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Harold Bradley, chief investment officer for the Kauffman Foundation, discusses the increase in derivatives held by commercial banks with CNBC's Maria Bartiromo and Herb Greenberg.Maria Bartiromo: Why do you think we should care much about derivatives that the banks are holding?Harold Bradley: Well, you know, I'm just sitting out here in the Midwest looking at government statistics, and the Bank for International Settlements is showing a chart that, to me, just seems so counterintuitive. When you look back at the last time they peaked in late '08 and early '09, when Ned Davis was issuing his first warnings, and he's been constant ever since, we saw about two quarters where the notional value of derivatives came down as the market was, quote, deleveraging, right? So, we're talking about the 'new normal' and saying markets are deleveraging, they're getting more transparent, we're derisking, and yet I look at this explosion in notional derivative values, and I'm thinking there's something broken. If you divide it by, say, U.S. GDP or divide it by U.S. credit markets, or you divide it by market cap, on all three scores, we have far more derivatives exposure today than we did two years ago. And I think that's the reason that I would be concerned about what this is telling us about the risks that banks are taking in a nominal zero interest rate environment.Herb Greenberg: I'm very curious on one issue here. Harold, these are all supposed to net to zero. That's what we're told, not to worry because everything's going to revert back to zero.Bradley: Well, I think we did that in '08, didn't we Herb? Didn't we revert back to zero as we settled all this stuff out?Bartiromo: Oh, we sure did.Bradley: So, when people are coming out of trades that they have on -- again, this is like the flash crash report, right? We assume there's an arbitrage. We assume that everybody's rational in the unwind. And what I'm really worried about is that when you see this increase...and let me ask this question...I was worried then because of the exposure to CDS and the enormous securitization market that people were worried about. It's gone. It vaporized.Bartiromo: But what about the reg reform? Herb, what has the reg reform done, new regulation to actually limit or make these derivatives much more transparent, which is all we heard about when reg reform was pushed through, that this was going to be a real transparent market. What happened?Greenberg: Well, we don't know what's happened Maria because we haven't seen what's going to happen next. We only know what we're told, that everything's going to be fine, and we've got it under control. Meanwhile, we see these derivatives held for trade at banks certainly ballooning, and I suspect if I were to talk to the people at the banks, they'd say, 'Just don't worry kid. Everything's OK.'Bartiromo: And Harold, how is it possible that we got back in this position given the fact that it was derivatives that blew up and all the swaps that plummeted in value on the banks' balance sheets to begin with?Bradley: Well, I find it more interesting...I think there are some bigger systematic risk issues at play. For instance, large institutions are using, I think, futures and ETFs -- and it was in the flash crash report -- to hedge, quote, their portfolio risks, right? Everybody is a hedger right now, and, so, as we have more and more players, what never showed up in the report [was] the term "portfolio insurance." I lived through the crash in '87. I was on the trading floor at the Kansas City Board of Trade trying to hedge my position in Chicago. It wasn't there. And that's what we just lived through. This was portfolio insurance, and because of the use of swaps and derivatives upstairs -- I use them. I also use hedge funds to manage our money. I understand the opportunities. I just think that these risks look terrifying to me on that chart.
Posted on October 6, 2010
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