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today dangerous derivatives and why our banks are hiding them [Applause] [Music] [Music] hello again it's Martin north from digital finance analytics world well it's a post covering finance and property news with a distinctively Australian flavor today I'm joined again by Robbie Barwick from the CEC hello Robbie hello man thanks very much to spend some time with us once again and we're going to look at a very important subject today the question of derivatives now this is something which has been bubbling around in the background for quite a few years but given the current state of the financial system around the world and the size of the derivatives pot now we think this is a very important subject absolutely the reasons come up right now is I was participated in meeting last week with John Adams and Philip Sousa from Ellerth economics with some real experts on the Australian financial system and economy and our external debt etc but these experts were frank about the fact that despite even they knew about the economy they didn't have that good a sense of even what derivatives are let alone where they fitted in with their current financial problems and so it's worth people knowing that in depth because I mean it's the scariest thing in the financial system without a doubt and it's the least understood and it's in a way super complicated but it's also super easy once you get to understand how it really works and so that's what we want to try and cover today this may be a quite a long post and it might be a bit complex in places but I think it's worth hanging in there because it is really really important for everybody to understand what derivatives are how they work and what the implicit risks are in the system which frankly nobody in the official world really wants to come to terms with or even to close disclose all right absolutely and just quickly before we begin not to go off the subject it is related because people are used to it you and I talking about glass-steagall breaking up the banks and this inquiry we've got a release on that on our website people can look at martin but effectively jane whom that we call the senate the senator for bankers position as chair of the inquiry to kill the inquiry because she insisted on can going while the election was on and now we find out she's even contest in the election herself while she's pretending to chair our inquiry however don't take this as defeat because this is going to blow back on them and we have to make it blow back on them what we're asking people to do who've DFA viewers if you made a submission call up Jane humans office and the community Secretariat and ask them to publish your submission because that's one of the things I haven't done there's a minute there's nearly a thousand submissions they've only put up thirty I'm sorry it was thirty last time who spokes now fifty foot and ask them to do that right because we're not gonna let them get away with this and it is related to this subject because of course the whole purpose that bill is to exercise this derivatives danger out of the normal banking system that I mean that's a big part of it anyway absolutely so there's a deadly embrace between the derivatives sector and the broader banking system and it's one of the biggest risk and it's the unquantifiable nature of it which is part of the issue so absolutely right okay well I think a good place to start would be to talk a little bit about what a derivative actually is because you know it gets quite complicated quickly but but let me just sort of give you my perspective so if you go back way way back right derivatives is started as essentially a way to help for example farmers in in the u.s. deal with the uncertainty about the price of the corn that they were growing so what they could do was to agree a future price at a time in the future for the delivery of their of their corn right or porkbelly's so it gave them more certainty and that's how derivatives started then what you could do is extend that slightly further and take an option on the price of the corn or the pork bellies and the option was actually a very small fee to basically take a position so you basically had a view as to where you thought a particular price was going to go in the future and what you could then do is effectively secure a particular price an option a right to something in the future so that's how it all started and it started with physical commodities but then it started to evolve into interest rates and currencies yeah and again originally it was to help companies essentially manage the future risk so you could take a view on the exchange rate or on the interest rate and you could take a particular option or one of the other derivative formulas to be able to secure a position to protect now that was all well and good but then some really smart people in the banking system started to realize that this opened the door just taking trading positions without actually needing to hold the physical as physicians right and so there was a massive acceleration and frankly a creation of many more different flavors of options and futures and swaps and other derivatives a whole bunch of different things options are options yeah to the point where now the bulk of the derivatives that are out there are not connected to nd any underlying asset or commodity they are effectively positions on positions on positions yep all right and the bulk of the derivatives in the system now are held by financial institutions who are trading these positions and making a profit or a loss depending on how the movements of exchange rates and interest rates actually go so we've moved away from something which was connected with physical commodities and actually had a reasonably good purpose to something which is now highly speculative highly tradable full of risk but it's all about turning a profit for those big financial institutions and you know that in a 5-second story is how we got to what we got - thanks professor and the view the viewers should know before we started martin informing that he taught this back in the 80s so if you want to know more contact martin that's that's great that is what it is the two aspects of what you said I want to emphasize though is even from the very first futures there's still a gamble involved right because if the farmer he bought he locks in that price if his washed out by the weather or whatever right he's he makes a loss so so there's from even the even the normal hedging derivatives the reason they call them hedging is specifically because there's there's an element of gambling involved and then what you've gone on to elaborate is what we're always concerned about every evolution every step is further and further and further away from the real economy right so they because they become completely disconnected to the underlying economy however they involve a lot of money right that gets there's 1.2 quadrillion or so some charts in a minute that's one estimate of these things globally they involve a lot of money and that money is coming from somewhere all right the actual there is real money that gets drawn out of the real economy to feed this growing bubble and that's in a bubble full of gambling debts essentially right that's what we're talking about and that's why we see a disaster you know what it's provably been a disaster and a bigger and bigger disaster is coming down the pipe and sorry it's row it's were just saying that there are courts out different ways to think about the quantum of the problem right so basically there is that the total face value of each derivative right which is effectively the amount that people have taken a bet on right and that's the big number and then of course many will claim well but that's an offsetting with another position that I've got over here so in fact the net position is it is a lot lower right and then they also say but of course if it all you know worked out then in fact the amount that I really am going to have to pay is much lower again now that is all well and good if interest rates and exchange rates stay roughly where they are but if there is any significant movement up or down in the exchange rates or interest rates then the exposure gets closer and closer towards the face value that we talked about right and so quite often you'll see that a lot of experts claim no no no the derivatives sector is really really small it's not not a problem at all right but they're actually making a whole bunch of well maybe informed maybe uninformed decisions about about the situation but the point is if the financial system starts to actually get rocky and we see significant move then the value of the exposures goes up significantly and because they're integrated into the broader banking system and and into banks it means that people's deposits and you know the rest of the banking system is absolutely caught right in the middle of potentially large losses from trading derivatives well this this became an issue in 2008 obviously that was the big time right and the the US banks and other banks around the world they were their derivatives brought them down derivatives on their mortgage securitization etc brought them down and of course then you know they were threatening to take the derivatives the deposits down with them and governments had to step in and do the bailout it was also the time Martin when from because we've we've been monitoring the derivatives of Australian banks for a long time it's the only time there was any attention in the the mass media that we saw about all what's going on Australia's banks I printed out this article from let's say November 4 2008 from The Sydney Morning Herald banks face challenge on billions of dollars of off-balance sheet exposure and and the the figures at the time total Australian banks derivatives were thirteen point eight trillion that was the the notional principal will the face value and but APRA accepted a discounted figure of the credit equivalent or whether they call it one hundred and twelve billion so there's a huge difference between the thirteen point eight trillion and one hundred and twelve billion after said now that's all that's all it matters but when Apple was questions about and it's all held off balance sheet no I want to talk about that a bit more in a minute I went out for was question about this hour I said we're not in the business of running banks we're in the business of supervising them so in other words don't ask us what it is really now in the case of the the one bank they highlighted in this at the time was Westpac which the face value was eight hundred and forty one point six billion one of their shareholders had started asking questions about this Westpac had reduced that face value to 51 billion all right so let's do a little bit over five percent credit equivalent and then using risk-weighting reduce that further 227 billion so so all on its balance sheet what was on its balance sheet was a twenty seven billion obligation that they claimed instead of the 841 billion anyway the media said I was saying well look what's happening in the states those calculations right there's this great quote here from Pauline Wallace she was a partner at PricewaterhouseCoopers an accounting expert she was starting to question this she says I've always regarded off-balance-sheet accounting as a bit of a magic trick she said magicians come to parties and they make things seem to disappear the risk is somewhere but you never knew where right and that's that's the main thing that that we need people to start understanding about these things there you know there's an enormous amount of risk as Robbie it's just just just to be gone from there at one point right so so here's the point you can hold a whole lot of this risk off the balance sheet right massive amounts right but because of the way that ball works and the other capital calculations the bit that actually appears on the balance sheet it's just the tiniest tiniest tip of the iceberg because they apply risk weights and you know they offset and they bake Mason basically mark to mark isn't all those things right so so that's that disconnect right so the bit you see in the bank's balance sheet is you know zero point or whatever it is of the real total exposures that they're actually dealing with and yet the regulator's around the world including in Australia seem to be relatively comfortable with that philosophy and approach and yet we know that if the market moves all our way then the amount of exposure that comes back onto the balance sheet is dramatically larger maybe let me make a plug here for dr. Wilson's size submission to the banking inquiry he's called it the faster fake regulation and it's on the the inquiry website it is it's also another website i'll give you the link and you can you can put it under the net we'll put it up but doctors so I worked at both APRA and ass I'll tell you what when you know what when you have someone like him prepared to say what goes on inside it's frightening and one of the I remember how blown away I was a few months ago when he told me that in the early 2000s assic formed a panel to define derivatives they worked on it so they defined derivatives for the purpose of how they should choose to regulate them they worked on it for a year and gave up right did not come up with a definition of derivatives and that's the regulator that's supposed to be making sure these things don't get out of control right so there's there's a real worry there and then let's let's just look now at the cases of derivatives disasters before I want to talk a bit about glass-steagall in 1999 and then there's Bill the following year in America to exempt derivatives from regulation called the Commodity Futures Modernization Act so let's look at the disasters before that and and and when you have an appreciation of that you see how dangerous these things can be and the the mistaken assumptions that the people who trade in them have can have right and it also means that the those bills in 1999 and 2000 in America and what's happened in Australia since is politically it's unforgivable right but the main so you'd remember you were you were there in the mid 80s when these things were started so but from about 86 onward that you know over over these over-the-counter derivatives between banks were starting to take off as opposed to the exchange-traded derivatives that the farmers use etc there was a in the early 90s there was a series of massive disaster zone so I'll just say some of them say in 1994 Gibson greeting cards suffered a twenty million dollar loss this is just a relatively you know it's a mid-sized company in America Ohio I think suffered a twenty million dollar loss on derivatives sold to a quad Bankers Trust also in 1994 Procter and Gamble big company suffered a hundred and fifty seven million dollar loss also under really was sold by Bankers Trust Bankers Trust is now Deutsche Bank right the biggest derivatives basket case in the world also 1994 and this is when people's really started paying attention was Orange County California right two billion dollar loss three thousand people unemployed this is a it's the richest county in America that's why they had so much money to invest but that this guy Robert citron was just a sucker for these mint this Merrill Lynch trader and massive losses on derivatives two billion dollars and then people go WOW what's what's happening here and then 1995 you had the first bank come down bearings Bank in the UK they tried to blame it on the lone trader in Singapore you know that they love doing that 1.3 billion dollar loss brought down you know the the oldest bank in the UK I think it was at the time within the real big one was 1997 long-term capital management right run by the smartest guys in the world Nobel Prize winners you know the the the Merton and sculls right these guys who had all the the calculations as you know on how to ahead of price options and all that the geniuses absolute geniuses and they produced the biggest derivatives lost to date 4.6 billion dollars was the loss but it wasn't just it wasn't just that hedge fund there was something like 16 Wall Street banks exposed to it they were all at risk
here was a massive crisis how do how do you stop this blowing up the financial system right at the time all in the back of this derivatives loss and of course what you can identify in that case with with um LTCM it's a good case to see how the the the assumptions can be really mistaken because as other peak as these losses mounted more people start to analyze them and see the flaws and the thinking one of the obvious flaws is that expert statisticians will point out is they're trained to ignore the outliers as possibilities right so they make these assumptions and extreme events or the Black Swan you know that that's not taken into account well in the case of LTCM that's what brought it down because Russia defaulted on its bonds massive spiking in interest rates there and all the bets that LTCM had made and they made all these little tiny bets the minutes the gazillions of them they all just cascaded into into quickly and mounting massive losses and that was all before the repeal of the glass-steagall Act in 1999 all that had happened and and Robbie just certainly threw out there I just give it my own history here right I was actually employed by national Westminster Bank in the UK to run their capital Marcus training unit yeah right because actually national Westminster Bank had a problem with blue arrow which was a another sort of similar thing right and they realized that none of their senior executives in in the bank back then understood the derivatives market right and so they decided to put all of their senior executives and the next level down which were hundreds and hundreds of people globally all through a training course to get everybody to understand what derivatives were how they worked and what the risks were because they were it was like completely closed but they had no idea as to what was going on and they had no understanding of the risks involved so I was in the middle of that right she's why I was teaching all this stuff then and it shows you the the problem that there was then and still is today but there aren't actually that many people who really have their head around this alright who really understand the way these things work and the risks in the system right and and they can be bamboozled by mathematicians who claim to have the latest and greatest math calculations and you know statistical models and all those sorts of things which is why it's not a problem etc etc right until it is a problem right because the problem is that all of these models and everything else is based on a certain set of assumptions about interest rates and exchange rates and what's going to do it right and if you then start running scenarios with changes in those interest rates you can begin to see the true implications and yet most of the models that people are running with don't do that it does use as you say they ignore the outliers they basically just assume the sort of normal course of business and of course the trouble is that occasionally it's not normal course of business right now going back to your point that was before glass-steagall was there taken away in the u.s. so there was at least some disconnection between retail banking and you know all this speculative stuff but of course that changed enough all right it did change and just before we get over that your story just said about national Westminster that's a you've had John Dyson on your show for manes at bank director he had a similar experience he was on the board and at the time same time right he's looking at these two revenues and going what are they and he's asked people to explain them to him and he admits he just is the minute he thought he had it it went out of his head etc but you know and then now there's a no there's a British economist John Kay you write a book other people's money he'd had the same experience at the same time with Halifax Bank of Scotland he was on the board and he was going what are you doing with these instruments so yes we come to 1999 the repeal of glass-steagall now if you look at the the figures for over-the-counter derivatives in America before the repeal of glass-steagall what you notice is that the biggest holders of derivatives were commercial banks JPMorgan Chase Citigroup it's at Citicorp etc now and the reason why is because in the 80s in the ear of deregulation where philosophically the whole US government I just want to deregulate everything and as an aside I'm reading William blacks at the book at the moment this way to rob a bank is to own one and and it's such a parallel that Australia today read that book if you get a chance okay in the 80s here there were two things that the bank regulator the office of the control of the currency was asked to rule on in relation to commercial banks activities one was securitization and one was derivatives because the glass-steagall Act said commercial banks cannot deal in securities they just can't and here's two forms of two new forms of securities and the oaths that they're deep the pro deregulation OCC the regulators said yet both of those things are exempt from the glass-steagall Act now so what happened by the time of the of 1999 drastic being watered down a lot that one of the effects of the repeal was the banks had already started this kind of gambling and derivatives and essentially the deposits are there to collateralize that gambling and the investment banks the standalone investment banks like Lehman Brothers like Goldman Sachs they complain because they said look they but they went to the Treasury Secretary the the Goldman Sachs guy Paulson and they said these big banks they have an unfair advantage with their derivatives gambling because they've got deposits you've got to let us increase our leverage right and so Paulson said okay all right they went from 16 to 1 to all of them well over 30 to 1 in leverage they were given permission to do that and that's where the repeal of the glass-steagall Act is was directly related to an absolute explosion and I'll show charts on this in a minute in derivatives gambling by all the banks right and later on that's what came a cropper the second event though was the next year that they passed a law called the Commodities Futures Modernization Act both of these bills were written by Phil Gramm the Texas conch Republican congressman and that's significant because Phil Gramm's wife Wendy Graham had been on the main derivatives regulator the board the Commodities Futures Trading Commission in the early 90s and as the head of that board her last act in around 94 was to exempt derivatives from regulation then she resigned and Bill Clinton put her on whether it's sorry she resigned that position and she went and joined the board of Enron let that that that moving from the derivatives regulator that she exempted from regulation to Enron was key so 2000 her husband then passes the law to exempt all derivatives effectively from regulation the next year Enron blow up a no derivatives fraud right and Nili blew the world up then in 2001 very important and so you've got these examples of with anyone working your way back of everything we've just said total totally dangerous but also an element of fraud involved so I'd like to play I my first introduction to to really getting a handle on derivatives which I recommend for layman is this book keep my books behind me let me hold it up to the screen that's in this is an excellent book Fiasco blood in the water on Wall Street so Frank Partnoy the author here was a Morgan Stanley derivatives salesman and what he does here he goes to great lengths to explain the various derivatives that they were trading in formulating and trading in right so you and he has to sometimes simplify because a lot of complex mathematics involved as you know etc but he gives a great example some are called MX missiles and all sorts of things you learn that Wall Street loves acronyms you also learned that the way they would get their traders you know sort of with a killer instinct which that would take him out to paintball events and get him shooting each other pretend to shoot each other and whatever because I wanted that killer instinct Frank Partnoy admits he quit the industry in the mid nineties because he says he was afraid of ending up in jail if it went on with what he saw and he wrote this book about it and it was ignored it was ignored so this this version came out this edition came out after 2008 and there's a foreword that basically says I told you so right it's very good but Frank Partnoy he's done he does it there's a there's a video you can see on YouTube which will link to as well though I want to play a little segment now and what he's doing he's going to show you a balance sheet and then tell you which bank is responsible for that balance sheet and this is a balance sheet leading up to the 2008 crash for the four years and you'll let him do it Frank Partnoy and this is a balance sheet it is a real balance sheet of an actual company who is it well let's look at it 2006 2007 2008 2009 we know what happened in those years company starts off strong lots of assets plenty of equity 2007 tough year still looks good rock solid too in a very tough year looks great 2009 Rock and year in the markets this is a stable company who is this do you know I'm a professor so I get to ask questions do you know who it is is this McDonald's is this a stable company that somehow survived the crisis do you know Citigroup this is the actual balance sheet of Citigroup I want to talk about off-balance sheet transactions what's not here this is a company that went from a market capitalization of a quarter trillion dollars to virtually zero this is a company that went from making tens of billions of dollars a year to losing tens of billions of dollars a year this is a company that required the government to ring-fence 306 billion dollars of its liabilities in its own off-balance-sheet transaction and that's the picture of this company according to the balance sheet what one word describes Citigroup's balance sheet I'll use a different F word fiction instead of fry the balance sheet is not a trivial document it's a document that regulator's rely on it's a document that is the source of information for tier 1 and tier 2 capital it's a document that regulations depend on it's a document that investors look to and it is a document that is a work of fiction and until financial reform takes this into account it won't work and this is an issue that's not currently part of the debate it's not on the table it hasn't been discussed much I want to try to persuade you in just a few minutes that it needs to be on the table and Lynn Turner and I have written a white paper and you can look at all the materials in there I want to try to make that case to you this is not just about Citigroup and it goes back a long time it actually goes back to before Enron there's a very good book called infectious greed which a few of you may have written that traces the history of some of this starting in the 1980s Bankers Trust Salomon Brothers Enron Bear Stearns Lehman Brothers Morgan Stanley we know that we know the story now the government of Greece and the United States has the largest off-balance transactions of all and it's not just about one bank it's about all of our major financial institutions it's also about a very large number of swaps and derivatives so this number here is to put put in context is roughly the notional value of derivatives I want to just say one thing there are a lot of media people here the industry has been pooh-poohing the use of this notional value but notional value is a common sense value that we should use to describe the size of the market if you have $100 worth of stock you say I have $100 worth of stock you don't say on a risk-adjusted basis based on var it's a normal distribution I have roughly three dollars worth of stock you say I have $100 with the stock if you made a if you borrowed $100 and you made a loan and you put that on your balance sheet you talk about $100 transaction if you do a swap it's the equivalent of that it has an asset leg and a liability leg it's economically equivalent it's a hundred dollar transaction this is the size of the derivatives market this does not appear on balance sheets now how big is six hundred trillion dollars it's a lot of zeros let me give you a metaphor here's the earth the total size of global GDP is about 660 trillion dollars there's the earth here are off balance sheet transactions represented as swaps here's the universe that we don't know about of other off-balance sheet transactions some of which we write about that are not captured in the 600 trillion dollars with it swaps fiction now the balance sheet as you saw is of Citibank the bank so here's a had a perfect balance sheet absolutely perfect balance sheet but this is the bank that was the recipient of the biggest bailout in the 2008 crisis because as partner it's it as you saw it's a fraud write this off balance sheet the Citibank proves this is off balance sheet accounting is fraudulent and therefore you've got to appreciate that when you see what we know about Australian bank derivatives so should we look at those near Martin you know I think we should bring it back to Australia because of course the global do his pie is very big but worryingly the Australian segment of the pie is also extremely exposed and we've got a small number of large players who are right in the middle of it yes so I've got a for those who've hung in this long appreciate that we've got pictures now so that's kind of that's going to make it easier so we're going to slide show here that you'll you'll all get to see but just before I give you the first one I want to I just want to make this point so the CC we're a political party and our interest is not not disgusting you know a functioning economy and over the year the over the era of neoliberalism the the concern was the whole economy not just derivatives got further and further away from the real economy and more financialized you can say right so we have an association with the late American economist Lyndon LaRouche and in 1993 his organization produced this pamphlet which is it was called tax derivatives speculation popped the financial bubble rebuild the world economy and the reason I'm highlighting this is because the same year that the Financial Review in Australia announced it was going to do he wanted to do a feature on these new products these new financial products called derivatives which no one knew anything about and they asked for submissions so we made a submission we we basically submitted this pamphlet of of how we reviewed derivatives and the Financial Review when when it produced this feature on derivatives it opened by quoting our pamphlet and the specifically it quoted was this let us imagine visitors from a solar system in a distant galaxy coming to earth on a trade mission presumably and ask oneself would they invest in the planet earth at this time after seeing the flurry of the market in derivatives I propose they would pack up and leave immediately riding earth off as an investment for perhaps at least a century to come and this is just you know these things were already unreal but at the time of writing that was about 30 trillion dollars worth of them in the world right and they just quickly got more and more out of control so let's have a look at the these charts now this is one that we that we produced in 2004 so that's why some of these are black and white and I apologize for that I've scanned them from all publications that we did so what you see there is just the really rapid growth in derivatives and that's in trillions of dollars right just this is us trillions of dollars the global picture and it's the notional values this is the gross value of of all the derivatives yep yeah and it only gets worse so you go to the next one so that is the up to date figure you can see you know that that's now stars roughly think of it as starting around the time of the repeal of glass-steagall okay right and you can see straight away this uptick in in the the growth rate and these things I imposed the GDP line there just by way of contrast and if anything that there's different there's different estimates
f what world GDP is that's one of the higher ones so you know it could even be less than that all right that the OTC derivatives definitions that the BIS is using for this chart they've actually skinned it back skin add it back right so this is probably quite a conservative picture of the true total exposure yes there's there's a there's a there's a mathematician in the United Kingdom who's a hedge fund manager and quite an expert in this he insists that the actual figure from his informed calculations I'm just looking for his name he insists it's it's at least 1.25 million dollars there are 1,200 trillion so effective it basically double what they've got here but the point is Robert if it's you know six hundred trillion or one point you know X quadrillion it's still way way way bigger than the real economy know for sure say you know what whatever is gonna put what's ever going to pay the bill on these things right alright so those are the days of the the overall let's look at some specifics near so this is the I did this back in 1997 and all you had to do was was read through the annual reports of the major banks and there was never a chart of it what you found is in the is in the footnote they would say this is what our total notional principal of derivatives are so the let me point out in this particular type of contrast of the derivatives to the assets of the bank in the equity this is all in the billions hundreds of billions compared to the the assets in the equity nothing was over a trillion dollars yet all right for this this is 1997 and of course ANZ is miles in front of say the CBA that was the Year CBA's privatization was finalized and you'll see in the next charts that the the difference that made to CBA so then if you jump to the next one so that previous one was the first derivatives chart that the CEC did to say look at the state of rivers and Australia banks now look at that difference we might I couldn't find if we produced any of that in the interim but in 2004 we produced this one again the information freely available in the footnotes of the of the annual reports but look at the difference with NAB right just so now it's broken not just broken a trillion dollars it's nearly two trillion dollars you saw my email button the what I found interesting is in that seven year period I and Zed had barely budged yeah and I and I said I asked John Dalton could this be the John Dalton effect because here's a board asking questions what are these things please explain them to me and did that have an influence in the bank saying you know we should be cautious on on these instruments because you know if it doesn't I don't know what it takes to make and cautious because there are derivatives explosions going off all over the world in this period right they must have this highly there's a good reason to be cautious that be certainly wasn't and it's worth saying that NAB of course you know around that time and a bit before expanded globally so they basically reached out to Asia to the UK and to the US so essentially they were trying at that stage to become a true global player so perhaps not surprising to see that their derivatives book exploded well that's right exploiting in two ways because you may also remember it was also around that time that NAB suffered what's probably regarded as Australia's only big derivatives loss or something like a four hundred million dollar they declared it declared four hundred million dollar loss on their derivatives my understanding is the the the nabi executive i can't remember her name at the moment someone informed me she was she's a mentor of Kelly O'Dwyer someone else pointed out that that our friend Jane him was within a be at this time anyway you got a you got a whole bunch of these nab guys in parliament now as well it's a it's proved to be a pretty disastrous Bank for its customers in many respects but this is this is you can see where its priorities lie in this chart and then the others are looking a bit more conservative by contrast but that doesn't last so have a look at this next one so what we so we produced this one in time for the because of the 2008 crisis right so we've jumped forward another four years you see NAB has it was nearly two trillion before now it's quite it's it's um well over three trillion irons dead is jumping back up Commonwealth banks a bit more cautious and I'm singling that out because I want you to see especially what happens to come off banking in the next period see so what this is what the Australian Bank derivatives are at the time of a global derivatives meltdown that's what's going on when they're when they're declared these figures right yeah if you go back to that earlier chart of from the Bank for International Settlements what you see in that chart is at this time that's when derivatives growth while the BIS figures stopped there was a plateau there was it's a full and a general plateau it's only really going above that once since why the BIS figures so globally the the incredible post repeal of glass-steagall growth that was seen came to an end in derivatives if you just go by the BS figures that's the snapshot of Australia's banks what happened in Australia after this period well so this is the next year the reason we did this say in and if I just show you the contrast there's there's not a lot of difference yet but the writ and there's NAB is gone down a bit the purpose of doing this particular chart was we wanted to contrast the derivatives with deposits and the potm the point of that was to show that the the the the if these became a problem the government here would also have to bail out the banks just as the US government had done right for the same reason there's no way that the the deposits will be able to pay the derivatives losses on on derivatives exposures at this peak so that's the purpose of doing that and just to be fair Robert just you know those are the glows gross exposures so essentially there will be some netting off and there will be some you know cancelling out but nevertheless the ratio comparing deposits to the derivatives just shows how big the the risks are and as we say it's unknowable that the amount of risk is actually unknowable because it depends on where interest rates and exchange rates go yep so yeah what about what are the what are the Dickey's of Australia's banks thinking the you know they've had a crisis the Rudi's were at the heart of it you know what do they do the rest the world's cooling off a bit what happens in Australia well now you start to see what really does happen in Australia this chart shows is following year massive jumps in why all banks in their derivatives exposure massive jumps the biggest one is the Commonwealth Bank it's gone from its it's now 2.8 trillion whereas it was 1.5 trillion in the 2009 chart it's near a two point massive jump you know you think what the hell's going on at this time now and before we you might have some views on that Martin but the next the next year so same thing even more but this year this is the last year the Commonwealth Bank disclosed its actual derivatives they started they started removing that figure from their annual report the notional principal and insisting that's not a relevant figure anymore okay I called them up because we which you know that we're producing this chart every year I called them up you know got put through that I remember I was put through Dawei obviously a boardroom where a couple of guys have me on a speakerphone I'm going what gives why aren't you producing that figure anymore and they say no no it's not relevant it's not relevant it's not relevant we're just a few years ago the global financial system melted down because of these things and you're saying a true picture of your derivatives is not relevant they go oh no no no but those were those those were dangerous credit derivatives we don't trade in those Khurana derivatives ours are this is a quote plain vanilla derivatives right plain vanilla and I said well if they're plain vanilla derivatives why are they growing so fast what are you doing that justifies this incredible growth in your plane quote unquote plain vanilla derivatives that suddenly you have to start stop disclosing them and of course I didn't want to answer that question right the call ended soon after that but if you move now to the next one just to emphasize the growth rate so well this is all for right side by side and the gray bars our estimates now we guess we get to we're making we have no idea right that's why there's big question marks on it but we're making those guesstimate on the basis that the Reserve Bank every year does produce growth figures for all the banks collectively not broken down by banks you don't know but that their growth was also that that the collective growth in this time and I'll show a chart on that in a minute was also going off the charts right so you see the red the red line is 2008 the global financial crisis and what you see is the incredible growth after that in all in the case of all the banks and then by this by the time we produced this report in in 2016 this chart NAB had also stopped disclosing its derivatives right so a few years after CBA did in a B D now then we produce this iconic poster what lurks below because that's it's just getting people to think about how that the banking system is actually working here right this is you know if they're not even so they're already off balance sheet therefore you're not allowed to see what the you know you're you don't know what the nature of the actual derivatives trades are right um that that's that's not known the Reg that regulators don't know the the auditors certainly don't bother looking at it right so no one knows and then in the case of CBA in this at the time of this you know we won't even tell you anymore all right so real real worries there and we're all trying to make these points about it all the time people need to look at this what's going on here and of course we took we produced a poster like that circulated through Parliament that's the sort of thing you do to get politicians attention smart absent it's simple all right and then oh so this one we made this one and there's something very obviously lacking in this one but we'll talk about in a minute I just want to make the point about it so we're looking at the growth of the profits of the banks and of course that's the other thing that was going on there they're just record-breaking profits again post GFC all the banks in the world of basket cases except these Great Australian banks record-breaking profits so we said well there's the profits on the left the difference between 2008 and 2014 incredible growth in profits what matches what's happening in the real economy that's that's justifying those profits right well GDP hasn't growing very much population hasn't grown very much employed persons hasn't grown very much weekly earnings haven't grown very much ah derivatives have grown a lot and then this is where I would like your view though because to me what's obviously missing from this chart is bank lending on mortgages correct yeah that's the other biggie yeah yep and the derivatives are related to those to that to that lending that's that's what people have to understand about the the if you had if you had to identify the number one source of the growth from the bank's to revenues it's their lending on mortgages that they're securitizing and gambling on yep that's what got it's worth saying that NZ and map reported their results this week right and because of the slowdown in the mortgage lending book all of them have profit problems with that part of the book but guess which part of the business actually overperformed it was the commercial institutional banking other words where all the derivatives live so what and in fact that I think one of them reported a 33 percent increase in profitability from that segment of their business so you can see that they are now extremely reliant on the institutional banking to try and prop the whole bank up yep and dare I say it I can't I have no basis of knowing this about Australia's banks but I remember when I read Portnoy's book the number one quote that caught my eye was derivatives can be used to hide losses and make losses appear to be profits for a time and that's a part of this we can talk about that derivatives on this you know on you know take it at face value and go you know well there's dangerous there's dangers just if they use normally but there's a hell of a lot of fraud that gets hidden away in these things as well and you know you've got to shake your head when it comes to the Australian banking system to be honest so I can't well I don't know we don't we don't have access to it it's why we're calling for a full audit of the banks or the order general they it needs the order general with the with what's happening the banks needs to get into this but they but there you go what you just said is further example the need of that so yeah this is this is what you're dealing with in Australia and then just of just two charts left so here's here's the situation now ANZ has also suddenly stopped disclosing its derivatives right and the only one that I mean the thing to point out what's the difference when Westpac and the other free I mean Westpac is you know in in all other respects are similar business model etc I think it's the second largest mortgage lender after CBA but you have to notice that its growth was more conservative its derivatives growth was more conservative the other banks so the three terror back tearaway banks that just went that just went the fastest into derivatives they've now all stopped disclosing their full face value right of what's arm off their balance sheet and to me that is incredibly suspicious right why do they feel the need to do that because I can tell you before 2012 Martin you've got Lilly you've got 15 years where religiously every year this figure was in their annual reports yep all right absolutely it's not and so the final one which viewers might have seen you do that you use this in one of your reports last year on derivatives is this one this is the aggregate this is these are the figures recorded by the Reserve Bank of Australia and one of the things you notice there is so the obvious thing they're growing fast enough before the global financial crisis slightly antique but then incredible growth after the global financial crisis in the last few years you see these massive spikes up there's but that one around 2015 that's that's there was like a six trillion dollar increase in derivatives bank drove his in one quarter six trillion dollars the fastest growth rate an Australian banker it is we've actually tracked and dare I say it that related this period where bank interest only lending just was soaring off the chart all all the bad practices of banks that we've been identifying in their normal banking was all going crazy as well right that now people that left the time bombs in the in the the mortgage sector that we're all waiting to to see explode and so the derivative go up come down a bit and then you know go up they broke over 40 trillion dollars last year they're back down to 38 trillion but you can you can see there that's just you know extreme fluctuations at the top at the moment the direction they're going is obvious so this is the this is the part of the financial system people need to pay attention to right if this is where when we when we express concern about bailing for instance the the the the logic of bailing is how do you stop one or more banks setting off global contagion and destabilizing the global financial system you've got a knock you like those banks you got to you got to arm you bailing their customers so it doesn't do that and the number one concern the architects are bailing have is with if banks such as Australia's banks default on their obligations to their derivatives counterparties right because I would have a lot of de Rivers counterparties around the world and massive problems in Australia's banks if that affects their derivatives trades and that what they are obliged to pay to their counterparties can set off that kind of scenario where Lehman Brothers in
008 its it defaulted on derivatives obligations that then set off a much bigger problem in by AIG right it's the logic yeah and you see where it's a disaster waiting to happen in any of you and it's worth saying robbery that the chances are that some of those derivatives contracts are between fellow Australian banks yeah right so effectively it could well be that Bank a in Australia has a you know connection with Bank be around derivative contracts but they'll also have a whole spiderweb of contracts and relationships globally with the other banks around the world oh just just on that beef sorry before you go on because you'd have a better view than me it occurred to me with the growth we've seen though that there would be there would be a it would be very it would be a somewhat limited how much the Australian banking system itself if it was just between the big four banks could absorb this growth and that alone tells me there must be a lot of trading with counterparties around the world yeah I was going to say exactly the same thing so there will be some locally but the bulk of it will be internationally and it will be in the context of the offshore funding of the banks as well as you know then taking positions these are the other institutions around so the point is it's like the banking system is like a whole series of threads woven together it's a rug right but if a bit of a fraying happens over here you know it might be in the US it might be in China it might be in Europe the chances are that that thread will go rip right cross and we'll hit the you know financial system globally which is why of course the regulators are absolutely panicky about trying to keep a cap on the financial system and not let any part of it fall apart right because they know that if one part goes the whole thing is likely to follow which is why we're at such a high risk point in the evolution of the financial system so we have to try and find a way but I'm picking all of that right and so the whole thing about glass-steagall is it tries to make some separation between these high-risk speculative activities and the meat-and-potato banking which is effectively the stuff that we need and want because the trouble is that the derivatives if they go wrong could well swamp all the rest of the assets of the banks in Australia or elsewhere and that could trigger you know a critical issue locally as well as a significant event internationally so we are at a very precarious state and this derivative story is right at the heart of it yep and that's that's right glass-steagall is that by any measure the first thing to do here that and the other thing as I mentioned earlier is we're calling for a a an audit of the big four banks right with with it you know but if your objective about the Australian financial system at the moment aka not Peter Switzer or Christopher joy and look at the the property problems the the property price Falls and how much the banks were exposed that you're going well we better see what's really in there the you know in their books the based on the US experience the Irish experience etc so we need that the big for global regulators are not good enough right there they've been complicit in bank problems all around the world we need the Auditor General take step in and do an audit that actually goes into the assumptions behind these derivatives as well right and so the government can actually start seeing what's there now and then what glass-steagall does is you can you can carve out the commercial bank and then you've got to deal with this derivatives problem but the investment banking side that you force off the derivatives that it can't handle itself have to be Unwin somehow right some have to be cancelled a lot of unwinding has to be done now we have the pleasure of knowing the former Deputy Director of the Ministry of Finance in Japan we brought him out to Australia not in 2014 and we got to have a meeting in Joe hockey's office Joe Hockey was the treasurer he wasn't there but we met with his chief economist he was an obnoxious character who now works at the banking association tony Pearson when this subject came up when this subject came up Tony Pearson said to us this all he said he said you ever you ever bought on the airline ticket yeah well you poured the review then and whacker Williams was present in this meeting at work and we chose to cut the tension made a joke he said I want maybe if you bought a Qantas one but yeah that's that was the mentality don't don't worry about that that's it this is all this normal stuff it's no different than buying an airline ticket no sorry it's very different to buying an airline ticket right many many many more steps removed from that slight game we can make when you buy an airline ticket and they that's that here's the guy in charge of the treasurer who's in charge of the regulator's at the time right that's the pan tell you're dealing with our friend no dice occur as the head of the Ministry of Finance in Japan in the 90s he had to resolve a Japanese banking crisis in 1998 that was caused by derivatives sold to it by American companies and the way they did it was they had to take these banks over on a weekend and get in there and cancel and unwind a lot of the derivatives and they're concerned at that time was making sure that Japanese crisis did not trigger a global crisis through the counterparties that's why I did it now at the time though Martin Japan had glass-steagall because it had had it ever since America took Japan over after World War two that America made sure they had jet their glass-steagall as well that provided a framework which helped him do his job right and just as a quick aside he likes telling this story he only had the authority to deal with banks that to deal with foreign institutions they had a license to operate in Japan and a bunch of them didn't one of those that didn't of those that didn't this this dicey Hakata guy why he you know he would call them in and give him a warning saying we know what you're up to we're watching you and so the main one of those companies that was I had the worst practices packed up and left and moved to London and set up office there instead and that was AIG financial products and anything that is the is the institution that brought down the global financial system in 2008 if they had have had a license in Japan in 1998 the Japanese authorities may have been able to take action against them that averted what happened 10 years later and irony history so this guy's an expert and he says that's what you got to do you've got to step in there in unone and cancel a lot of these things he's also read more recently when he was asked about how you would deal with deutsche bank because deutsche bank for those who have followed this is the biggest de rubies basket case in the world it's got all this left bankers trust bad bets etc and he said the same thing the German government has to take it over and step in and cancel and unwind these derivatives right you cannot lead this up to free market to sort of work it out otherwise if you ought this you're just let it waiting for a bomb to go off and that's what that's how what's what we're saying has to happen Australia or if the bank's find out what the real problem is and separate them and get this out so you have a firewall between that problem in the financial and the real financial system but with the derivatives you know there still needs to be a attention given to them so that you can reduce the problem massively yeah and I've got just one more point Robbie this may be a bit contentious but I believe that something else that should be brought in is a financial transaction tax right yep because if you actually have a small tax on every one of these the profitability would just completely disappear and it would actually stop dead in its tracks so one of the things that I've held for some time is that a financial transaction tax one would generate a bit of income which would help the government coffers but two it would actually also help to solve this so that's something else which I would advocate that's all that's what we said to the Australian government in 1993 you know get these tax these things because yeah we did a calculation a few years ago we calculated the turnover in all financial markets in Australia and if you did a $1 in a thousand zero 1% tax which a normal shareholder in a bank could easily afford you know if every six months if they buy new shares I can handle $1.00 in a thousand that would raise a hundred and thirty billion dollars because the term the total turnover in this exchange rates etc one hundred and thirty trillion dollars but of course it would only raise at once because the very act of taxing it would reduce so much the the completely useless speculation here that contributes nothing to the financial system nothing to the economy but you know it's a real danger when it's left unchecked ya know that's right another final point I'd like to make is you know people might be saying well what can I do right now my my thought is if you are a shareholder of one of our big banks right why don't you write to them and ask them why they are not disclosing the amount of derivatives they actually have and ask what that number is that's right the annual general meeting and ask it from the floor if you got so rekt exactly because it seems to me strange peculiar and Donna right deceptive not to be disclosing this gross amount well that man from the the reason The Sydney Morning Herald did this article in 2008 not just because the financial system it had got out of whack royally and people weren't worrying it's because the William Pender the mayor of robe in South Australia he made an issue of it with Westpac he said I want to know and that force the media got their attention we've got the media's attention and in force Westpac to try and answer some questions here do that write to them go to the annual general meetings and demand it hmm it's pretty important Robbie I think we've hit the hour pretty much so that's probably our longest post ever but I think it's is really a really important subject right not just for the local banks here but but globally but specifically we do have issues in Australia we know we have issues and in the context of that banking separation you know inquiry which is you know petering out and you know this is another reason why that's a critical thing to happen yep absolutely and we'll keep pushing we'll keep pushing glass-steagall keep pushing bank separation but you know this this is another reason if you if you're wondering why we push it so hard you know and and all the viewers can help in the process keep keep supporting the fight for those things keep on to members of parliament they know nothing on this stuff just keep pushing pushing pushing all the time and the message will get through and please share this post as wide as you can because the more people who understand what's really going on the more chance we have of effecting positive change absolutely Robby thank you very much your time as I appreciate you man so they have it a very important discussion and whilst it was a long post and a bit complicated I think there are some really important messages bottom line is that derivatives are a high risk activity in the banking system and more controls need to be brought in place to bring it back into line a Martin North from digital finance analytics may thanks for watching RC [Music] [Applause] [Music] [Music] you
