Derivatives Market to Cause the Next Financial Crisis?
We could be on the cusp of a financial crisis. The soaring key stock indices may convince you that everything is great, but there are problems that shouldn’t be ignored.
Calls for a financial crisis are very bold, but it could be possible sooner rather than later.
Investors need to pay attention to the derivatives market. It’s a ticking time bomb that continues to be overlooked by many. It could be the source of the next financial crisis.
According to the most recent report by the Office of the Comptroller of the Currency (OCC), in total, U.S. banks had derivatives that had a notional value of $185.5 trillion at the end of the second quarter of 2017. (Source: “Quarterly Report on Bank Trading and Derivatives Activities,” Office of the Comptroller of the Currency, September 2017.)
A staggering amount of these derivatives were based on interest rates: 75.4%, or $139.8 trillion.
Here’s one more thing that must be noted: with derivatives that have a notional value of $185.5 trillion, U.S. banks have assets of just over $15.2 trillion.
In other words, for every $1.00 in assets, U.S. banks have $12.17 in derivatives.
Interest Rates Expected to Go Higher
Now digging deeper…
In case you didn’t know, interest rates are increasing.
To get some idea, just look at the chart below. It shows the yields on the U.S. two-year Treasury.
Chart courtesy of StockCharts.com
In the last one-and-a-half years, the yields on the U.S. two-year Treasury have soared over 200%. These yields currently stand at the highest level since 2008.
The long-term U.S. bonds haven’t really started to move yet, but there’s some momentum building up.
Mind you, the Federal Reserve has made it clear that it will be raising rates. By 2020, it expects the federal funds rate (FFR) to be around three percent. With U.S. economic data coming in strong, it wouldn’t be shocking if the Fed, in its upcoming meeting, raises the federal funds guidance further.
Bear in mind, as the Federal Reserve is increasing rates, we are hearing that other major central banks could follow in its footsteps. It wouldn’t be shocking if we hear news of interest rate hikes from the Bank of Canada, the Bank of England, and even the European Central Bank (ECB).
Why Does It Matter?
Remember, derivatives with a notional worth of $139.8 trillion are based on interest rates.
With interest rates increasing, one has to really question if these derivatives will remain stable.
Dear reader, derivatives are weapons of mass financial destruction. It’s just not me saying this. Legendary investor Warren Buffett said this. With derivatives, losses mount higher very quickly if they go wrong.
If you want to know a recent example of this, look up the “London Whale Trade.” A derivative trade at JPMorgan Chase & Co. (NYSE:JPM) cost the bank $6.2 billion. It wasn’t a huge bet to begin with, but it had a snowball effect.
The financial crisis of 2008–2009 was due to derivatives going haywire as well.
As interest rates move higher, the derivatives market could be really worth watching. As said earlier, it could be the source of the next financial crisis. You don’t need all the derivatives to go “bad.” Just 10% of the interest rates derivatives facing headwinds could send waves of uncertainty throughout the financial system, and suddenly, we could have a financial crisis at hand.