I’ll pull a couple of items out that illustrate how little is revealed by even the most diligent reading. Here’s a discussion of a disclosure about something called “customer accommodation,” making trades on behalf of customers, that includes a nice explanation of the idea of notional value:
That might seem safe, but the report notably fails to explain why this activity would be so profitable. In fact, at many large banks, customer accommodation can be a euphemism for “massive derivatives bets.” For Wells Fargo, the subcategory of “customer accommodation, trading and other free-standing derivatives” included derivatives trades of about $2.8 trillion in “notional amount” as of the end of 2011, meaning that the underlying positions referenced in the bank’s derivatives were that large then. By way of explanation: if we were to make a bet with you about how much the price of a $70 share of Walmart would change this year—we pay you any increase, you pay us any decrease—we’d say the “notional amount” of the bet is $70.
Wells Fargo doesn’t expect to gain or lose $2.8 trillion on its derivatives, any more than we would expect the payment on our Walmart bet to be $70. Bankers generally assume that the likely risk of gain or loss on derivatives is much smaller than their “notional amount,” and Wells Fargo says the concept “is not, when viewed in isolation, a meaningful measure of the risk profile of the instruments.” Moreover, Wells Fargo reports that many of its derivatives offset each other, as yours might if you placed several wagers that Walmart stock would go up, along with several other bets that it would go down.
Yet, as investors in bank stocks learned in 2008, it is possible to lose a large portion of the “notional amount” of a derivatives trade if a bet goes terribly wrong.
In the future, if interest rates skyrocket or the euro unravels, Wells Fargo might sustain huge derivatives losses, just as you might lose the full $70 you bet on Walmart if the company went bust. Wells Fargo doesn’t tell investors how much of the $2.8 trillion it could lose in a worst-case scenario, nor is it required to. Even a savvy investor who reads the footnotes can only guess at what the bank’s potential risk exposure to derivatives might be.
For me, the most valuable bit was looking at how assets, including exotic securities, are valued. I’ve spent a bit of time looking over Citigroup’s 2005 10-K for a book I’m writing, wondering how much of the pending catastrophe was visible to the curious reporter at the time. There were clues, and certainly it provided the basis for many questions. But in and of itself, it is a deeply deceptive document.