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The U.S. is not vulnerable militarily. Its achilles heal is to be found in the excesses of its financial system.
--Marvin Zonis

Just What Is America’s Vulnerability – It’s Not Military

By Lincoln Y. Rathnam

With military spending around ten times as great as Russia's, the United States need not fear a direct military response to our and our allies’ bombing of Syria. The Russians would likely seek a vulnerable spot upon which to exert retaliatory pressure, but what is this area of vulnerability? 

The weakness of the US and its allies is their highly leveraged financial system, from which Russia, ironically, is insulated by the sanctions. Total nonfinancial debt in the US is approximately 350% of GDP. That is a high level, exacerbated by the fact that the US economic system is now generating negative cash flow.  (government budget deficits, growing trade deficit, net national savings rate approaching an all-time low, etc.) The buildup of debt has, however, been going on a long time and may continue awhile longer. 

The near-term trigger for a financial crisis probably lies in the derivatives market.  The BIS (Bank for International Settlements in Basle) reports that as of the end of 2017, the notional value of derivatives outstanding in the world is $542 trillion, which is about 7.8x world GDP of $80 trillion. Financial regulators are not concerned with notional amounts (the $542 trillion number), however, because the issuers of derivatives are hedged by buying offsetting derivatives issued by others.

For example, the US Comptroller of the Currency says that the top 25 commercial banks in the US have $171 trillion in notional amounts of derivatives, compared to a US GDP of $20 trillion. (Almost all this exposure is at four banks: JP Morgan, Citigroup, Goldman Sachs and Bank of America – see table below.) Their net exposure, however, is relatively trivial; they are hedged by contracts with each other and with third parties. The difficulty arises from the fact that when one of these counterparties fails to perform on a contract; it could trigger other failures, like a row of dominoes falling. When a party fails to perform on a derivatives contract, the net exposure of its counterparties is increased from the net amount towards the notional exposure because the hedge is gone. (An analogy would be the case where I owed you $11 and my sister owned me $10; my net indebtedness is $1.  If my sister can’t (or, more likely, won’t) pay me, however, my net indebtedness rises from $1 to $11.) This was almost the case with AIG’s counterparties during the crisis; default on the derivatives contracts AIG had issued was avoided only when the Federal Reserve advanced $38.7 billion to AIG in October 2008. This prevented the chain of dominos from falling.

AIG’s collapse was then only the latest in a long line of dominos. I have a 2011 report from Wintonbury Risk Management named “Financial Panics, Scandals and Failures” that lists 285 such instances beginning with the 1343 failure of the Peruzzi Bank in Florence, which was triggered by the default of King Edward III of England. Glancing over the most recent events, we are reminded how, in 1982 Drysdale Securities, a small Florida-based dealer with a $300 million government bond portfolio, mismatched and failed, threatening the collapse of the Chase Manhattan Bank, which required Fed support. (I remember well the event and how shocked we credit analysts were at the time; very few of us had even heard of Drysdale.) The Mexican Peso crisis in 1994 led to a rise in T-bill rates from 3.7% to 7.2%, wreaking global havoc. Barings Bank failed in 1995 due to speculation in Japanese securities by its Singapore-based trader Nick Leeson and the Bank of England was obliged to intervene. Long Term Management failed in 1998 and the Fed had to intervene. Bear Stearns was seized in 2007.

What do these dominoes have in common? None is the first place one would look for a systemic problem, and yet each small failure brought the mighty to their knees and shook the global system.

What would again set the dominos in motion? In 2008, the effective demise of AIG resulted from its issuance of credit guarantees on mortgage pools (credit default swaps - CDS), without hedging themselves. (They were an insurance company after all, and insurance companies take on such risks, although in this case they clearly did not understand their magnitude.) By taking this unhedged risk, they received cash payments with no investment on their part. This seemed to them much better than buying a bond to get cash flow. They simply provided their written promise and received payments. Free money.

AIG were counting on the probability that actual defaults in the portfolios they had guaranteed would be trivial compared to the proceeds from selling the guarantees. Unfortunately, the defaults were larger than the money coming in. That was bad for them, of course, but just as bad for their counterparties who would be unhedged if their hedges with AIG failed, thus triggering the fall of the domino chain. In this case, the Fed stepped in and agreed to give AIG a two-year loan of up to $85 billion ($38.7 used) in exchange for 80% ownership of AIG; the falling of dominos was averted. 

In summary, a counterparty is vulnerable (1) if it is not hedged, (2) if it is hedged with a counterparty that cannot perform on its guarantees, or (3) if its hedges fail to perform as modeled (e.g. volatility levels outside of model parameters.) Important parts of the market, besides puts and calls, include credit, interest rate, stock market, commodity and exchange rate guarantees, operating through swaps, futures, options and other exotic creations.

A novel by Andrew Capon and co-author Michael Hyman, Tournament of Shadows published in 2016, lays out a step by step account, in an exciting and well-written fictional story, describing how the US treasury bond market might be torpedoed by the Russians using a small dealer in London to push on the least stable dominos. (You can read my review on Amazon.)  And remember, the other major players each has his own domino.

With the Fed raising rates in an extraordinarily leveraged system where the strains are already appearing (U.S. corporate bankruptcies up 64% in March year-over-year according to this week’s Barron’s), this would be an unusually propitious time to give some domino a little push.

Lincoln Rathnam is a market watcher and investor. He can be reached at LincolnY@rathnam.org.

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