This Globally Systemic Bank Just Went Into Crisis Mode (Derivatives)
Summary
TLDRThe video script discusses a potential financial crisis triggered by a Japanese bank's derivatives exposure and wrong-way bets on interest rates. It outlines the bank's predicament with inverted yield curves and rising funding costs, leading to a need to sell off assets at a loss. The script further explores the interconnectedness of the global banking system and the systemic risks posed by one bank's failure, drawing parallels to the 2008 financial crisis. It concludes with the bank's risky strategy to mitigate losses by investing in higher-risk assets, suggesting a possible 'Big Short 2.0' scenario and the implications for the broader economy.
Takeaways
- 🏦 A globally systemic bank, Noren Chukin, is in crisis mode due to derivatives exposure and wrong-way bets on interest rates.
- 📉 The bank plans to sell around $63 billion in US and European Sovereign bonds to mitigate losses from its investment strategy.
- 💡 The script raises the question of whether this could be the start of 'The Big Short 2.0', indicating a potential financial crisis.
- 📚 The bank's balance sheet is under scrutiny, with assets and liabilities affected by the inverted yield curve and increased funding costs.
- 🌐 The global monetary system is described as a network of interconnected bank balance sheets, implying systemic risk.
- 🔄 The bank's strategy of borrowing short and lending long has backfired due to rising interest rates, leading to a negative carry.
- 📉 The bank is forced to sell off low-yielding assets at a loss as their funding costs have increased significantly.
- 💸 The sale of treasuries will result in a substantial loss, but it's a temporary solution to a more significant systemic issue.
- 🔗 The interconnectedness of banks means that the failure of one can impact many, creating a domino effect in the financial system.
- 🚀 The bank's potential solution to buy higher-yielding but riskier assets, such as CLOs (Collateralized Loan Obligations), could amplify future risks.
- 📊 Economic indicators are showing signs of weakness, with the PMI rule and unemployment rate suggesting an impending recession.
Q & A
What is the core issue that led to the crisis at Noren Chukin Bank?
-The core issue is that Noren Chukin Bank, like many other global systemic banks, engaged in borrowing short-term at low interest rates and lending long-term at higher rates. However, when the yield curve inverted due to the Federal Reserve raising rates to combat inflation, their funding costs increased significantly, leading to a negative carry and financial losses.
Outlines
🏦 Derivatives Crisis at Noren Chukin Bank
The script discusses the crisis at Noren Chukin Bank, a globally systemic bank in Japan with significant derivatives exposure. The bank plans to sell $63 billion in US and European Sovereign bonds to counteract losses from wrong-way bets on interest rates. The video aims to explore if this is the start of 'The Big Short 2.0'. It begins by explaining the bank's balance sheet, highlighting the issue of borrowing short and lending long, which becomes problematic when the yield curve inverts. The bank's strategy of buying low-yielding assets while taking on high-risk derivatives is scrutinized, and the impact of the Federal Reserve's interest rate hikes on the bank's funding costs is discussed, leading to a negative carry situation.
🌐 The Global Monetary System's Interconnected Risks
This paragraph delves into the interconnectedness of the global monetary system, using an analogy of a string of Christmas tree lights to illustrate how a single bank's failure can affect the entire network. It explains how banks lend to each other, creating a complex web of liabilities and assets, with derivatives playing a significant role in systemic risk. The script uses an oversimplified diagram to demonstrate how a loan from one bank to another can create a chain of credit that, if broken at any point, can destabilize the entire system. The potential for a deflationary bust in the financial system is also mentioned, drawing parallels to the events of the GFC and the movie 'The Big Short'.
📉 The Dilemma of Negative Cash Flow and Risky Solutions
The script outlines the predicament of J Bank, which is experiencing negative cash flow due to rising interest rates and the need to sell off low-yielding assets at a loss. It discusses the bank's strategy to mitigate this by selling treasuries and investing in higher-yielding, but riskier, Collateralized Loan Obligations (CLOs). The risks associated with CLOs are highlighted, emphasizing that these are high-risk loans to smaller corporations that traditional banks would not fund. The potential for a banking crisis is underscored by the inverted yield curve and deteriorating economic data, suggesting that the banks' strategies may exacerbate rather than solve their problems.
💸 The High-Risk World of Collateralized Loan Obligations
This paragraph provides an in-depth look at CLOs, explaining that they are pools of high-risk loans to businesses that cannot secure traditional bank funding. The script introduces a character named 'Slick Rick' who represents the sponsors of CLOs. It describes how these loans are divided into tranches with varying risk levels and interest rates, and how the pursuit of higher yields leads banks to take on excessive risk. The discussion includes the broader economic context, with the unemployment rate and the 'P rule' indicating a potential recession, and the Fed's continued high-interest rates adding to the banks' challenges.
🚨 The Looming Banking Crisis and Potential Government Intervention
The final paragraph predicts a deepening banking crisis, suggesting that we are in the middle innings of an event that began in March 2023. It anticipates more bank failures, especially among globally systemic banks, and speculates that central planners will attempt to mitigate the crisis by expanding central bank balance sheets and increasing government spending at unprecedented rates. The script warns of the economic distortions and reduced living standards that such actions could cause, framing the situation as a lose-lose for banks and society at large.
Mindmap
Keywords
💡Derivatives
💡Yield Curve
💡Negative Carry
💡Collateral
💡Counterparty Risk
💡CLOs (Collateralized Loan Obligations)
💡Inverted Yield Curve
💡Systemic Risk
💡Fed's Balance Sheet
💡Deflationary Bust
💡Economic Distortions
Highlights
A globally systemic bank with huge derivatives exposure just went into crisis mode.
Noren Chukin Bank in Japan, with $800 billion on its balance sheet, is selling around $63 billion in US and European sovereign bonds.
The crisis is due to wrong-way bets on interest rates.
Noren Chukin Bank is a major player in the CLO market, which was problematic during the Global Financial Crisis (GFC).
The bank borrowed dollars when rates were low and invested in low-yielding assets.
As interest rates rose, the bank's funding costs increased, causing a negative carry.
The bank has to sell low-yielding assets at a loss to manage the funding costs.
The global monetary system is a network of interconnected bank balance sheets, increasing systemic risk.
If one bank fails, it can create a cascade effect similar to old school Christmas lights where one bulb going out affects the whole string.
Banks are facing increased counterparty risk, leading to reduced lending in the real economy.
Increased counterparty risk can lead to a deflationary bust similar to the GFC.
The solution proposed by the bank is to sell treasuries and buy more CLOs, which are high-risk loans to midsize or small corporations.
The CLOs have a higher yield but come with significantly higher risk.
The inverted yield curve indicates an unhealthy economy, increasing the risk of the bank's strategy.
The P rule indicates an increased risk of recession as the unemployment rate rises.
The FED keeping interest rates high while the economy deteriorates adds to the banks' challenges.
Banks may take on excessive risk, increasing the probability of future failures similar to the 2008-2009 crisis.
Central planners might intervene with increased spending and balance sheet expansions, potentially papering over financial issues but creating economic distortions.
This could lead to a lowered standard of living for society due to the economic distortions.
Transcripts
a globally systemic bank with huge
derivatives exposure just went into
crisis mode noting chukin Bank saying
that he plans to sell around $63 billion
in us and European Sovereign bonds to
Halt the bleeding from wrongway bets on
interest rates so this begs the question
is this the beginning of The Big Short
2.0 I'm going to answer that question
for you in three simple fast Steps step
number one let's go over what's at the
core of this specific problem we have a
bank called noren chukin in Japan it's
about 800 billion on its balance sheet
now before you say well George that's
not really a huge Bank ah but you forget
the global monetary system is simply a
network of banks balance sheets more on
that in Step number two but they are a
huge player in the clo Market in these
derivatives that were at the root of the
problem during the GFC so it starts with
we'll just call it J bank for the E
that's kind of a hard name to pronounce
so J Bank we're looking at their balance
sheet assets on the left liabilities on
the right now what they did is they went
out and borrowed a lot of dollars when
that was cheap because remember way back
in let's say 2020 or 2021 before the FED
started to raise rates rates they had
interest rates at zero and the yield
curve was steep meaning the longer term
interest rates were actually higher than
the shorter term interest rates what you
would expect so a bank makes money by
borrowing
shortterm and lending longterm well this
works fantastic when the yield curve is
steep but when it inverts now all of a
sudden you got a problem so quick
summary of what took this bank and
possibly a lot of other globally
systemic Banks into crisis mode is they
went out and bought low yielding assets
that would be the asset side of their
balance sheet and the ones that are high
yielding have massive amounts of risk
more on that in just a moment they're
borrowing short lending long so they
have to roll over that debt on the
liability side of their balance sheet
constantly but what happens when your
funding costs go up this is the
predicament that this J Bank along with
probably quite a few other globally
systemic banks in Japan is facing right
now it's a similar problem to what
Silicon Valley Bank credit s signature
First Republic I could go on and on and
on about these banks that have had a lot
of issues over the past year so let's
get back to the way the balance sheet
was set up so you guys can get a visual
like I was saying we've got the
liability side of the balance sheet
let's just assume for a moment they were
borrowing dollarss at 2% I don't know if
that's the exact number we're just using
it for the sake of this example so they
are going out and buying treasuries at
3% so a lowrisk asset okay fine but they
wanted to juice the return a little bit
so with the other portion of the balance
sheet on the asset side let's assume
they went out and bought seal well we
don't have to assume that that's pretty
much exactly what they did so they were
getting a higher interest rate here so
combined the seven and the 3% let's say
their average rate of return on the
asset side of their balance sheet right
around 5% okay well this is fine because
remember they're paying 2% so they're
pocketing a 3% spread but then what
happens is the Federal Reserve comes in
and they have to fight inflation the
inflation that was caused by all the
economic distortions the government
imposed during the surva sickness so
they take interest rates at the front
end of the curve the short-term interest
rates from 0% up to
5% okay well let's think this through
let's assume for a moment that J bank is
having to roll over the debt on the
liability side of their balance sheet in
other words the dollars they owe every
month but the assets that they own have
a maturity of 10 years you see how this
poses a problem so if these assets that
you bought let's say the treasuries
yield 3% for 10 years but then the FED
takes rates at the front end of the
Curve Your short-term borrowing costs
they call them the funding costs up to
5% now all of a sudden this 2% turns
into let's just
say
6% okay well you can see how that dog
don't hunt because now what you're doing
is you're paying out 6% to collect 5% we
would call that a negative carry or in
real estate terms this is having
negative cash flow so basically J bank
is hemorrhaging money every single month
so what do they have to do they have to
sell those low yielding assets on their
balance sheet okay well interest rates
now are at
5% not 3% so you guys know that there's
an inverse relationship between the
price and the interest rate so the rate
goes up what happens with the price the
price goes down they liquidate these
treasuries 63 billion of them and they
have to take a massive massive loss but
unfortunately although this may stop the
bleeding temporarily this makes the
overall problem much much bigger more on
that in Step number
three step number two now let's go over
how the global monetary system is set up
this network of bank balance sheets and
then you'll understand why even though
this J Bank we'll call it is $800
billion there's still quite a bit of
systemic risk especially when you
include the derivatives so this is an
oversimplified diagram of how some of
these transactions work and what you see
is that if one of these Banks goes bust
it's just like those old school
Christmas tree lights I don't know if
any of you had those growing up but
remember you'd have this long string of
lights and if one bulb went out the
entire string wouldn't
work and it's very similar in the global
monetary system here's why we've got
Bank of Russia Grand Cayman Singapore
Montreal Bahamas Switzerland and then we
have euro dollar Enterprise so a private
entity one of these multinational Mega
corporations so Bank of Russia let just
say lends a million dollars to the Grand
Cayman bank so that's represented by
this orange shaded area okay well they
lend the million dollars they've got a
million dollar liability because they
owe that money to the bank of Russia but
then that gives them a million dollar
asset so then what happens is Singapore
Bank goes to gr Cayman and says hey we
need to borrow a million dollars they
said great we've got those million
dollars so they send them down to the
Singapore bank and of course the million
dollars of cash on their balance sheet
is replaced by that loan that they just
made to the Singapore Bank the Singapore
bank doesn't have very good credit so or
they're a credit risk let's say so the
Grand Cayman Bank says we'll do the loan
but we need some collateral
unfortunately the Singapore bank doesn't
have any good collateral but they need
us treasuries to execute the transaction
so they take some of this garbage
collateral I think Jeff is this gray
shaded arrows calling it uh junk
collateral okay so they take the junk
collateral that they have on their
balance sheet and they pledge it to the
global first dealer Bank who they have a
relationship with and so the glob mob
first dealer Bank charges them an
interest rate and then they take the
junk collateral onto their balance sheet
and then they give them the us
treasuries that they need to post as
collateral to the Grand Cayman
bank then what happens is Montreal goes
to Singapore and says hey we need a
million dollar loan and Singapore says
sure we've got the million dollars they
send it down to the Bank of Montreal and
keep in mind these million dollars that
we're talking about they're not green
pieces of paper they're not Bank
Reserves it's just credit it's just
dollars that were created by lending
them into existence so we go through the
same routine here with Montreal they
take the million dollars and then the
million dollars of cash leaves the
Singaporean Bank side of their balance
sheet or the asset side of their balance
sheet that's replaced with the loan but
then the Bahamas Bank does the exact
same thing Montreal lends to them uh but
they like the Singaporean Bank need to
post collateral so they don't have a
relationship with global first dealer
bank but they do have a relationship
with BSD Global dealer bank and it's the
exact same thing they pledge them some
junk collateral and the BSD Global
dealer Bank charges them a little bit of
a higher interest rate give them the
treasuries they post the collateral to
Montreal Montreal gives them a loan for
the million dollars and they go ahead
and lend the million dollar
to the bank of Switzerland who finally
finally lends the million dollars to
euro dollar Enterprises the only entity
in this entire diagram that's actually
part of the real economy the only entity
that is a nonbank let's say so looking
at this let's just say that uh I don't
know the uh Bank of Switzerland is a
smaller Bank let's say ' got 800 billion
of assets and liabilities so you'd say
oh well George that's not a globally
systemic Bank really what happens if
they go
bust then you've got this daisy chain
that blows a hole in the balance sheet
of Bahamas Montreal Singapore gr Cayman
and
Russia now you see what I'm saying this
is like a string of those old school
Christmas lights and of course there's
some banks that are more important to
the network in some banks that are less
important but the main idea is that even
if the bank of Switzerland went
bust and the other Banks could handle
that hit to their balance sheet it still
increases the counterparty risk within
the system because now all these other
Banks say wow Switzerland went bust
yesterday I wasn't expecting that maybe
I'm next maybe it was because they had
all those Clos on their balance sheet
and well I have Clos on my balance sheet
or maybe it's because their dollar
funding costs shot up to 5% but wait a
minute that's happening to me as well so
I'm going to lend a lot less out into
the real economy so what happens if
those banks are lending a lot less
because the counterparty risk or
perceived risk in the system skyrockets
it makes it much harder for the system
to get the liquidity it needs to pay off
the existing debt which takes you into a
deflationary bust because we live in a
debt-based monetary system and it's just
like the deflationary bust in the
financial system we saw during the GFC
that was highlighted in the movie The
Big
Short step number three so what's their
solution to the problem which as you can
probably guess will just make it much
much worse in the future all right well
we go back to remembering in Step number
one they've got this negative carry so
every single month they're hemorrhaging
money so they've got to sell those
treasuries but then the question becomes
okay they're going to take that 10
billion doll loss at the very least but
then what are they going to buy how are
they going to shore up their balance
sheet to where they're not losing money
every single month in other words what
are they going to buy to create enough
yield over here to compensate for their
increased funding costs on the liability
side of their balance sheet well with
the J Bank representatives are telling
us in the media is that hey this is
actually pretty easy you guys are making
this seem a lot harder than it really is
you see remember we are getting the 3%
on the treasuries but we're getting 7%
on the Clos and that's
7% yes is higher than the 6%
our funding cost and the liability side
of our balance sheet so all we really
have to do is just sell the treasuries
and buy more
Clos problem
solved then we've got nothing to worry
about but what they're not telling you
is by increasing the amount of Interest
they're receiving on the asset side of
their balance sheet how much risk are
they having to take well let's go over
to this simple chart that I just drew up
just so you can get the the visual and
what we have on the left- hand side are
interest rates the interest that you
would receive by making XYZ investment
or in this case speculation or
Gamble and the bottom we go from low
risk to insanely high risk in fact it's
so high I put RR which stands for
Russian Roulette you were playing
Financial Russian roulette with your
balance sheet so at 3% the risk is
relatively low with treasuries and you
say well George they were high risk
because the interest rates went up
therefore they had to sell them at a
loss right but if they weren't making
idiotic Bets with their balance sheet
capacity they could have held those
treasuries to maturity and they wouldn't
have lost a dime so getting back to
their predicament they have got to reach
they've got to go as far out that risk
curve to get as much yield as possible
so that takes us to the Clos so what are
CL
O's this is where I hope you're sitting
down because it is officially stiff
drink time like we say on this channel
so Clos are pools of loans but they're
not pools of treasuries loans to the
government Oh No in fact they're not
even loans to Mega corporations like
apple or Nvidia or Tesla they're
actually very highrisk loans to midsize
maybe even small Corporation or business
entities in the United States that
really couldn't get funding from a
normal bank so you've got this high-risk
corporation that goes to the bank and
say hey we need a $100 million for XYZ
project and the bank looks at them says
yeah not even close because the
probability of you paying me back is
almost zero so then what this high-risk
Corporation does is they go over to this
guy right here we've been using him for
the last couple months here because he
is the guy that sets up this clo I
believe officially they call him a
sponsor maybe he sponsors other people
in his AA classes but his name is Slick
Rick and he is all about the benjes you
can tell by his glasses they have dollar
signs on them and he is keeping his pimp
P strong here with his Cane so Slick
Rick says Hey high-risk Corporation I've
got some money for you that oh by the
way I just borrowed likely from J bank
or one of J bank's counterparts so they
go ahead and lend them the money they
take the loan and they put it into a
pool of other loans that are separated
by what they call
tranches so the bottom tranch is paying
you 5% which is pretty good but the risk
is very high and that's at the lower
level as you go higher and higher and
higher yeah yes you get more interest
but it gets to the point where you're
taking insane amounts of risk but let's
not forget the yield curve is inverted
and it's been inverted for about 2 years
and this usually tells us that the
economy is very unhealthy fundamentally
it's
unsound okay well let's think about this
so you're going into an economy that's
likely deteriorating and you're taking
the riskiest bet possible well usually
that doesn't end well and I'd also like
to mention that the data is becoming
weaker and weaker and weaker in fact if
we look at the P rule which we have to
because the unemployment rate just went
up to 4% so what the PM rule says is
pretty much every single time going back
to the 1950s that the unemployment rate
increases by a half a percent or 50
basis points over the span of a year you
are in or very near a session well right
now over the last 12 months we've gone
from
3.4% up to 4% so an increase of not half
a percent or 50 basis points but 60
basis points. 6% now if we want to get
technical about it the S rule is
actually a moving average so assuming
the next couple months we stay at around
4% unemployment or actually increase
that will trigger the Som rule which has
100% accuracy again going back to the
1950s in fact the creator of the Som
rule just came out on CNBC and said that
right now I'm quoting her I'm not making
this up this not George gamon speaking
she said the FED is playing with fire
because the underlying economy is so
weak deteriorating quickly and the FED
isn't dropping rates they're keeping
them at
5.25% so when you dive into the details
you see a lot of these banks are in a
lose lose situation and a lot of these
banks are definitely globally systemic
where the only move they have the only
option is to take on so much risk that
it increases the probabilities
exponentially that they blow up in the
future just like we saw during 2008 2009
during the GFC it was great for a movie
but terrible for the overall econom
and Society at large so what is my base
case how do I think this is going to
play out well again there are no
certainties there are only probabilities
but I think we're just in the middle
endings of a banking crisis that started
March of 20123 and when we get into the
eighth and ninth inning we'll likely see
a lot more bank failures a lot of them
could be these globally systemic Banks
but this time I think the central
planners will come in and try to paper
over the problem almost immediately by
increasing the size of the fed's balance
sheet or a lot of the central bank's
balance sheets and the government's
spending money like we have never seen
something that exceeds the rate of
deficit spending we saw during March
April May or throughout 2020 and 2021
and while they may be able to paper over
the financial problem as you guys know
from watching my videos this will create
massive economic distortions in the real
economy that will lower the standard of
living for Society at large for more
content that'll help you build wealth
and thrive in a world of out of control
central banks and big governments check
out this playlist right here and I will
see you on the next video
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