NEW YORK (TheStreet) -- Oh, boy. My buddy over at The Wall Street Journal busted out the security filings of the top banks today.
David Reilly wrote in Heard on the Street that "gross derivatives assets jumped 52% at
Bank of America
from the previous quarter, to $2.17 trillion. At
, they rose 47%, to $2.04 trillion. And at
, they increased 31%, to about $1.1 trillion."
OK, I get it, this is not good. If you are a bank or hedge-fund apologist, you can wax lyrically about how these hedges protect the banks' assets and make profits for greedy shareholders. I totally understand. Who shouldn't be able to buy dodgy assets, then buy insurance if they go south? Or what about making dubious loans with complex interest-rate structures? You wouldn't want a bank to be on the wrong side of a rate change, right? Sort of. I propose my question/outrage of the week.
Which derivatives actually have practical counterparty risk?
Let's break it down.
When you buy derivatives, whatever that is suppose to mean, there are two major venues.
First, you have well-established exchanges like the
Chicago Mercantile Exchange
Chicago Board of Options Exchange
that, like the New York Stock Exchange, will vouch for the other side of the bet. How can they do this? They think. Remember this year when silver prices when ballistic? The Mercantile changed the margin requirements, making people put up more money to speculate, reducing leverage and increasing the ability for people to make good on their bets.
The exchanges make their living on survival. There is clear and transparent monitoring (for Wall Street standards) of how many people are doing what, and when things get out of hand, they come to you like other Chicago organizations and let you know to either pay up or close out. I have had the honor of meeting some of the floor arbiters and you basically do what they tell you. All kidding aside, these are truly professional people who care deeply about the continuity of the markets.
The second venue isn't one at all. It resembles the U.S. bond markets where dealers just talk to each other with no central exchange, thugs (I mean that in a nice way) to enforce rules and handicappers (I mean risk-management professionals) to keep the casino going. Called the over-the-counter market, or OTC, I believe it is the root of all evil. It is essentially the difference between playing craps at the Wynn Hotel or on the street corner.
is the poster child for over-the-counter bets it couldn't pay off.
For a minute, let's attempt to be agnostic about how much and why banks have so much derivative exposure. What we need to demand of Wall Street and regulators is to classify what is covered by a traditional exchange and what is owned or obligated through back-room OTC contracts. At least the mob will break your legs if you don't pay. In our country, the government pays off your debt.
Lee Munson, CFA, CFP, is the founder and chief investment officer of Portfolio LLC, an asset-management firm based in Albuquerque, N.M. His first book, �Rigged Money: Beating Wall Street at its Own Game� (John Wiley & Sons), will be published in December. Munson is a frequent guest on CNBC�s "The Kudlow Report." His contributions have appeared in "The Wall Street Journal," "Forbes," "Smart Money," "Kiplinger�s Personal Finance," "CFA Magazine," "SeekingAlpha.com" and "TheStreet."