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For Banks, Derivatives Trading Remains big Business

A few disquieting things jump out in this report today from the Office of the Comptroller of the Currency on banks' derivatives trading activities.

First, the estimated value of all derivatives held by U.S. commercial banks is rising, increasing nearly 1 percent over the last quarter and 12 percent compared with the year-ago period, to $203.5 trillion (total includes interest rate, FX, credit and other derivatives).

Second, bank holdings of credit default swap (CDS) contracts remain greatly elevated. Although down from their peak in the fourth quarter of 2008, banks hold more than five times the amount in such derivatives than at the end of 2004, when the U.S. economy was starting to boom. As you'll recall, default swaps, which ostensibly insure against a potential loss, are largely responsible for crippling AIG and were implicated in the bankruptcy of Lehman Brothers.

Third, banks exposure to derivatives, while falling slightly, remains alarmingly high. Bank of America's total derivatives-related credit exposure relative to its capital is 137 percent; Citibank's is 209 percent; Goldman Sachs is at 921 percent.

Fourth -- and this is key, relating as it does to point three -- trading credit derivatives is once again "good" business. After seeing huge losses on these instruments toward the end of 2008 and into this year's first quarter, banks generated $1.9 billion in cash and derivative revenue in the second quarter. That's especially unsettling because regulators have yet to get up to speed on derivatives, and they never may given the amount of push-back from industry participants. More important, as their loan portfolios decay, banks are relying heavily on trading, including derivatives, to drive profits.

Judging from these OCC numbers, banks have decided it's safe to get back in the water. Bankers will say, as they have for years, that derivatives help financial firms manage risks. So they do. But they also help companies make money. The issue isn't whether derivatives have constructive uses, such as in hedging risk -- it's whether derivatives are more useful in generating profits. If so (and it is so), that can lead to banks acting recklessly, especially when they're under enormous pressure to boost their financial results.

A final concern relates to a golden rule of regulation: What's said is often less important that what's left unsaid. And what the OCC doesn't address in the report are some fundamental questions about derivatives.

For instance, what does it mean for a derivative to be "sound"? The biggest fallacy about these things is that they're safe. By their very nature, these instruments are enormously difficult to price because their value depends on a range of variables, such as interest rates, currency fluctuation, trading volumes and numerous other factors. The box is black, and the pools swirl darkly. Meanwhile, how are banks chiefly using derivatives -- to offset potential losses, or for speculation, sweeping risk off the balance sheet and boosting leverage?

The OCC doesn't say. And what it does say isn't reassuring. In its report, the agency seeks to deflect concerns about the risk posed by derivatives to the biggest U.S. banks with this quite remarkable statement:

Second, because the highly specialized business of structuring, trading, and managing derivatives transactions requires sophisticated tools and expertise, derivatives activity is concentrated in those institutions that have the resources needed to be able to operate this business in a safe and sound manner.
This is tautological claptrap. Derivatives are "safe and sound" because the only financial companies that specialize in trading them are "sophisticated," enabling them to determine if derivatives are safe and sound -- ergo, only sophisticated investors trade them. Worse, it's patently false. Goldman Sachs, by reputation the greatest financial sophisticate in the world, stood to lose billions of dollars on CDSs issued by AIG if U.S. taxpayers hadn't floated the insurer a $182 billion loan (click on chart below for list of banks ranked by total derivative holdings).

As the global economic crisis has shown, derivatives are at once a cause and an effect of financial instability. They are the tumor and the malignant cell. A cure, if one is to be found, starts with regulators dropping the denial and admitting that the patient has a fever.