Wednesday, August 25, 2010

Economics 25/8/10: Derivatives time bomb?

An interesting number popped out today from the dark depths of the past (hat tip to Ed).

With my emphasis, quoting from the article published in December 2008 by the Chartered Accountants Ireland (linked here) titled "Financial Derivitives (sic), Villian (sic) or Scapegoat" written by Grellan O'Kelly (who worked at the time in the Policy Section of the Financial Institutions and Funds Authorisation Department of the Financial Regulator):

"...when looking at the outstanding derivative positions (notional values) of our main banks as reported in their annual reports, the amounts are extremely small when compared to the total global amounts. A recent BIS survey2 on global OTC positions shows that global notional amounts come to a staggering $516 trillion. The most recent disclosures from our two main retail banks show that their gross notional exposures amount to €640 billion, only 0.17% of the total. ...noting that access to accurate data on derivative products is not always publicly available."

The article contains the usual caveat that "Any views expressed in this article are made in a personal capacity and are not intended to represent the views of the Financial Regulator." Nonetheless, it would be good to get some comment from the FR on this. After all, €640bn might be a small level of exposure to derivatives from the point of view of global banks, but for BofI and AIB to have such an exposure... is roughly 170% of the total 2009 asset base of all Irish banks combined.

For now, I cannot confirm whether this was a typo or not.

The problem is that unwinding even the straight forward swaps can be extremely costly. Buffet's unwinding of lost contracts against reinsurance claims cost Berkshire some $400mln back in 2008. In the case of interest rates swaps written against property, De Montfort University research in June 2010 has estimated that for a book of £143bn of interest rate swaps in the UK (57% of the total existing UK £250bn book of loans is estimated to be hedged by derivatives - here), the cost of unwinding these positions runs into ca £10bn.

So applying the UK estimate to our potential exposure, the cost of unwinding those €640bn in derivatives can be to the tune of €45bn.

Of course, this is just an estimate, but it gives some perspective to the numbers.

But let's ad some relative comparatives (hat tip to Conor for both):
  • Ireland accounted for 0.17% of global estimates of OTC derivatives but only 0.03% of Global GDP (based on CIA fact book and CSO data)
  • €640bn is 4.12 times our 2008 Gross Value Added (ca €155bn)

I am totally at a loss as to this figure - given its size - so any comment on its validity will be appreciated.


Peter Mathews said...

Excellent observation, Constantin.

Further examination and analysis of the Banks' positions in derivatives will be most instructive. It behoves both banks (AIB and BofI), who rely at this point totally on our State guarantee, to provide full information in regard derivatives exposure as a matter of urgent priority.

Peter Mathews


In the 2008 books for AIB, they state the total derivative holdings notional value is €218bn –
Page 191 –
At BOI they state the notional value is €334bn –
Page 139 - )

Fungus the Photo! said...

I imagine that the derivative position is already known.

I cannot see it as good news. Commercially very sensitive, it will not be released until irrelevant. Pig in a poke? Given the unfounded optimism that preceded the GFC, they can only be on the wrong side of interest swaps etc.

Destroying the bondholders might even have positive benefits if it meant the derivatives were negated. All depends on terms etc and now I find myself engaged in wishful thinking!

Vast mess.

laughingbear said...

From all the first class entries in your bog, this could pretty well be the most important to date!...

Anonymous said...

It had struck me at the time that governments initially took the stance of bailing out big finance, that the intention was to prevent a folding of the derivatives bubble - according to Tom Forenski, the extent of this bubble is 190K dollars for ever person living on the planet!!

yoganmahew said...

It is an entirely valid number.

Anglo had a peak derivative book size of 268 bn in its 2008 accounts. The number increased sharply from 2006 - 103 bn, 2007 - 180 bn

2006-2007 70% increase
2007-2008 50% increase...

In 2006 they stopped giving a breakdown of their book.

80% of the book is trading, with only about 20% held for hedging purposes.

At end 2008, AIB had 260 bn notional derivative book value on assets of 182 bn; BoI had 394 bn notional amount on assets of 194 bn.

Note that collateral posted for derivate transations is counted as interbank deposits until the derivative contract is unwound or expires.

Any downgrade of Ireland increases the requirement to post collateral (not sure whether best rating or lower of best two is taken).

Note also that the derivative section of the PWC report into the banks (remember that one?) was considered too sensitive to release...

Brought to the attention of the world by Bungaloid and jmc on thepropertypin... (some time ago, it might be said...).

TrueEconomics said...

Good one, yoganmahew.

Yes, I highlighted derivatives issue in earlier post on Nama BP2 as well and in the post on the Central Bank exposure to them via Anglo.

It seems the issue is really too explosive for the Official IRL to handle.

Thanks for great comments to all! Keep the issue alive.

yoganmahew said...

"It seems the issue is really too explosive for the Official IRL to handle."
It certainly does. I passed the figures and some of the implications to someone who used to be a prominent opposition politician a couple of years ago.

He thanked me for them and then got back to the business of party infighting.

I should have looked left for some rigour. Perhaps I will now. With 160 bn of trading IRS, Anglo could be sitting on a loss of some further 10 bn. I have always presumed that this is the gap in the immediate wind-down costs and the longer-term 'good' bank. As such, I also presume is what they are betting on is a return to a more normal interest rate environment (so that some of the swaps come back into the money).

The implications of these presumptions are shocking. If they are true, nothing has been learned and further leveraged bets are being made on uncertain outcomes. Having failed on red, chips are being stacked on black...