For bank stock investors, the time to sell is right now, before the next correction or recession happens. Last year, Zero Hedge published an article that highlighted derivative contracts to the top 25 banks. Just over a year later, the outlook is even worse with total contract values up 15%.
In short, when you buy a security, you are purchasing an ownership (stock) or debt interest (bond) in a company. But when you buy a derivative, you do not actually own any assets at all. Instead, you are making a wager on what that asset will be valued at in the future. These side bets can be complex. Warren Buffett (Trades, Portfolio) referred to them as financial weapons of mass destruction in 2003. In 2008, many of the banks held credit default swaps. Even though it was just a small portion of their overall derivate trades, when they started to collapse, the market came down with them.
Things look better for some banks
JPMorgan Chase JPM has $57 trillion in derivatives and $2.5 trillion in assets, which is a much better ratio than what it had back in 2008: $80 trillion in total derivatives and $4 trillion in credit default swaps.
Bank of America BAC currently has total derivative exposure of $36 trillion and $2.3 trillion in assets, putting it in a much better place today than 10 years ago. At that time, it had the same amount of derivatives but half the assets.
Things look worse for other banks
Citigroup C has $57 trillion in total derivatives and just $1.9 trillion in assets. Compared to June 2008, when the bank had $34 trillion in derivatives on just $1.2 trillion in assets, the ratio is the same but with greater risks.
At Wells Fargo WFC, the bank looks riskier with $8.8 trillion of total derivative exposure on $1.6 trillion in total assets as of June. In 2008, it was the big bank champion of limited derivative exposure with just 3 times the risk on $500 billion in assets and $1.4 billion attached to credit default swaps.
At the time, the top 25 banks held $166 trillion in total derivatives. Today that number is $90 trillion higher, yet the banks are experiencing a boom period as investors have made superior market returns.
Since 2008, Citigroup has seen its market capitalization rise from $36 billion to over $158 billion; Bank of America's market cap is up from $70 billion to $260 billion; JPMorgan's value has risen more than $230 billion to $350 billion; and Wells Fargo, despite the recent trouble, is $140 billion more valuable today than in 2008.
The big banks have only grown larger, much to the chagrin of politicians like Elizabeth Warren. While some believe there is unlimited downside risk in the market right now, the Dow has a lot further to fall if we are to experience a similar correction to 2008. In the worst-case scenario, if the market has one-third of its value wiped off from today's level, it would still be 30% higher than the pre-correction high in 2008.
The real danger is in the currency markets if the U.S. defaults on its debt payments because of high interest rates or the dollar collapses under the weight of inflation. That would play into the analysis of Peter Schiff, who predicted the 2008 housing bubble years before its collapse. Again, U.S. bank stocks are a bad trade right now, especially the big four. Add to those big banks financial firms like Morgan Stanley MS and Goldman Sachs GS, who are also very intertwined in the financial system. Predicting when a collapse will happen is a lot like the odds of winning the lottery. Sure, a few people will guess correctly, but everyone else will get it wrong. For investors, it's better to stay in cash and wait.
Disclosure: I am not long or short any stocks mentioned in this article.
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