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Deutsche Bank is hardly a bank in the traditional sense considering their balance sheet. With $72.8 trillion euro in derivative exposure (the largest in the wor

Deutsche Bank is hardly a bank in the traditional sense considering their balance sheet. With $72.8 trillion euro in derivative exposure (the largest in the world, 21x the GDP of Germany) this will have to blow up in a spectacular fashion once one of these counterparties fail: http://imgur.com/MNECKC4.jpg http://imgur.com/MNECKC4.jpg A former Kansas Fed president called them "horribly undercapitalized", with a leverage ratio of 1.63 percent: http://www.reuters.com/article/2013/06/14/us-financial-regulation-deutsche-idUSBRE95D0X620130614 http://www.reuters.com/article/2013/06/14/us-financial-regul...

cm2187 11y ago
The notional amount doesn't tell you anything meaningful in term of risk. Say I am Deutsche, you are Citi. I trade a €1bn 10 year interest rate swap with you and then another €1bn 10 year interest rate swap with you in the opposite direction. The risk is exactly zero (the two transactions will be netted to zero in case of an insolvency) and the cash flows will perfectly offset each others. We each have €2bn of notional of derivatives outstanding. Banks like Deutsche aren't in the business of taking large directional derivative bets. They are market makers so the quasi totality of these 72 trillions are offsetting positions, which are mostly collateralised, i.e. each counterparty has to post assets to match the evolution of the value of the derivative in order to keep the credit exposure minimal. With such a massive book, there will be residual risks all over the place but 72 trillion is a meaningless number for assessing them.
- retube 11y ago
  Absolutely correct. Notional is an absolutely meaningless figure. If anything it is comparable to the total notional of derivatives ever traded: contracts are rarely torn up (1), more usually offsetting derivatives are entered into in order to cut the exposure. And anyway notional tells you nothing about the risk or exposure. 1bn of 30y is a lot riskier than a 1bn of 1y etc. 1 - End customer trades do sometimes get torn up. Also trade compression services between street counterparts also result in bulk tear-ups from time to time. But still the vast majority of trades are legacy and largely offset each other.
- PhantomGremlin 11y ago
  Well, in theory, in the example you site, "the risk is exactly zero". However, it's not always this way, because there is also gambling, err speculation, err market making, err ... Not everything is always perfectly hedged. And when it's not, there are mark to market issues. And, the market isn't always liquid. Levine is in fact writing about a market that "froze up". One of my favorite anecdotes (pg 212) from The Big Short involves Deutsche. It was perhaps embellished a bit for the book. It involved credit default swaps: In early July, Morgan Stanley received its first wake-up call. It came from ... Deutsche Bank ... the CDS (sold to) Deutsche Bank had moved in Deutsche Bank's favor Deutsche: Triple-A-rated subprime CDOs ... were now worth ... 70 cents on the dollar Morgan: Our model says they're worth ninety-five Deutsche: our model say's they're worth seventy Morgan: Well, our model says they are worth ninety-five, repeated the Morgan Stanley person Deutsche: Dude, fuck your model. I'll make you a market. They are seventy---seventy-seven. You have three choices. You can sell them back to me at seventy. You can buy some more at seventy-seven. Or you can give me my fuckimg one point two billion dollars. That's exactly what happens at just the wrong point in time when there is stress in the markets. This isn't something from ancient history, this all happened less than 10 years ago. So, while 72 trillion is indeed a "meaningless" number, quite often the "residual risks" you mention will greatly exceed the equity in the big investment banks. Notably, Deutsche has in the past been considered to be very over-leveraged. The banks smartly foisted off some of their "residual risks" onto muppets and companies like AIG, who stupidly accepted the business. But AIG wasn't liquid enough to pay off. If the Fed hadn't bailed out AIG, who then bailed out their counter-parties, the fallout would have utterly destroyed the world's financial system. As it was, we came pretty close to everything crashing down. IIRC at one point the Fed had to provide liquidity to e.g. Verizon, because the banks weren't willing to. Sheesh.
- randomname2 11y ago
  Yes, gross derivative exposure is irrelevant... until there is a breach in the counterparty chain and suddenly all net becomes gross (as in the case of the Lehman bankruptcy), such as during a financial crisis. Perhaps rather than total notational outstanding, a more meaningful number is the amount of real assets this is all backed by. According to the IMF we have $600 trillion in gross notional derivatives backed by a $600 billion in real assets, i.e. 1000x systemic leverage: http://www.imf.org/external/pubs/ft/sdn/2012/sdn1212.pdf http://www.imf.org/external/pubs/ft/sdn/2012/sdn1212.pdf One can imagine this to become just a tiny bit problematic once collateral chains start breaking, such as when "AAA-rated" AIG failed :)
  - cm2187 11y ago
    Your exposure is not the notional, it is the mark-to-market minus any collateral received or posted. This will be a small fraction of the notional.
    - randomname2 11y ago
      Well the point still stands... in case of an "event" that blows up collateral chains, Deutsche will be in big trouble. Also, interestingly, from the piece I quoted, a lot of these derivatives get to be created without any collateral being posted at all: "Another important metric is the under-collateralization of the OTC market. The Bank for International Settlements estimates that the volume of collateral supporting the OTC market is about $1.8 trillion, thus roughly only half of exposures. Assuming a collateral reuse rate between 2.5-3.0, the dedicated collateral is some $600 - $700 billion. Some counterparties (e.g., sovereigns, quasi-sovereigns, large pension funds and insurers, and AAA corporations) are often not required to post collateral. The remaining exposures will have to be collateralized when moved to CCP to avoid creating puts to the safety net. As such, there is likely to an increased demand for collateral worldwide."
      - arjunnarayan 11y ago
        > Well the point still stands... in case of an "event" that blows up collateral chains, Deutsche will be in big trouble. Not for bilateral derivatives that can always be netted, even in bankruptcy, which make up the bulk of the notional outstanding. If you read the ISDA Master Agreement[1], derivatives can always be netted as there is a provision that exempts derivatives from the usual bankruptcy automatic stays to stop literally this exact threat you posited [2]. Even beyond the bilateral case, the multilateral cases are increasingly cleared through central clearinghouses[4]. But even when they aren't, multilateral nets can still be pushed through, in one of two ways: 1) even when Lehman failed, there were some multilateral nets that greatly reduced the exposure, under mutual agreement by all creditors, and 2)The Dodd-Frank Act, since 2009, has also greatly helped this, giving the FDIC and Fed enhanced powers under the Orderly Liquidation Authority[3], which allow them to multilaterally net to reduce contagion risks even if there is no such master agreement that a priori would have let them do so[5]. [1] http://en.wikipedia.org/wiki/ISDA_Master_Agreement http://en.wikipedia.org/wiki/ISDA_Master_Agreement [2] A Dialogue on the Costs and Benefits of Automatic Stays for Derivatives and Repurchase Agreements, by Duffie and Skeel, alternatively see [3], or [4] [3]The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences by David Skeel. [4] The Risk Controllers by Peter Norman. [5] Even pre Dodd-Frank, when there wasn't a law that let this happen, usually the creditors come together and fix things, a la LTCM "bailout"[6], which was funded entirely by the creditors and unwound in an orderly fashion through multilateral netting. Bear Stearns and Lehman Brothers were the only creditors that stiffed everyone else, by refusing to participate, and that was partly why they got fucked in 2009 since the other bankers remembered their unwillingness to help out in 1998, and reciprocated. [6] I hate that this is called a Bailout. No taxpayer funds were spent. The creditors (i.e. big banks) bailed out one of their own by pooling together money and fixing their shit. The only governmental involvement was that the Fed president called the CEOs of the big banks and said "yo fix your shit before it spreads", and they did. That's not a bailout in the sense of "taxpayers bailed them out". They bailed themselves out.

cm2187 11y ago

The notional amount doesn't tell you anything meaningful in term of risk. Say I am Deutsche, you are Citi. I trade a €1bn 10 year interest rate swap with you and then another €1bn 10 year interest rate swap with you in the opposite direction. The risk is exactly zero (the two transactions will be netted to zero in case of an insolvency) and the cash flows will perfectly offset each others. We each have €2bn of notional of derivatives outstanding. Banks like Deutsche aren't in the business of taking large directional derivative bets. They are market makers so the quasi totality of these 72 trillions are offsetting positions, which are mostly collateralised, i.e. each counterparty has to post assets to match the evolution of the value of the derivative in order to keep the credit exposure minimal. With such a massive book, there will be residual risks all over the place but 72 trillion is a meaningless number for assessing them.

retube 11y ago
Absolutely correct. Notional is an absolutely meaningless figure. If anything it is comparable to the total notional of derivatives ever traded: contracts are rarely torn up (1), more usually offsetting derivatives are entered into in order to cut the exposure. And anyway notional tells you nothing about the risk or exposure. 1bn of 30y is a lot riskier than a 1bn of 1y etc. 1 - End customer trades do sometimes get torn up. Also trade compression services between street counterparts also result in bulk tear-ups from time to time. But still the vast majority of trades are legacy and largely offset each other.
PhantomGremlin 11y ago
Well, in theory, in the example you site, "the risk is exactly zero". However, it's not always this way, because there is also gambling, err speculation, err market making, err ... Not everything is always perfectly hedged. And when it's not, there are mark to market issues. And, the market isn't always liquid. Levine is in fact writing about a market that "froze up". One of my favorite anecdotes (pg 212) from The Big Short involves Deutsche. It was perhaps embellished a bit for the book. It involved credit default swaps: In early July, Morgan Stanley received its first wake-up call. It came from ... Deutsche Bank ... the CDS (sold to) Deutsche Bank had moved in Deutsche Bank's favor Deutsche: Triple-A-rated subprime CDOs ... were now worth ... 70 cents on the dollar Morgan: Our model says they're worth ninety-five Deutsche: our model say's they're worth seventy Morgan: Well, our model says they are worth ninety-five, repeated the Morgan Stanley person Deutsche: Dude, fuck your model. I'll make you a market. They are seventy---seventy-seven. You have three choices. You can sell them back to me at seventy. You can buy some more at seventy-seven. Or you can give me my fuckimg one point two billion dollars. That's exactly what happens at just the wrong point in time when there is stress in the markets. This isn't something from ancient history, this all happened less than 10 years ago. So, while 72 trillion is indeed a "meaningless" number, quite often the "residual risks" you mention will greatly exceed the equity in the big investment banks. Notably, Deutsche has in the past been considered to be very over-leveraged. The banks smartly foisted off some of their "residual risks" onto muppets and companies like AIG, who stupidly accepted the business. But AIG wasn't liquid enough to pay off. If the Fed hadn't bailed out AIG, who then bailed out their counter-parties, the fallout would have utterly destroyed the world's financial system. As it was, we came pretty close to everything crashing down. IIRC at one point the Fed had to provide liquidity to e.g. Verizon, because the banks weren't willing to. Sheesh.
randomname2 11y ago
Yes, gross derivative exposure is irrelevant... until there is a breach in the counterparty chain and suddenly all net becomes gross (as in the case of the Lehman bankruptcy), such as during a financial crisis. Perhaps rather than total notational outstanding, a more meaningful number is the amount of real assets this is all backed by. According to the IMF we have $600 trillion in gross notional derivatives backed by a $600 billion in real assets, i.e. 1000x systemic leverage: http://www.imf.org/external/pubs/ft/sdn/2012/sdn1212.pdf http://www.imf.org/external/pubs/ft/sdn/2012/sdn1212.pdf One can imagine this to become just a tiny bit problematic once collateral chains start breaking, such as when "AAA-rated" AIG failed :)
- cm2187 11y ago
  Your exposure is not the notional, it is the mark-to-market minus any collateral received or posted. This will be a small fraction of the notional.
  - randomname2 11y ago
    Well the point still stands... in case of an "event" that blows up collateral chains, Deutsche will be in big trouble. Also, interestingly, from the piece I quoted, a lot of these derivatives get to be created without any collateral being posted at all: "Another important metric is the under-collateralization of the OTC market. The Bank for International Settlements estimates that the volume of collateral supporting the OTC market is about $1.8 trillion, thus roughly only half of exposures. Assuming a collateral reuse rate between 2.5-3.0, the dedicated collateral is some $600 - $700 billion. Some counterparties (e.g., sovereigns, quasi-sovereigns, large pension funds and insurers, and AAA corporations) are often not required to post collateral. The remaining exposures will have to be collateralized when moved to CCP to avoid creating puts to the safety net. As such, there is likely to an increased demand for collateral worldwide."
    - arjunnarayan 11y ago
      > Well the point still stands... in case of an "event" that blows up collateral chains, Deutsche will be in big trouble. Not for bilateral derivatives that can always be netted, even in bankruptcy, which make up the bulk of the notional outstanding. If you read the ISDA Master Agreement[1], derivatives can always be netted as there is a provision that exempts derivatives from the usual bankruptcy automatic stays to stop literally this exact threat you posited [2]. Even beyond the bilateral case, the multilateral cases are increasingly cleared through central clearinghouses[4]. But even when they aren't, multilateral nets can still be pushed through, in one of two ways: 1) even when Lehman failed, there were some multilateral nets that greatly reduced the exposure, under mutual agreement by all creditors, and 2)The Dodd-Frank Act, since 2009, has also greatly helped this, giving the FDIC and Fed enhanced powers under the Orderly Liquidation Authority[3], which allow them to multilaterally net to reduce contagion risks even if there is no such master agreement that a priori would have let them do so[5]. [1] http://en.wikipedia.org/wiki/ISDA_Master_Agreement http://en.wikipedia.org/wiki/ISDA_Master_Agreement [2] A Dialogue on the Costs and Benefits of Automatic Stays for Derivatives and Repurchase Agreements, by Duffie and Skeel, alternatively see [3], or [4] [3]The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences by David Skeel. [4] The Risk Controllers by Peter Norman. [5] Even pre Dodd-Frank, when there wasn't a law that let this happen, usually the creditors come together and fix things, a la LTCM "bailout"[6], which was funded entirely by the creditors and unwound in an orderly fashion through multilateral netting. Bear Stearns and Lehman Brothers were the only creditors that stiffed everyone else, by refusing to participate, and that was partly why they got fucked in 2009 since the other bankers remembered their unwillingness to help out in 1998, and reciprocated. [6] I hate that this is called a Bailout. No taxpayer funds were spent. The creditors (i.e. big banks) bailed out one of their own by pooling together money and fixing their shit. The only governmental involvement was that the Fed president called the CEOs of the big banks and said "yo fix your shit before it spreads", and they did. That's not a bailout in the sense of "taxpayers bailed them out". They bailed themselves out.