Credit Suisse and Nomura Holdings lost about 15% of their equity market value during the past week, due to losses in derivatives contracts with Bill Hwang’s Archegos Capital Management. Credit Suisse now trades at just $11 a share in New York; it was over $40 when I left there in 2002.
Is it time to get out of bank stocks? I don’t think so. In fact, banks are one of the few sectors that benefit when interest rates are rising in longer maturities. They borrow short and lend long, so higher long rates help them.
The Archegos disaster is atypical. It appears to be the result of second-string banks taking too much risk to keep a huge and highly profitable customer.
Ordinary folk can lever their stock positions twice, by borrowing on margin, or they can pay hard cash for options on stocks, which multiply gains and losses but at no risk to the brokers who sell them the options.
Hedge fund honchos, on the other hand, can use a variety of derivatives to pile on leverage in equity positions. These are over-the-counter – private – contracts, and they can leave brokers exposed to customer defaults.
Just how much credit risk is attached to the enormous market in derivatives? According to the Bank for International Settlements, a sort of central bank for central banks, total credit risk is $3 trillion – or almost the gross domestic product of Germany.
That risk arises from over-the-counter derivatives contracts with a market value of about $15 trillion.
The notional value of all OTC derivatives is many times greater, because most such contracts cancel each other out. That notional is an astonishing $600 trillion (right hand scale on the chart). But it isn’t what counts.
$3 trillion in credit exposure sounds like a lot, and it is, but banks globally have about $50 trillion of shareholders’ capital with which to absorb losses. Even if the Bank for International Settlements numbers are too low, the credit risk attached to derivatives can’t punch a big enough hole in bank capital.
Problems crop up, though, when a second-tier institution tries to win business from aggressive traders like Bill Hwang, who churn through vast quantities of commission-rich trades each day and pay up for derivatives that increase their leverage.
That’s the kind of client that drives trading-desk profits, and there’s enormous pressure on risk managers to minimize the risks attached to derivatives trades. The regulators require banks to run risk models in real time that estimate prospective losses under extreme scenarios. The models can be tweaked a bit, but not too much or for too long.
The moral of the story is to be choosy about banks. The largest and best-managed institutions can benefit from the steepening of the yield curve. The also-rans may take risks that they could come to regret.