and currency swaps, has exploded since the middle of the last decade. That trend has continued even recently. The Bank for International Settlements (BIS) estimates that the total notional amount of derivative contracts synthesized rose by $106 trillion in the first six months of 2011. There are estimated to be, as of June 30, 2011, about $707 trillion in notional exposures across derivative classes. Even in terms of gross market values, the BIS' equivalent of Bank of America's "Gross Derivative Asset" total, the number is still a confounding $19.5 trillion.
For a global economy that is supposed to run on credit, after all that is what central banks have been telling us that we need for a robust recovery, that is a lot of financial resources expended to not have to deal with the real world. If these derivatives did not exist and banks were unable to robustly synthesize cash flows of these immense sizes, they would be forced to lend out tens of trillions of dollars in the real world. In terms of price discovery alone, I sincerely doubt that financial firms would expend so much effort.
The massive liquidity support that central banks have been providing these past three years was done with the intent on stimulating real lending, not synthetic lending. But this is exactly the outcome that they should have expected. Financial firms, in the age of monetary supremacy, are simply systems of maximizing monetary growth. That was their usefulness to the economic plan of central bank management of the larger economy. Credit, especially credit advanced through the new investment banking model, became the marginal factor of real economic activity. Wall Street became the marginal source of the economic fudge factor that allowed the Fed to try to overcome the business cycle by smoothing out bumps with debt.
Unfortunately for us, Wall Street became very good at finding ways to achieve maximization (this is referred to as innovation, but that has a very positive connotation to it that may not be appropriate in this context). The Synthetic Banking system represents one of the "pinnacles" of financial evolution. Think about it, massive banking firms manage the cash flows of what would be $707 trillion in financial assets - a feat that outside of the dire circumstances of the current economy would be extremely impressive.
In terms of the overall financial economy, though, this impressive accomplishment means that the financial system devotes an increasing amount of time, energy and attention to matters that have nothing to do with actual intermediation in the real economy. Not only that, as with all asset bubbles, success in one area leads to increasing desires to commit more resources to that area. So as the Synthetic Banking system grew it attracted more and more "capital", or, to get around capital charges, increasingly complex and opaque ways to minimize impacts on capital ratios. These complexities are playing the primary role in generating and sustaining the negative emotions of uncertainty and fear, hampering system operations since uncertainty and fear are largely and liberally applied to unscientific estimations of that erstwhile unimportant counterparty risk.
While this is efficient in terms of bank profitability, it is inherently inefficient toward the real economy since it is essentially a siphoning of vital resources. The ages old fear of machines breaking away from their human masters to create their own civilization has been somewhat realized by a banking system that no longer exists to service the real economy. The technological innovations of finance have allowed that sector to almost completely disengage from the traditional notion of intermediation. Central banks (especially the Federal Reserve) have created trillions of dollars to plug a disastrous hole in the Shadow Banking system. In the process it appears as if they are simply blowing another asset bubble, this time in the Synthetic Banking system, much to their own consternation since this latest bubble has no real connection with the real world.
All of this contributes to narrow the margin of safety for the entire banking system since, as AIG amply demonstrated, real money collateral is needed to cover inevitable miscalculations. The potential for further strain is elevated directly by the size of "legally enforceable master netting agreements", leaving a large wake of instability since small moves and mistakes are magnified and amplified as they transmit through the trillions in synthetic positions.
The Fed likes to pat itself on the back for returning the financial system to normal functioning shape (which it obviously is not), but how much of that perceived normal functioning is synthetic? If banks are making money on interest rate and currency swaps, what incentive do they have to foster real economic growth? It is worth noting that while Bank of America's total asset portfolio was declining by $45 billion from the end of 2010 to the end of September 2011, net derivative assets on the balance sheet rose by that $6 billion I referenced above (gross derivative assets rose by $635 billion).
AIG nearly destroyed the modern financial system because it's synthetic mistakes required real solutions, real capital and money. All of these phantom activities, because they have no direct bearing on the real economy, are fairly classified as speculation. The near-destruction of the financial system because of an imbalance of speculation is not all that surprising.
But the bailout of the system afterward was supposed to restore some kind of balance between speculation and true "investment". Instead, the monetary policies of the global central bank cartel have simply allowed the previous imbalance to grow even further as the incentives to synthesize assets now so far outweigh real intermediation. Why lend to individuals or governments that exhibit far too much traditional risk when you can create the same cash flows without having to actually come up with the principal amount by swapping with Dexia or Credit Agricole?
The pyramid of money into shadow money into synthetic money has grown immense. Central banks have created an inefficient Frankenstein of a financial system that no longer can operate within the bounds of the traditional notions of intermediation and banking. There is simply not enough real credit in existence to generate the cash flows and profits banks need to maintain the capital ratios that keep the system from imploding.
If we think about the banking system in terms of being able to grow retained earnings, and thereby strengthen their weakened capital ratios, the $107 trillion increase represents obviously necessary cash flows that would be impossible without the synthetic option. Therefore, the financial system is simply unable to make enough money off the real economy in order to even survive its past episodic spasm of over-speculation, describing the scale of dysfunction as something far greater than anyone perhaps realizes.
In many ways the system is at a terminal crossroads, as it cannot function without the synthesization of so much credit, but the real economy may not be able to survive the resource drain and monetary inefficiency that this much synthesization requires. Intermediation was supposed to be a tool for the real economy. Now the real economy is nothing more than a support system for the global investment banking regime.
In bailing out the banking system, central banks have put their money on the wrong horse since banks are almost completely disconnected from their true role as a tool of the real economy. The labyrinth of complexity and intentional opacity is designed to hide this fact. Real credit is shrinking throughout the system, but synthetic credit is alive, well and flourishing. The financial system now exists to its own exclusive benefit.
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