Enormous market
Exactly how big is the market for derivatives? The Bank for International Settlements puts the global over-the-counter market for derivatives at $110 trillion. The U.S. Comptroller of the Currency, the federal official in charge of tracking these markets in the United States, puts the notional value of derivatives held by U.S. commercial banks in insurance portfolios alone at around $50 trillion. That dwarfs the U.S. gross domestic product of $10.4 trillion. (Notional value is a figure that represents the amount used to determine the fees paid for the derivative. It isn’t a measure of value at risk, the Comptroller notes.)

Let’s look at just this U.S. part of the global portfolio because it has some important peculiarities, according to the Comptroller’s second quarter 2002 report. First, it’s highly concentrated in the hands of just a few banks: seven banks hold 96% of derivatives. One bank, J.P. Morgan Chase, accounts for $26 trillion of derivatives all by itself. Second, the vast majority of these derivatives -- 85%, or $43 trillion -- represent interest rate contracts; they are designed to protect against the risk of interest rate changes. And, third, 90% or so were individually tailored to meet the needs of specific clients with specific risks, and the terms are anything but simple or standard.

All these peculiarities are important, but let me start with concentration because that one puts the spotlight directly on J.P. Morgan Chase, the company that comes up most frequently when analysts conjure up a derivatives disaster scenario.

The J.P. Morgan Chase exposure
You’ve got to understand how important the derivatives business is to J.P. Morgan Chase today -- accounting for 15% to 40% of revenue. That’s not insignificant at a bank that issued a huge earnings warning on Sept. 18, saying that third-quarter earnings would be substantially below those for the second quarter of 2002. Anything that would threaten that revenue stream would be a big deal.

To understand what might threaten that revenue, you’ve got to understand something called counterparty risk. When a derivative is created, somebody winds up holding the risk; it’s the other party in the transaction that helped someone shed the risk. Counterparties themselves don’t hold onto all of the risk. They use more derivatives, in fact, to pass it on to other parties. Part of the science of designing a derivatives portfolio lies in putting together the pieces of the portfolio so that all the risks -- those the bank has assumed and those it has laid off on other counterparties -- net out to something close to zero under most market conditions. That leaves the bank with no risk, as far as the mathematical models can tell, and just the fees earned in passing paper around.

Now, the company that is trying to lay off risk through a derivative certainly doesn’t want to pay a fee and take on the potential risk that the counterparty won’t have the cash to pay off on the derivative. Rather than just trusting that the counterparty has built its portfolio correctly and laid off its own risk, the derivative customer looks for a counterparty with a solid credit rating. It’s therefore critical to J.P. Morgan’s revenue that its derivatives-facilitating unit retain a top-notch credit rating. Otherwise, derivatives customers will go elsewhere with their deals.

Before the earnings warning, the J.P. Morgan Chase Bank unit had a credit rating of AA-, well above the rating of most investment banks and most of the corporate customers who do business in the derivatives market.

But after the earnings warning, Standard & Poor’s cut the long-term counterparty credit rating at the unit to A+, down one grade, and the short-term rating to A1 from A1+. And Standard & Poor’s has the company on credit watch with a negative outlook for further possible credit rating downgrades.

The disaster scenario
From this, I think you can construct the disaster scenario that so scares some on Wall Street. The downgrades are enough to encourage some of J.P. Morgan’s customers to take their business elsewhere. That -- plus the other big problems at the bank that are part of the general carnage among investment banks and its portfolio of bad telecommunications loans -- takes another bite out of earnings. Which leads to a further credit rating downgrade. Which leads to more earnings declines. Which leads to more credit rating downgrades. At some point in this process, J.P. Morgan finds that it has more at risk in the derivatives market -- the bank’s actual value at risk runs in the tens of billions, according to some estimates -- than cash and … something bad happens. Whether it’s an outright failure or simply a near-failure that requires a Federal Reserve-led buyout, the event would certainly send shock waves through the financial markets

How likely is that worse-case scenario? No one really knows, but here’s my take on the odds. (Please take this with more than the usual grain of salt.)

Yes, J.P. Morgan Chase is in deep trouble. The bank’s basic strategy hasn’t worked. Its earnings are under pressure, and more credit downgrades will hurt the company’s ability to compete in all its businesses. A crisis at J.P. Morgan Chase would certainly hurt U.S. and probably global financial markets.

But the worst-case scenario that I’ve sketched above doesn’t lead to a stock market crash from current levels, in my opinion. The process that sinks J.P. Morgan Chase in that story is much too orderly and predictable to create a crash. Companies looking to hedge risk with derivatives would have time to find other counterparties to take on the business. There are alternatives to J.P. Morgan Chase and plenty of banks eager to take market share away. The worst-case scenario would be truly bad for Chase, but it wouldn’t lead to a general market collapse.

I’d argue, in fact, that this scenario would actually demonstrate that the market in derivatives works. Sure, there would be dislocations; the highly customized over-the-counter products that dominate the derivatives market can’t be effortlessly moved from one counterparty to another, but they can be moved. The flight of customers away from J.P. Morgan Chase in response to declining credit quality would actually be a rational response to clear signals.

And rational responses that affirm the orderly workings of a market aren’t what send the financial markets into a nose dive. What that takes is the irrational and unpredictable event that calls into question the very basis of a market’s operation.

That would require a very different scenario, one in which some company that was vitally depending on the insurance policy that a derivative represents gets crushed when a counterparty can’t meet its obligations. This demonstration that no one can depend on the promises of the derivatives market would be enough to call the entire derivatives market into question and send everyone scrambling for cover.

Catch-22
That leaves investors in an awkward position.

The danger that’s most obvious and most feared – a J.P. Morgan Chase “collapse” caused by its derivative business -- isn’t as dangerous as the market fears. It is, however, enough to keep financial stocks falling and to make J.P. Morgan Chase itself a very risky proposition.

And the danger that could really do the damage that is ascribed to the J.P. Morgan Chase collapse scenario can’t be either pinpointed or predicted. The kind of blowup that I believe could undermine the derivatives market to a degree that would put all the financial markets at risk has to be unforeseen to have that effect.

Catch-22, it would seem. The predictable danger isn’t as dangerous as it seems, and the unpredictable is more dangerous but can’t be avoided.

Even if we can’t predict it, that doesn’t mean we know nothing about the probabilities that it will take place. It certainly raises the odds that the derivatives market is so unregulated and that disclosure on specific derivatives is so insufficient. But I think it lowers the odds that the Federal Reserve seems to be aware of the dangers of moving unpredictably on interest rates; remember peculiarity No. 2 says that 85% of U.S. derivatives in commercial banks represent interest rate contracts. The Federal Reserve has so far very carefully telegraphed its intentions, and that lowers the risk of some unexpected blowup.

And finally, any surprise in the derivatives market would have to involve companies with enough size and visibility to call the entire market into question. No one is going to panic if Joe’s Fender and Hubcap Palace gets in trouble because the Third National Bank of East Mooseberry defaults on a derivative obligation. That doesn’t eliminate the chance of this kind of default -- this stock market has proven that big companies can do really stupid things too -- but it does reduce the number of potential players that could lead us into disaster.

Not comforting perhaps. But this isn’t exactly a comforting market now, is it?

Next column, from the gloom to the boom -- some time for the positive side. I’ll look at the probability of a seasonal rally and how to play it.

New developments on past columns