Have Derivatives Nailed Us Again?

As the stock market has plunged in recent weeks, banks stocks have often led the way into the abyss. This, in part, is because we don't know enough about the major banks.

Lack of information casts doubt on the value of a stock. Pigs in a poke sell for less than pigs out in the open. Banks, as we know from centuries of financial panics and runs, are volatile institutions that can seem healthy one day and on the verge of collapse the next. A bank's standing depends not only on its operational performance and financial condition, but also its public image. Gossip, whispers and rumors all can affect its image, and therefore its stability. Lack of information can inflame the impact of fast-moving negative news.

Europe's banks hold large quantities of troubled EU sovereign debt. The amounts are not entirely clear, but are hefty--hundreds of billions and maybe even trillions of Euros worth of dodgy debt. American banks are linked to European banks, among other ways through the settlement and clearance process for negotiable instruments, interbank loans, securities transactions, and derivatives deals. The first three exposures are pretty easily quantified. The last is not. Since most derivatives transactions are still direct, over-the-counter deals, there is no centralized venue for collecting information about many of them. No one knows if counterparty risk is concentrated in one or a few firms (a la AIG, circa 2008). No one knows if nonstandard transactions have created atypical risk profiles.

Banks often assert that they hedge their derivatives exposures. But there is no easy way to verify that. Hedges can be collateralized in whole, in part, or not at all. They can depend on creditworthy counterparties or hinky ones. They may be perfect, mirror-image hedges, or they might be approximations that don't fit any better than a used cheap suit bought in a thrift store. The Long Term Capital Management mess of 1997 resulted in part from "hedges" that turned out to be ill-fitting cheap suits.

The lack of information means that we can't tell how bad the derivatives exposures of big banks are. And that means we don't know what their stocks are worth. Hence bank stocks nose dive in times of doubt.

The Dodd-Frank legislation was supposed to cast sunlight on the derivatives market. Financial regulators are, as far as can be discerned, proceeding with perhaps some deliberate speed. The securities industry has wheeled out shiploads of lobbyists to to impede progress. Profit margins, like mushrooms, thrive in darkness. So the industry welcomes transparency as much as the Lakota welcomed Custer.

For all we know, the ghost of AIG-2008 lurks and derivatives might have done us in again. Remember that derivatives transfer risk, and an American bank doing a derivatives deal with a European bank or other firm may take on European risks as a result. Comparable risk transfer can occur if an American bank does a derivatives deal with an Asian bank that offsets its exposure by doing a mirror-image deal with a European bank. In such ways, derivatives can expand an American bank's risk profile well beyond its normal depositary and lending activities. Thus, derivatives can exacerbate the problem of too big to fail. But there's no ready way to tackle this problem, because information is lacking.

Europe's financial ministers today stopped another market rout with some talk therapy, leaking the word that they are vigorously studying the possibility of boosting the capitalization of Europe's banks. But they didn't say they had any concrete plans or proposals, just that everyone should feel good because they are concerned. The market bounced back, betting on positive rumors and gossip. But recent experience shows that bouncing balls readily fall back after going up, and the market will fall back again without something more concrete that inspires confidence. Given the darkness in the derivatives market, building confidence will be more easily said than done.