Morgan Stanley is bit more complicated as a derivatives dealer than the Big 4. Those other banks hold most of their books at their bank subsidiaries. In this case, the term bank actually means something, the legal distinction of a depository institution. Each of the four banks, JPM, C, GS, and BofA, have a holding company umbrella over them like MS which does conduct financial business, they just choose to operate more exclusively under the depository framework.

Morgan Stanley for reasons beyond the scope of this investigation has gone the other way. Therefore, Morgan Stanley Bank, NA, reports only a couple hundred billion in gross notional derivatives contracts outstanding (a/o Q1 2018) while Morgan Stanley the holding company tallies $35.5 trillion (including the $278 billion at its bank sub).

Regardless of its structure, MS is quite the template for Economists overvaluing monetary policy and bank managers somehow still following that advice. The holding company’s derivative book inflates with each reflation, particularly those that followed QE2 and QE3. It inevitably shrinks or deflates when in pretty short order the markets or the world doesn’t live up to whatever it is each time that is supposed to lead toward economic recovery and financial opportunity.

What makes MS interesting is the lack of VaR shocks following QE3, meaning for the “rising dollar” and afterward. It has been largely steady since 2013 despite a whole host of serious events during that time.

For the global eurodollar disruption in 2014 and 2015, VaR rose for the company but only modestly. Still, the firm responded by reducing its book dramatically which might propose a certain high level of sensitivity.

That seems to have held during Reflation #3 starting in 2016. VaR has swung only a little higher or lower, not so much that it has disrupted the modest recovery in the holding company’s derivatives book. MS is therefore something like a control group against which we might analyze what the Big 4 banks have been up to lately.

When the OCC’s report on bank derivatives came out last month it showed an unusually (for the last six years since 2011) large increase in gross notionals. That would have been consistent with accelerated reflation and maybe it was in inflation hysteria of the bond market selloff – but only up until the global liquidations at the end of January.

It really leaves us with a bit of a puzzle surrounding what the dealers might have been doing to start 2018. The chart above, set upon a logarithmic scale, actually understates the jump during the first three months. Total gross notionals climbed to $203.8 trillion in the first quarter from $172.0 trillion in the fourth of 2017. That was a gain of 18.5% which will get your attention either way.

But it wasn’t just the systemic increase that is of note, it’s more so who and then why.

The most obviously aggressive was Goldman Sachs. That bank’s book rose to $51 trillion from only $41 trillion in Q4. That level is just shy of the record high set importantly in Q3 2014 – right as the “rising dollar” was getting started.

And we can easily observe the patterns in VaR, too. A sharp increase in Value-at-Risk can suggest a couple different things. Primarily, however, it gives us a sense of unanticipated risk that wasn’t so readily managed by the usual risk techniques more easily obtained when systemic monetary conditions are more benign (balance sheet capacity is plentiful or even abundant in the aggregate, the ability to take on and lay off risk without getting dinged for it).

Two of the other Big 4 banks, Citigroup and JP Morgan, display similar tendencies about Q1.

The last of them, Bank of America, falls into the same kind of control group as Morgan Stanley does. This latter bank has been unwavering in its negative impressions about derivatives dealing. Following the shock and crisis in 2011, for obvious reasons if you aren’t an Economist, there is a clear conscious decision to exit the business as orderly as possible. That strategy remains in place even during the past year and a half of Reflation #3.

So, what does all this mean?

I think the contrast between the two in the control group, these firms that have been more cautious and determined about their dealer activities, and the lack of any VaR shock in Q1 is instructive; especially as it appears balanced against GS, C, and to a lesser extent JPM.

In other words, it does seem like these other three banks all bet heavily on globally synchronized growth and the inflation hysteria and it all blew up in their face (VaR shock) starting with the events in January. It wasn’t enough or long enough of a time period for any sort of reversal in those books but I’m guessing that we might find it in Q2. It may have been that those initial shocks were set aside and that these other three simply tried to wait out the burgeoning market upset (it was, after all, just T-bills, right?)

That would propose one possible answer as to why Q2 was in some ways (globally) more alarming than even the major fireworks contained within Q1. Why did the EM crisis flare so bad starting around April 18 and 19? What was it that so disturbed everything so as to initiate a clear collateral call on May 29?

I don’t know the specific answer to either, but I suspect GS, C, and JPM being caught so flat-footed the wrong way and eventually pulling back might have had something to do with it. It could have been that after trying to ride out the rest of Q1 when nothing seemed to get much better to start Q2 that’s when they thought they better run for the exits. This is where the control group comes in, those other two who weren’t aggressive in Q1 and thus didn’t suffer a VaR shock possibly linking the event with the trait.

Remember, these are only US banks and US subs of foreign banks. Others such as Deutsche Bank and its massive (if shrinking) derivatives book aren’t included in the OCC figures. As we know from one report last month (good Bloomberg), the troubled German giant suffered a major VaR hit at some point during Q1, too.

“Such a high trading loss is off the charts,” said Gregor Weiss, a professor at Leipzig University and an expert in financial risk management. “It’s definitely something a supervisor will look into.”

The size of that one day’s loss was nearly 12 times estimated baseline daily VaR for Deutsche. That only raises our suspicion for where these other three banks who were likely as aggressive or more so than DB were caught to a lesser extent the wrong way. If they bet on Janet Yellen, then as Reflation #3 increasingly failed and liquidity, which isn’t supposed to be a problem, became more and more of one throughout the balance of the first quarter it stands to reason it would have hurt being so exposed.

There is nothing in the OCC report that is conclusive in this regard. It is circumstantial in that this one interpretation might seem to fit with the events especially spilling over into Q2 and why they may have. There are a couple other pieces of separate information within the OCC numbers that are similarly suggestive, including some major collateral shifts starting in Q4 2017, but those are more detailed and require more of an explanation than I want to get into here (I’ll have to save them for an undetermined future date).

There are still some key unanswered questions. Hopefully the next derivatives report for Q2 which isn’t scheduled for release until September will shed some light on everything even as we go forward in Q3 with deepening monetary doubts.

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