Wall Street’s Pending $100-Trillion-Dollar Margin Call

“Run through the bond market like an elephant?” A very odd choice of words coming from a “policy maker.” Similar to flying at 35,000 feet and hearing the plane’s captain say on the PA he doesn’t want to fly into a mountain like an idiot.

Here’s a chart plotting weekly data for Barron’s Best and Intermediate Grade Bond yields going back to the 1920s. Best-grade bond yields declined to historic levels last spring, and in Barron’s last issue for November 2020, yields for intermediate-grade bonds broke below their last all-time lows of February 1946, as noted in the chart below.

C:\Users\Owner\Documents\Financial Data Excel\Bear Market Race\Long Term Market Trends\Wk 681\Chart #B   Corp Bd Ylds 100 Years.gif

Here’s a shorter term chart of these two bond yield series.  Note March 23 also marked a spike in bond yields (a crash in bond valuations). Last March most “market experts” commentated on how the FOMC action of “supporting the credit markets” benefitted the distressed stock market. But if the corporate-bond market wasn’t also crashing, would the FOMC have begun buying corporate bonds?  I think not.

C:\Users\Owner\Documents\Financial Data Excel\Bear Market Race\Long Term Market Trends\Wk 681\Chart #C   Barron's Best & Int Ylds.gif

Decades ago the big topic “market experts” discussed was OTC derivatives. The US Senate had a big public hearing on them in 1999 which was covered in full by CNBC, when then Secretary of Treasury, Robert Rubin and Fed Chairman, Alan Greenspan endorsed in glowing terms.

Apparently these marvelous financial instruments would “stabilize the financial markets by distributing market risk to those best able to bear them.” Who could be against that? They posed no risks to the public as they traded in a “private market” operated by professional money managers. Hence the OTC derivative market had no need to be regulated by the Federal Government, not with J.P. Morgan and Goldman Sachs providing leadership in this “private market.” And with these derivatives stabilizing the financial markets, the US Government could finally overturn the depression era Glass Steagall Banking Act.

This act forced Wall Street to act in a responsible manner by splitting up the banking system, in effect placing a firewall between commercial and investment banking. Banks had to commit whether their daily operations were focused on stocks and bonds, in which case the bank was classified as an investment bank and could no longer accept savings deposits from the public.  

If banks chose to take savings deposits from the public, they were classified as a commercial bank. The Glass Steagall Act allowed commercial banks to use the public’s savings only for commercial loans (prohibiting the use of the public’s savings in stock market speculations) and to function as a clearing house for settling payments between buyers and sellers in the economy.

The next time CNBC televised in full a public hearing at the US Senate was only nine years later in October 2008, when we all discovered who was best able to bear Wall Street’s market risks in the OTC derivative market: the US Treasury and Federal Reserve. And with the Glass Steagall Banking Act’s firewall removed from the banking system, the global banking system, and its payment system, was on the verge of collapse.

That was twelve years ago, and since then, these OTC derivatives haven’t gone away. In fact going to the BIS link, they now have notional value for total (global) interest-rate derivatives as of last June at $495 trillion. 

C:\Users\Owner\Documents\Financial Data Excel\Bear Market Race\Long Term Market Trends\Wk 681\Chart #D   Inter Rate Derivatives.gif

That’s a lot when considering SIFMA’s fact book reports global bond market capitalization of only $105.9 trillion as of 2019. So for every $1.00 of bond market, we have $4.66 notional dollars of derivative hedging it.  

No doubt financial institutions, such as pension funds and insurance companies are hedging their bond market risks. But apparently, most of these derivatives are being used by people who have no interest-rate risks, but wish to place off-track bets on interest rates.

Here’s a six minute clip from the movie The Big Short that will explain the role derivatives (structured finance) played in the 2007-09 sub-prime mortgage debacle that almost took the world down with them.

$495 trillion dollars in notional value for interest rate derivatives; what does that mean? To better understand the scope of “hundreds-of-trillions” it’s best to look at them in terms of astronomy. Our solar system exists within the Virgo Super Cluster of galaxies. As seen in this link, the Virgo Super Cluster is a vast array of galaxies spanning 100-million light years of space, containing only 200 trillion stars.This is less than half the notional dollars comprising the $495 trillion in interest-rate derivatives.

This is a mind boggling large number.  How can such a huge market function with little apparent impact on the rest of the economy? To see how, let’s look at one Chicago Board of Trade (CBOT) corn contract in the table below.

This futures contract is a derivative, and by definition a derivate is a financial contract whose value is derived from an underlying asset; in this case 5000 bushels of corn. This CBOT corn contract is not an OTC derivative as the corn market in Chicago is opened to the public, and every contract is a standardized contract of 5000 bushels of clean corn of a certain moisture content.

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Disclosure: None.

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