Fact and Fiction Behind Too Big to Fail

An Even Playing Field? This Is the Himalayas!

An even playing field is an essential component of America’s sense of fair play. Nowhere is it more critical to success than in the very competitive world of our largest banks.

So a Bloomberg News article of October 18, 2011, led to a number of surprises in that arena. The article described how the Federal Reserve overrode the FDIC and allowed Bank of America to move Merrill Lynch derivatives into the FDIC-guaranteed bank, Bank of America N.A. The bank is owned by the bank holding company Bank of America Corporation.

The article said the Fed justified its action as the move gives relief to the bank holding company. The bank, however, is where the Federal deposit guarantee is lodged. This is one of many examples that the Fed’s management of the biggest bank holding companies is based upon survival of these giants rather than any well-grounded public policy.

Congressional hearings are showcases for what Congress and regulators purport to be the nation’s financial policy. Reality is radically different in the case of derivatives. Former Fed Chairman Alan Greenspan is known as a believer in minimal regulation. He testified before Congress on two occasions in favor of eliminating the barriers between investment banking’s risky trading and the Federal deposit guarantee of commercial banking — on June 17, 1998, and on April 28th, 1999. Even he claimed that the risky new activities should be housed in a sister subsidiary of the holding company, separately financed from the FDIC-guaranteed bank. In the June testimony Chairman Greenspan praises House bill H.R. 10, soon to become Gramm-Leach-Bliley, which overturned the Depression era Glass-Steagall barriers. The decision in H.R. 10 to use the holding company structure “prevents the spread of the safety net and the accompanying moral hazard to the securities and insurance industries and assures a level playing field within the financial services industry.” He was even more explicit in April 1999. “This requires that the new activities be permitted through holding companies and prohibited through banks.”

Those who remember the Dodd-Frank debates might recall that Senator Blanche Lincoln proposed moving derivatives out of the holding company altogether. She didn’t find much support. Of course few on the planet understand derivatives, and that’s what both the industry and Congress count on to continue.

The Bloomberg journalists, Bob Ivry, Hugh Son and Christine Harper, provided some statistics to illustrate. About 71% of Bank of America’s derivatives, which totaled nearly $75 trillion at June 30, 2011, were lodged in the FDIC-regulated bank. At fellow big bank holding company JPMorgan Chase about 99% of derivatives were lodged in the bank. They used data from public reports on bank derivatives assembled by the Office of the Comptroller of the Currency, the multi-state bank regulator.

The data in the OCC reports leads to even more interesting observations. Merrill Lynch was one of five major purely investment banks before the crisis. But so were Goldman Sachs and Morgan Stanley. Calculating the percentage of derivatives in the FDIC-guaranteed bank in earlier quarters does in fact show the movement of Merrill’s derivatives into the Federally-guaranteed banking subsidiary. At the end of the first quarter of 2009 50% of Bank of America’s derivatives were in the banking sub. The percentage increases over subsequent quarters and was 75% at the end of the third quarter of 2011.

But the percentages for the historically-commercial banks that merged to become JPMorgan Chase were always very high. At the end of 1998 the percentages for Chase Manhattan Bank, Morgan Guaranty Trust and the First National Bank of Chicago were 99%, 99% and 98% respectively. The high percentage wasn’t the case for all though. Citibank’s percentage as a subsidiary of Citigroup was 46% in 1998, but 100% at September 30, 2011.

The real surprise was the comparison of Goldman Sachs and Morgan Stanley. These two investment banks became bank holding companies in the fall of 2008 after the collapse of Lehman Brothers. That’s why much of the reporting data isn’t available from these two bank holding companies before 2009. Yes, they do have FDIC-guaranteed bank subsidiaries. But these bank subsidiaries were always very small, almost inconsequential, until they became the vehicles to quickly make these investment banking behemoths bank holding companies subject to Federal Reserve regulation.

The OCC derivatives report shows that Goldman housed 84% of its derivatives in its FDIC-guaranteed subsidiary at the end of the first quarter of 2009. The percentage for Morgan Stanley for that period was zero. Fast-forwarding to the end of the third quarter of 2011, the most recent of the reports, Goldman’s percentage had risen to 90% while Morgan Stanley’s was still a meager 4%.

Goldman’s counterparties enjoy the benefit of the FDIC guarantee, but Morgan Stanley’s don’t. Not only is the taxpayer on the hook for underwriting of credit default swaps by these big banks. This is no even playing field. It’s the Himalayas.

Fairy Tale Capitalism: Fact and Fiction Behind Too Big to Fail

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Was the mortgage debacle the sole cause of the financial bubble's collapse? Do you believe those who say the elimination of Glass-Steagall barriers didn't contribute to its building? Fairy Tale Capitalism: Fact and Fiction Behind Too Big To Fail places the mortgage mess into a broader perspective. It explains how the Federal deposit guarantee was married to investment banking's trading intensity, why the Fed had no choice but to bail out the biggest banks and how derivatives played a poorly-understood, but equally important role in the crisis. In simple terms Emily Eisenlohr walks with those who live on Main Street down Wall Street's darker alleys.

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