Fact and Fiction Behind Too Big to Fail

JPMorgan Chase, Derivatives and Really Crazy Too Big To Fail

Jamie Dimon is still both chairman and CEO of JPMorgan Chase. That was a decision appropriately left to shareholders. Some may have hoped that systemic risk could have been reduced by separating the two roles at the nation’s biggest bank. Why should financial market structure center on the abilities of one man? Mr. Dimon certainly is a very talented guy and did a better job of managing risks as the financial bubble grew. But the public never had a chance to test his institution’s fortress balance sheet. The biggest banks were not allowed to fail.

What glues these largest banks together is derivatives. The largest by assets are also the largest derivatives dealers. If one fails, their huge derivatives counterparties are also very likely to fail. That means all of them along with the hedge funds who trade with them. Dodd-Frank defined “systemic” as banks with assets greater than $50 billion. The really crazy systemic story was not addressed.

One picture is worth a thousand words. The following chart shows Federal Reserve data taken from bank holding company peer reports. If one searches for the “top bank holding companies,” the Fed’s fifty largest bank holding companies list pops up. Each name has a hyperlink to its peer and other Fed regulatory reports. The Fed ranks these bank holding companies by assets. Take a look at their derivatives. (Click on the PDF file.)

  Peer_Group_1_Indiv_Bank_Credit_Derivs_as_Percent_of_Assets_thru_2012.pdf (28.6 KiB, 404 hits)

As of the end of 2012 JPMorgan Chase topped the derivatives volumes at  $63.5 trillion in notional amount. They are the largest bank by assets and by derivatives. The largest banks’ derivatives portfolios are 27 times as large as their assets, except for Wells Fargo, which may be why Warren Buffett liked them so much. Nearly all the smaller, yet still Dodd-Frank-systemic banks’ derivatives portfolios are smaller than their asset base. Credit derivatives are particularly concentrated, as the Office of the Comptroller of the Currency mentions in its quarterly report on derivatives.

The chart illustrates a number of issues. It shows each bank’s rank in the Top Fifty, for those U.S. headquartered banks with at least $50 billion in assets. It lists the absolute amount of each bank’s derivatives and assets, both in billions of dollars. As can be seen, the largest banks hold nearly all their derivatives for trading, not for hedging. It shows their credit derivatives. Their credit derivatives as guarantor are basically insurance contracts they have underwritten on corporate and sovereign debt of other borrowers. Finally, it compares six years of history of the ratio of their notional amount of derivatives to their asset base. The biggest are severely systemic — highly concentrated in derivatives. This is really crazy wacky gonzo systemic.

As was shown in 1998 and 2008, just the fear of failure and resulting unsettled markets caused government intervention. Dodd-Frank actually strengthened the government’s ability to interfere. While it talks about an orderly resolution, that orderly resolution contemplates orderly resolution of single institutions. When markets start to get really nervous, liquidity begins to dry up and credit spreads widen, senior government officials are not likely to stay calm and pursue those orderly resolutions. The best protection for taxpayers and for ordinary citizens and businesses who have to live without government bailouts is to prevent bubbles of systemic severity.

Break up the biggest banks and separate their trading from their commercial and retail lending.

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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