A U.S. two dollar bill is taped to the revolving door leading to the Bear Stearns global headquarters in New York...A U.S. two dollar bill is taped to the revolving door leading to the Bear Stearns global headquarters in New York March 17, 2008. JPMorgan Chase & Co said on Sunday it would buy stricken rival Bear Stearns for just $2 a share in an all-stock deal that values the U.S. investment bank at the centre of the credit crisis at about $236 million. REUTERS/Kristina Cooke (UNITED STATES)
A two-dollar bill was taped to the revolving door leading to the Bear Stearns global headquarters in New York on March 17, 2008. JPMorgan Chase had agreed to buy Bear for $2 a share the day before, a price that was subsequently revised to $10 © Reuters

At the end of January 2008, in what would turn out to be its final annual report, Bear Stearns went into some detail about its big book of derivatives. The book had a notional value of $13.4tn at the end of November, Bear said, up more than 50 per cent from a year earlier. A two-notch downgrade in the firm’s credit ratings, it added, would require it to come up with an extra $353m in collateral.

This huge cluster of financial instruments — swaps, futures, forwards and options — may not have been the main cause of Bear’s collapse, about six weeks later. The firm was stuffed with mortgage assets at a time when the housing market was sinking, and had a tiny sliver of equity to absorb losses. But the dense web of interlocking claims in the derivatives book certainly did not help, as hedge funds and other counterparties scrambled to get their money out.

Shares in Wall Street’s fifth biggest investment bank went from $62 on Monday March 10 to $30 on Friday March 14, when Moody’s — yes — announced a two-notch downgrade. Bear was sold to JPMorgan Chase for $2 a share on the Sunday, a price that was subsequently revised to $10.

“It was the definition of a run on the bank,” says Steve Abrahams, a former senior MD now running Milepost Capital Management.

Derivatives have never really gone away in the ensuing decade. The total value of the books at five of the biggest US banks has dropped about one-quarter since tougher capital rules kicked in, from 2013. Even so, there were $157tn of derivatives out there at the end of last year, according to data prepared for the FT by Aite Group, a Boston-based research firm. That’s about 12 per cent more than the amount these banks had, entering the crisis.

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At Citigroup, the derivatives book of $44tn is about 50 per cent bigger than it was back then. That should make people uncomfortable, says Javier Paz, senior analyst at Aite. “[Citi] seem to have forgotten the time when they were a buck a share,” he says, alluding to the trough in March 2009.

The banks say these huge numbers — $157tn is more than twice global GDP — do not tell the whole story. And they are right: headline figures say nothing about the counterparties, the collateral, the offsetting positions, or whether the trades are centrally cleared. (Bear’s actual credit exposure — or its “net replacement cost of derivatives contracts in a gain position”, in the jargon — was much smaller, at $12.5bn.)

It is true, too, that big banks now have much more cash and cash-like instruments on hand to meet margin calls. Citi, for example, had a total of $446bn at the end of December: enough to meet the increased collateral requirements triggered by a one-notch downgrade about 370 times over.

Danielle Romero-Apsilos, a Citi spokesperson, says: “We have seen gradual, risk-managed increases in interest rate derivatives activity over the last several years as a result of client demand and this has brought us in line with our competitors.”

Still, these huge books are worrying. At a futures-industry conference in Boca Raton this week, Tom Russo argued that contracts like these just cannot be relied upon. Mr Russo should know: as chief legal officer of Lehman Brothers for 15 years, right up until the last rites in September 2008, he found that a lot of counterparties simply refused to pay, when it came to the crunch.

In ordinary times, he says, financial markets function like bee hives: everyone working together, performing the roles expected of them. But when things start to turn and panic begins to spread, people want nothing to do with anyone beyond their very closest associates. Everyone acts independently, and in their own interests. Or to put it another way, “bees become chimps”.

Even in non-crisis situations, derivatives contracts have proven unenforceable. In the UK in the early 1990s, a court ruling voided all interest-rate swap agreements between banks and local governments. Lawmakers in Milan reached a similar verdict five years ago.

So if a bank’s counterparty baulks, claiming it was duped, or an entire class of contracts is declared illegal, is an auditor really going to say these things are worth 100 cents on the dollar?

“When you owe a little bit of money you call your banker to pay it,” says Mr Russo. “When you owe a lot of money you call your lawyer to get out of it.”

ben.mclannahan@ft.com

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