This Globally Systemic Bank Just Went Into Crisis Mode (Derivatives)

Summary

The 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

00:00

🏦 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.

05:04

🌐 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'.

10:05

📉 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.

15:07

💸 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.

20:09

🚨 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.

Keywords

💡Derivatives

Derivatives are financial instruments whose value is derived from an underlying asset, such as stocks, bonds, commodities, or currencies, or from a pool of such assets. In the video, the bank's exposure to derivatives is highlighted as a significant risk factor, especially in the context of wrong-way bets on interest rates, which can lead to substantial losses when market conditions change unexpectedly.

💡Yield Curve

The yield curve is a graphical representation of the interest rates on debt for a range of maturities, with the time to maturity on the x-axis and the yield on the y-axis. In the video, the yield curve's inversion is mentioned as a problematic situation for banks, as it implies that short-term interest rates are higher than long-term rates, which can lead to negative carry and financial losses for banks that borrow short and lend long.

💡Negative Carry

Negative carry occurs when the cost of borrowing is higher than the return on investment. In the video, the concept is used to describe the financial predicament of the bank, where the increase in short-term interest rates by the Federal Reserve has led to a situation where the bank is paying more for its borrowing costs than it is earning from its assets, resulting in a loss.

💡Collateral

Collateral is an asset or store of value that a lender requires a borrower to pledge as security for a loan. In the video, collateral is discussed in the context of banks needing to post US treasuries to secure loans, indicating the interconnectedness of financial institutions and the reliance on assets to facilitate lending.

💡Counterparty Risk

Counterparty risk is the risk that the other party in a financial contract might default. In the video, the concept is used to explain the systemic risk in the global monetary system, where the failure of one bank can affect others in the network, leading to a chain reaction of financial instability.

💡CLOs (Collateralized Loan Obligations)

CLOs are a type of asset-backed security, which is a security collateralized by a pool of loans. In the video, CLOs are described as high-risk investments involving loans to midsize or small corporations that may not be able to secure funding from traditional banks. The bank's decision to invest in CLOs is portrayed as a risky move to compensate for increased funding costs.

💡Inverted Yield Curve

An inverted yield curve occurs when long-term interest rates fall below short-term rates, which is often seen as a predictor of economic recession. In the video, the inverted yield curve is mentioned as a sign of an unhealthy economy and a factor contributing to the bank's financial challenges.

💡Systemic Risk

Systemic risk is the risk that the failure of one financial institution could cause a ripple effect, leading to the failure of other institutions and potentially the entire financial system. In the video, the concept is used to discuss the interconnectedness of banks and the potential for a single bank's failure to impact the entire global monetary system.

💡Fed's Balance Sheet

A central bank's balance sheet is a record of its assets and liabilities. In the video, the speaker suggests that central banks might increase the size of their balance sheets as a response to a banking crisis, which could involve measures such as quantitative easing or other forms of monetary policy to stabilize the financial system.

💡Deflationary Bust

A deflationary bust is a period of economic decline characterized by falling prices, increasing unemployment, and a decrease in the supply of money and credit. In the video, the term is used to describe a potential outcome if the financial system fails to manage debt and maintain liquidity, leading to a broader economic downturn.

💡Economic Distortions

Economic distortions refer to the misallocation of resources or the disruption of market mechanisms due to external factors, such as government policies or central bank interventions. In the video, the speaker warns that attempts to stabilize the financial system could lead to economic distortions that negatively affect society's standard of living.

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

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