Of course derivative exposure is a financial time-bomb of nuclear dimensions waiting to be detonated. And when it does .... o boy ... I bet that there should be no windows in office buildings above the ground level.

However, every bank plays along in the system. At least they are exposed to issues surrounding treasury-bonds and maybe much more.

With every system, there comes systemic risk. To assess those risk, there are risk manager who should be great at answer the question: what if, then what?

But as always, just like with the COVID-scamdemic, these people kept their mouths shut tight.

In the covid case, it is quite obvious from a risk approach, the RPN, or risk priority number was max 20 on a scale of 1000, with very limited fall out. Yet, the pushed for solutions where in themselves the biggest contributors to a rising RPN.

With the financial system it is exactly the other way round. Playing around with treasury bonds used to be rather boring and low risk. However, the proliferation of treasury bonds together with a changing interest environment causes strange effects to happen.

With an increasing interest rate, the treasury bonds on the books, though on paper only, become lower in value. According to the GAAP, General Accepted accounting rules, such changes need to be reflected in the books.

Say for instance there is a treasury bond of a 1000 on the books, yielding 1%.

Normally, a book entry would follow at the acquisition.

a.1.treasury bonds 1000 on the debet side.
a.2.account balance for the payment: 1000 on the credit side.
b.1.expected interest to be received: 10 on the debet side.
b.2. results to be achieved: 10 on the credit side.

The moment the interest payment is done, a subsequent book entry is made. b.1 and b.2 are reversed. Then a new entry for the receipt of the interest is made: c.1.account balance for the receipt of the interest: 10 on the debet side. c.2.received interest payment: 10 credit side.

To better comprehend what went on here, you can check the balance sheet (BS) and the profit and loss sheet (PnL).

a.1. BS debet 1000 (debtors, other) a.2. BS credit 1000 (usually hidden in the balance of the bank account) total = 0

b.1.BS debet: 10. (debtors short term) b.2.BS credit: 10. (reservation on the balance sheet)

c.1. bank account balance: debet +10 .
c.2. received interest on the PnL: +10.

So far no heavy shit has happened. However, when the situation in the market changes, the books should reflect these changes.

Let's say the interest paid on treasury bonds ups to 2%. What happens to this bond? In practical effect, nothing, as the US government will pay this bond no matter what, even if the FRN is driven into the ground.

However, all of a sudden, the value of that treasury bond has changed on paper, since, when needs be, this bond has to be sold, in order to meet customer demand.

So, let's assume that the value of the bond is reduced to 50% to create a market in which this bond can easily be exchanged for cash. What happens?

Well, all of a sudden the bank has to "write off" some value. In the first instance we saw that the bank made a little profit of 10. Watch what happens:

d.1. write off: 500 debet on the PnL. d.2. correction value of treasury bonds. 500 credit on the balance.

Now we have the "correct" assessment of the value of that bond in the book, yet we have to report a loss on paper of: 490 (-500 + 10).

Where does the risk manager come in? Well in this phase. Smart as he is, he proposes to price risk into the books and in this way safe for a rainy day. In all his benevolence, this risk manager cannot in any way shape or form guess what the FED or the international situation with the dollar will be. Guestimates are his best bet.

Let's assume this bank has followed the advice of this riskmanager and saved for a rainy day 10% of the interest amount.

e.1.risk reservation BS on the credit side: 1.
e.2.risk costs PnL on the debet side: 1.

As you can imagine, to cushen these kind of wild swings, savings such as these won't help. And what is often forgotten, such a riskmanager does costs a lot of money too. So in actuality, more loss in terms of risk aversion.

With this in mind, are we fucked? Yes, big time. But this is exactly what the FED is for.

Patman Argues for Payment in Money," Dallas (TX) Morning News, January 16, 1933, sec. 1, pg. 4, col. 6. This appearance includes only the first part of the quotation ("If the American people ever allow the private banks to control the issue of their currency, first by inflation and then by deflation, the banks and the corporations that will grow up around them will deprive the people of all property until their children will wake up homeless on the continent their fathers conquered")

Thomas Jefferson also was not a fan.

And I sincerely believe with you, that banking establishments are more dangerous than standing armies that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale

With all this info, how ca you proceed? Well, the same as the risk manager with one simple question: What if, then what?

SO, you are looking at bonds? What determines the value of the bond. What happens if the interest goes to x, y, z, in 5, 10, 15 years, or 2,6,10 months?

And do not take: that will never happen for an answer. Why? Murphy's law.

And if you want to discuss these things, be sure to prime yourself with Dilbert.