The Eurodollar’s Soul; Part 2

From Alhambra Investment Partners, by Jeffrey P. Snider

Part 1 is here.

The story of the asset bubbles is one of eurodollars alone. We can tell so much of the history of the past few decades by examining its pieces. The primary component has been derivatives, these financial instruments that are largely misunderstood shrouded often by what can appear to be incomprehensible complexity. That their own purveyors more often than not fall under that category explains a lot about the dizzying heights the eurodollar system achieved, and now its unending global economic drag. Combined with visible ignorance and arrogance on the part of policymakers, the whole story is neatly documented on both sides of the permanent crisis divide.

In September 2014, much of the mainstream was sublimely confident that the cusp of recovery was no longer some theoretical condition. It was truly believed at hand, in no small part because that was what everyone was saying, including all the right people. Among them were banks that outwardly were at least as cautiously optimistic as Fed officials. Some banks, however, were more than that. The chief example was Deutsche Bank, but that institution was not alone.

Citigroup was in an unusual position at that time. In the US, it had received the largest bailout by far, appreciating in late 2008 $45 billion in direct government investment along with more than $300 billion in asset guarantees just to keep the bank afloat to see 2009. From almost the moment of its public sector rescue, it alone among American banks started to bet heavily again, at least in terms of its derivative book.

According to call reports filed with the Office of Comptroller of the Currency (OCC), the sum of all its derivatives contracts had declined to a low point of $29.6 trillion (gross notionals) in Q1 2009 – the moment of the government’s deepest involvement. That was down 21% from a peak of $37.7 trillion in Q1 2008, the usual apex we find around Bear Stearns’ liquidity stumble into a troubling merger.

By the time of the 2011 crisis, Citi had far surpassed that level betting heavily, it seems, on the success of QE1 and then QE2 to the lead the world and the global money system back to its pre-crisis glory. Despite the setback in the summer of 2011, the bank’s activities continued to surge so that by September 2014, under the auspices of QE3, Citi had actually taken the derivative crown from JP Morgan.

It was simply the case of one bank seeing opportunity at the expense of another. JPM had always been the big kid on the derivatives block, due in no small part to its position in the dealer network as its central axis (from triparty repo to clearing activities to funding clearinghouse). In September 2014, a Citi spokesman claimed that the bank’s rise was merely due to demand it was realizing from its customers.

We have seen gradual, risk-managed increases in interest-rate derivative activity over the last five years as a result of client demand, which has brought us in line with our competitors.

Earlier in the year, the bank had reported using an exemption to the Volcker Rule so as to do some prop trading in MBS in large chunks. They may have described it as client related flow and “gradual”, but you can already see that there was much more than that. Citi was betting on Bernanke, now Yellen, in a big, big way.

What happened next was all-too-predictable, as the history of the eurodollar is uniformly one that ends in contraction. The idea that risks can be so low and the opportunity, in this case more so to take business and market share from competitors, so great always ends badly. The OCC records that Citi’s derivative book peaked at $70 trillion in Q3 2014 just as the “rising dollar” was getting started. By Q4 2015, heading into the worst of it, Citi’s notional total had collapsed to just $46.4 trillion. By February 2016, Citi’s stock was trading at a 34% discount to its tangible book value, as investors began to wonder what was really going on across the bank’s balance sheet.

In that one respect, Citi’s spokesman was right at least going forward. The firm’s derivative book from that point on was almost perfectly in line with its chief competitor JP Morgan; just not in the direction all that risk-taking talk might have had you believe in late 2014.

It is not just a microcosm of the “rising dollar” so much as it completes essentially the crisis circuit to this point. There are in the US domestically four banks responsible for 90% of derivative capacity, meaning the kind of eurodollar internals that make it all go – or don’t go. Citigroup figured it out at the end of 2014 while JPM, as you can see above, arrived at the same conclusion far earlier, all the way back in 2007 (as an aside, you can from JPM’s perspective appreciate why they might have treated Bear, Lehman, and AIG so harshly due to the risks embedded in that position of central dealer).

The other two of the Big 4 derivatives dealers staggered to the same position, too. Bank of America, a bank with a huge derivative book long before it absorbed Merrill Lynch, saw its derivative book peak unsurprisingly in Q3 2011 at $55.1 trillion. It has in the five years since been cut back to merely $$21.4 trillion, an absolutely astounding reversal.

The last, Goldman Sachs (its reports don’t appear in the OCC data until 2008 when it was reclassified as a commercial bank so as to be able to receive liquidity assistance from the Fed if it ever got that far), was more like Citigroup if more restrained in its enthusiasm. The events of 2011 gave the bank pause in its risk-taking dealer activities, but it clearly did believe in QE3 that brought its book up to a peak in the middle of 2014.

You can really begin to understand why the “rising dollar” was such a serious event that at root had nothing to do with the exchange value of the dollar. After the 2008 panic, the biggest dealer, JPM, was out; after 2011, BofA joined JPM; by the start of 2015, none of the Big 4 dealers was taking any additional risk. All four had by that point synchronized their withdrawal and retreat, taking away the last possible path back to a pre-2007 state of growth.

These major differences in only timing demonstrate pretty clearly that regulations are not the driving force behind this behavior. Why would Citigroup continue its expansion, joined partway by Goldman Sachs, if Basel 3’s LCR, for example, was to blame since it applied to each and every bank? All three inflection points, 2008, 2011, and 2014-15, correspond with monetary not regulatory events. What is being shown are various stages of idiosyncratic liquidity preferences, only in this case liquidity is defined by the ultimate form of it under the eurodollar system – balance sheet capacity. For each bank, the unraveling of recovery into depression is not universally accepted, instead over time after successive emergencies has it finally become so.

The defining characteristic is as it has always been, meaning risk vs. reward. In the post-crisis era, the latter has been squeezed and diminished to the point that very little of it remains, leaving asymmetry toward only risk as that sole basis. It is an enormous drag on the global economy, just as monetary issues always have been. In fact, it is practically textbook in its application and nature; it only departs from it in how we define “money” in this 21st century case.

Derivatives are central to the modern wholesale monetary system, and the total of gross notional balance sheet coverage is a very important window into the heart of the system. It tells us a lot about what’s going on in places that can’t otherwise be observed, at least not so directly. Derivative books are risk-taking behavior, and the shrinking of them delivers further striking evidence of global monetary problems that have proved so far intractable because they speak to the very basis of what eurodollars were supposed to be (risk vs. reward).

It is a core example of liquidity preferences expressed by balance sheet behavior, the vital element of the system that cannot be fixed by QE’s, macroprudential rules, or any other monetary designs that remain stuck in the 1950’s. It isn’t even subject to modernization, meaning that even if the Fed were to finally realize the results of what Alan Greenspan was hinting at all throughout the 1990’s it wouldn’t make any difference. The change in dealer behavior is irreparable at this point, and the few who realize that and its implications seem to be banking (pun intended) on non-banks to simply take their place.

The result is now what it has consistently been since the moment on August 9, 2007, when the whole thing broke; the tightening monetary noose on the neck of the global economy. In the domestic case of derivatives, it has been that way as one bank drops out followed by the next and then the next, leaving only the pocket change of smaller players to occasionally fade in and out – like the remnants of First Union in the form of a beleaguered Wells Fargo. The system is shattered and we have here a great deal of evidence as to why.



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