03/18/2010 05:12 am ET Updated May 25, 2011

Big Derivatives Risks Loom For Banks

Yuck! After a two-year financial horror show, we could be in for an encore in 2010.

The bearer of these ill tidings is veteran Florida investment adviser Martin Weiss, who has accurately warned of impending economic and financial stress in recent years. The nature of the new financial danger he envisions is the threat of severe derivatives losses this year stemming from what he sees as the inevitability of higher interest rates, which could trigger a new crisis.

If he's right, it raises the prospects of considerable risk for the struggling banking fraternity, in particular the shares of three big banks that have wowed Wall Street with giant-sized rebounds from their past year's lows. They are JP Morgan Chase, Bank of America and Goldman Sachs, each of which sports huge exposure to interest-rate derivatives, financial instruments that are tied to bond yields, mortgage rates and a variety of other rates.

Any such problems, of course, if they were to become a reality, would, clobber the stock market.

Forecasts of financial horror, such as the one now offered up by Weiss, are generally greeted with much skepticism because they're often outlandish and that's not what people want to hear or read about in these tough economic times.

Still, such worrisome predictions have turned out to be agonizingly real in recent years, suggesting it makes little or no sense to blissfully ignore such warnings, as dire as they may seem, and simply write them off as the nonsensical thinking of a group of crazies.

With this thought in mind, it's worth taking note of a recent commentary that Weiss fired off to his clients in one of his firm's newsletters, Money and Markets, in which he called attention to the "ubiquitous, unprecedented exposure to the risk of rising interest rates."

Based on his uncanny crystal-ball gazing prowess in the financial arena, Weiss is not a fella to be taken lightly. For example, in late 2007, he went way out on the limb with a series of forecasts calling for a dramatic economic slowdown, a bunch of financial failures, major credit crises, a housing bust and a meltdown in the stock market.

In response, another newsletter publisher told me to shun Weiss, whom he characterized as "a madman." We should all be so mad; all of those forecasts came to pass."

As Weiss views the current financial scene, with global markets growing, federal deficits exploding and central banks printing money like there's no tomorrow, there can be little doubt that rising markets will also bring rising interest rates.

Even if the Federal Reserve continues to hold down short-term rates, he observes, there are too many rates that the Fed cannot control, such as long-term bond yields, mortgage rates and countless other rates that are driven primarily by free market forces.

The immediate implications of rising rates are two-fold: All borrowers with debts coming due must pay more to roll them over. And all lenders who have extended medium or long-term credit at fixed rates will suffer an immediate loss in the market value of their loans.

Now let's get to derivatives, essentially a highly leveraged financial instrument that derives its value from some good or service. Simply put, it's a contract between two parties to exchange value based on the action of that good or service. Typically, the seller receives money in exchange for an agreement to purchase a good or service at some specified future date.

Financial devastation tied to derivatives is hardly new. They made news in 1995 when a rouge trader, Nick Leeson, single-handedly used them to bring about the collapse of the Barings Bank of England. Four years later they reared their ugly head again as they brought about the destruction of Long Term Capital Management, a once high flying $2.7 billion hedge fund.

The big risk now, according to Weiss, stems from the fact that U.S. banks now hold $175.2 trillion worth of those interest rate derivatives I mentioned earlier.

As banks go, he points out, JP Morgan Chase leads the way with $79 trillion in derivatives, 80.8% of which are tied to interest rate changes. Bank of America is next at $40.1 trillion, with an even larger share, 89.2%, tied to interest rates. Goldman Sachs has $42 trillion in derivatives, and among the top 10 U.S. derivatives players, it has the single largest share, 94.3%.

It all reminds me that one of Yogi Berra's most famous Yogi-isms is "it ain't over till it's over." And that's precisely Weiss's grim view when it comes to the risks inherent in interest-rate derivatives.

So the message here: Caveat Emptor, market bulls and buyers of bank stocks beware.

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