Paul Volcker knows something you don’t know and that Congressmen don’t want to know. The biggest banks have become massive collectors of hedge funds and other alternative private investment vehicles, hidden behind a facade of traditional banking. To understand this is to understand a major reason why Paul Volcker proposed the Volcker Rule. The largest banks are no longer about traditional lending. They are about trading — derivatives, mortgage-backed securities, anything they can break up, price and move. The government’s FDIC guarantee now stands behind much more than loans to those without access to public markets like small and medium-sized businesses. It backs up trading. 

In a September 20th New York Times Deal Book article Ben Protess described the pushback from certain lawmakers on final Volcker Rule details. The article noted that key points of contention in the debate center on placing risky trades and investing in hedge funds. An aide to Senator Scott Brown (R-Massachusetts) lobbied the Fed and the Treasury Department, requesting changes. The aide, Nathaniel Hoopes, is a former Lehman employee. Lehman, as you will see, owned a number of private investment funds.

If you think the rules regulators will develop will prevent the next crisis, consider this. In 2008, just months before the collapse of the large investment bank Bear Stearns, the U.S. Government Accountability Office (the GAO) published a major report on hedge funds. (HEDGE FUNDS: Regulators and Market Participants Are Taking Steps to Strengthen Market Discipline, but Continued Attention Is Needed.  January 2008) On page one the GAO concluded that market participants cannot fully assess risks — either market risks or counterparty risks — and stated why. It concluded, “Financial regulators and industry participants remain concerned about the adequacy of counterparty credit risk management at major financial institutions because it is a key factor in controlling the potential for hedge funds to become a source of systemic risk.” The report points out that hedge funds are large users of derivatives.

Regulators knew that risks lurked in these markets. The GAO wrote about it. The systemic impact of derivatives has yet to be explored. What we have lacked to date is anyone in the government willing to take the initiative to reduce systemic risk in our financial markets posed by hedge funds, the biggest banks and their derivatives trading.

Hedge funds and derivatives expanded in lock-step. Since hedge funds are large users of derivatives, that correlation cannot be a coincidence.

The GAO stated that in 1998 there were 3,000 hedge funds managing $200 billion. 1998 is noteworthy as the year the big (at the time) hedge fund Long-Term Capital Management collapsed and was rescued by Federal Reserve action (coercing its biggest bankers into taking it over). LTCM was founded and managed by some of the best minds in the industry. That event launched government studies and Congressional debates over hedge funds and the moral hazard of bailouts. The continued expansion of hedge funds over the next decade prompted the GAO’s 2008 report. By early 2007, the report stated, 9,000 hedge funds managed over $2 trillion.

Derivatives also grew exponentially over the same decade. The Bank for International Settlements reported that the notional amount of global derivatives had grown from $80.3 trillion at the end of 1998 to $592 trillion at the end of 2008. Derivatives volume expanded further despite the passage of Dodd-Frank, to $648 trillion at the end of 2011.

The biggest banks state in their annual reports that they are actively involved in and profit from hedge funds in many ways. They own and advise hedge funds in their asset management segments. They provide prime brokerage, administration, clearing and custody services to them. They buy and sell securities and derivatives for them. And they compete with them.

To find specifics I searched the Securities and Exchange Commission’s Edgar site where official company filings reside. The question on my mind was how the legal entities associated with somewhat smaller, but still “officially” systemic bank holding companies differ from those of the largest bank holding companies at the top. (Dodd-Frank categorizes bank holding companies with at least $50 billion in assets as “systemically-significant” banks.) Do all systemically-significant banks have big relationships with hedge funds and actively trade derivatives? Here’s what I found.

Fifth Third Bancorp is ranked #23 by asset size among bank holding companies by the Fed as of June 30th with $117.5 billion in assets. Searching Edgar using the name of the bank, simply “Fifth Third,” a single page of 29 legal entities related to that name appeared. Seven were bank subsidiaries, by state. Eight were capital trusts used to fund the bank. The holding company and bank holding company comprised two. Four were auto trusts. One asset management subsidiary, a few securities subs and a few miscellaneous subs rounded out the page. Many fewer than 40, which the SEC’s Edgar system uses to group search results. Just one LP, a limited partnership. Limited liability entities like LPs, Ltds and LLCs are typical of sponsored hedge and other private investment funds.

I then did a search under the name “Lehman Brothers.” Various LPs and LLCs popped up. Lehman Brothers Credit Arbitrage Fund Ltd, eleven Barclays Wealth Advisor Series LP/LLC, Lehman Brothers Alternative Investment Management LLC, Lehman Brothers Distressed Opportunities Fund, etc. And that’s just on page one. There were four pages at 40 to a page.

So I then tried to be more specific. I searched for “Goldman Sachs hedge.” 23 entities appeared, all with “hedge fund” in the name, followed by LLC, LP or Ltd. Then “Morgan Stanley hedge.” 1 1/2 pages (at 40 to a page) of legal entities popped up.

There usually is little information in the filing though. So I tried another means to see what legal entities JPMorgan Chase owns. I looked at its annual report on the SEC’s form 10-K, exhibit 21. Exhibit 21 shows a list of the holding company’s subsidiaries. JPMorgan Chase’s subsidiaries went on for 9 1/2 pages of its report.

Even though the largest banks state explicitly that hedge funds are a large part of their business, it’s hard to find out how large and how significant, even if you are a trained analyst. The SEC now requires a new report to try to help in that regard for those considering an investment advisor. It’s form ADV. JPMorgan Chase’s lists its many funds, many of which are marked as hedge funds and contain hundreds of millions of dollars invested.

The Federal Reserve publishes more explicit reports on the banks’ derivatives trading. Its most widely followed report is the FR Y-9C. That report can be easily accessed through a link in each bank holding company’s name on the Fed’s list of the Top 50 Bank Holding Companies.

In the June 30th FR Y-9C of Fifth Third Bancorp, the bank had $50.6 billion in notional amounts of derivatives held for trading. (In the HC-L section, line 12, in the report.) The credit equivalent amount (a measure of credit exposure associated with the derivatives portfolio) was $3 billion. (In the HC-R section, line 54, column B.)

If that is systemic, what does the Fed and Congress call the derivatives exposures of the biggest banks? In its FR Y-9C JPMorgan Chase had $63 trillion in notional amounts of derivatives held for trading. $63 TRILLION. The credit default swaps on which it had provided credit guarantees totalled $2.9 trillion. The credit equivalent amount of JPMorgan Chase’s derivatives portfolio was $342 billion. JPMorgan Chase is the largest bank holding company on the Fed’s list, with $2.3 trillion in assets.

Goldman Sachs, the fifth largest bank holding company at $949 billion in assets, is in the same range. Its notional amounts of derivatives held for trading totalled $41.8 trillion. The credit default swap protection it sold was $1.8 trillion. And the credit equivalent amount of its derivatives portfolio was 372 billion.

Little about derivatives exposures appears on bank balance sheets. (It’s in the footnotes.) Out of sight, out of (someone’s) mind?

One concludes from looking at these numbers that roping a bank like Fifth Third Bancorp into the “systemically significant” category isn’t really addressing true systemic risk.

Hedge funds are a legitimate investment vehicle, a mutual fund for sophisticated investors. Derivatives can be very useful risk management tools. But they are little used by small businesses and individuals. When the federal government stepped in to support credit markets by providing the FDIC deposit guarantee in 1933, it didn’t intend to prop up sophisticated investing or trading. But that is what the federal guarantee has become. This is what needs to be explored by our politicians, regulators and financial experts.

Derivatives and the hedge funds which actively use them are very profitable to the banks which trade them. This is what Mr. Volcker knows and tries to curtail. Many Congressmen benefit from those profits in their campaign coffers. But the taxpayer should not be behind those derivatives trading risks and the sophisticated investors in hedge funds who use them.