Over-the-Counter Underground Derivatives

Gretchen Morgenson’s description last week of just a few of the ways Timothy Geithner protected the largest banks rather than the nation’s financial system concluded with the former Treasury Secretary blocking a bill to limit the size of deposit-taking banks. (Banks, at Least, Had A Friend in Geithner) By this action Secretary Geithner was protecting the biggest banks and enhancing the moral hazard of systemic risk. Lurking behind this event is one aspect of the biggest banks’ size that has been totally missed by regulators, Congress and federal officials. That is their size, measured by derivatives.

The least understood sector of global financial markets is derivatives. Nearly all citizens know they exist, but have no clue what they are. Even Congressmen, who are charged with establishing our market framework, don’t understand these influential instruments. I’d venture that a large percentage of those who work in the financial sector also don’t understand them. Only those who actually trade derivatives truly understand what they are, how they tie the largest banks together through counterparty risk and how they can influence markets. These are a relatively small number of sophisticated investors and traders.

The senior executives who run our largest banks profit greatly from preserving the derivatives status quo of ignorance and neglect. They and their boards are tasked with overseeing the massive risks assumed by their derivatives traders. The Whale Tale showed how derivatives can cause large losses even at a bank as well managed as Jamie Dimon’s JPMorgan Chase.

Our Congressmen and President continue to say that regulators must do their job this time. Our top regulators continue to provide public reports on our largest banks’ derivatives activities. They point out astounding risks, but still take no visible action to address the issues they raise.

Example 1: The Federal Reserve.

The Federal Reserve publishes its Bank Holding Company Peer Reports each quarter. The Peer Report for a bank can be accessed through the Fed’s list of the Top 50 Bank Holding Companies. The Top 50 list ranks the banks by asset size. Clicking on a bank’s name leads to three kinds of reports. The top one is the Peer Report. Just follow the choices.

In the most recent ranking on the Top 50 list of September 30, 2012, our largest banks’ assets exceeded $1 trillion. JPMorgan Chase and Bank of America exceeded $2 trillion. Goldman Sachs and Morgan Stanley were a little smaller at $950 billion and $765 billion, respectively. The asset size drops rather rapidly from there. The next two after Morgan Stanley are about $350 billion in assets. The 38th largest bank holding company by assets, Zions Bancorporation at $53 billion, is the first to exceed the $50 billion asset threshold defining “systemic” under Dodd-Frank. One could say there are “Systemic Banks” and “Really, Really Systemic Banks.” But wait until you look at the derivatives numbers.

The Peer Reports have another statistic, the notional amount of their derivatives as a percentage of their assets. The Fed divided the total notional amount of each bank’s derivatives portfolio by its assets. The average for Peer Group 1 was 113.4% at the end of 2011. That means Peer Group 1’s average derivatives portfolio was a little larger than their average asset base — 1.1 times. (Quarterly numbers aren’t audited, but year end numbers are. I use year-end here. Peer Group 1 contains the largest bank holding companies with at least $10 billion in assets.)

The percentage for the largest of these largest banks needs some thought. The percentages are huge. Huge times huge.

The number for Goldman is the largest in Peer Group 1 at 4,789%. That says that their derivatives portfolio was nearly 48 times the size of their rather large asset base. Morgan Stanley’s derivatives portfolio size, 6,301% or 63 times the size of its asset base, is larger, but Morgan Stanley is classifed in Peer Group 9 — “atypical” by the Fed. (It’s another story for a different post.) JPMorgan Chase’s percentage was 2,880% (29 times its asset size), Bank of America’s 3,028% (30 times) and Citigroup’s 2,577% (26 times).

Wells Fargo is huge, measured by assets, with a $1.4 trillion asset base, but its derivatives portfolio is 244% of its assets, a mere 2.4 times. It isn’t one of the big derivatives dealers. This is the same story for the other large bank holding companies. The next largest derivatives percentage was State Street Corporation at 643%, or six times its asset base, which was only $204 billion. Bank of New York Mellon followed at 417%, or four times its $340 billion asset base.

Why didn’t Dodd-Frank have a “Really Crazy Systemic Bank” category that would focus the tsunami of derivatives regulation on those who really trade them?

Example 2: The Office of the Comptroller of the Currency (OCC)

When the big bank CEOs are summoned to Congressional hearings, they defend their derivatives practices using examples of well-known household names. They claim the named corporations providing useful products to the public would suffer if the derivatives marketplace were touched. The regulators’ conclusion in Example 2 might disagree.

The Office of the Comptroller of the Currency, or OCC, publishes a quarterly report summarizing the derivatives activities of both the FDIC-guaranteed banks and their bank holding companies. They obtain their data from the Fed’s reports in the link described above and the FDIC-guaranteed banks’ call reports, the official quarterly filings with the FDIC.

Pick any OCC quarterly report in recent years and you will find Chart 1 showing that nearly all derivatives trades are the dealers’ trading, not the end users like a consumer products company. The end users’ derivatives are a tiny sliver of the action. Note on the same chart that the credit derivatives that were so toxic for AIG are still being underwritten by these largest firms. The reader will find that the OCC concludes in Graph 4 that a small number of banks dominate credit derivatives trading. These are the Systemiest of the Really Really Systemic Banks.

Example 3: Regulators and Credit Default Swaps.

If Congress wants our regulators to really regulate and take action, why does it not heed the warnings of Sheila Bair, the former FDIC chairman? She asserted both while in that office and in her recent book, Bull by the Horns, that only those holding an “insurable interest” in a debt security should be able to buy a credit default swap. Yet any market player can still buy a credit default swap underwritten by a small group of banks now officially backed by the U.S. government and get a payout if the underlying debtor defaults, even if that player doesn’t hold the debtor’s debt. It’s like anyone being able to buy an insurance policy on your neighbor’s house, which is illegal in the insurance industry.

Example 4: Ignoring Credit Default Swap Concentration

The concentration in the CDS market is clearly described by the OCC. Also, the continued presence of CDS risk was described by Michael Casey in his book, The Unfair Trade: How Our Broken Global Financial System Destroys the Middle Class, in the chapter on “PIIGS and the Systemic Crisis.” Officials from the European Union, the International Monetary Fund and the European Central Bank consulted with the International Swaps and Derivatives Association to change the definition of a default so that payouts wouldn’t be required. The world’s largest banks were too weak to make payouts. They changed the language in private sector contracts rather than addressing the issue of insured interest or taxpayer backing of a concentrated CDS market.

The OCC changed the wording in Graph 4 from “Five Banks Dominate in Derivatives” in 2011 to “Four Banks Dominate in Derivatives” at the beginning of 2012. As can be seen in Tables 1 and 2, little had changed to explain why only four rather than five banks dominated derivatives in 2012. HSCB, a foreign-based big bank, was removed from the group considered among the biggest credit derivative dealers. If it was hard to explain a foreign-based bank in the ranking, maybe that’s why they excluded Morgan Stanley, whose fourth-largest consolidated derivatives portfolio in Table 2  was larger than even Goldman Sachs’.

Rather than commenting on leverage, the OCC report seems to hide Goldman Sachs Bank USA’s leverage relative to its FDIC-guaranteed peers’ leverage in Graph 5A. Take a look at the scale and the data. Goldman looks a little less leveraged the way the graphs are designed, but its leverage is actually substantially higher within this bank.

Example 5: Congress — Completely Ignoring Derivatives Altogether

The Financial Crisis Inquiry Commission, appointed by Congress, seemed to have a comprehensive schedule to examine the housing bubble and financial meltdown. Its three days of hearings on derivatives commenced on June 30, 2010, the same day the House agreed to the conference committee version of what became the Dodd-Frank bill. They’d already planned what to do about derivatives before they even got to that part of the inquiry. The Senate agreed to the conference committee version in mid-July, about two weeks later.

On June 30th in the first FCIC hearing Professor Michael Greenberger of the University of Maryland School of Law testified that $52 trillion in derivatives risk was at stake at the time of the meltdown, an amount nearly the size of the entire world’s GDP — measured using the Fed’s assumptions, but conservatively measured in his opinion. This wasn’t the notional amount. It was the derivatives risk exposure that really mattered.

He emphasized the point that “The Taxpayer is the Lender of Last Resort in the CDS Casino” and described the interconnectedness of the other types of over-the-counter derivatives that actually create “Too Big To Fail.” He referenced former regulators who shared his opinion. Congress didn’t take any time to understand derivatives when passing Dodd-Frank.

Franklin Roosevelt had his reservations about the government guaranteeing deposits back in 1933. But the measure was deemed necessary to keep deposits stable to support loans to businesses and individuals, commercial banking’s vital credit function in the economy. What would he have thought of the U.S. government backing sophisticated derivatives trading among institutional financial entities?

Example 6: The Fed Overrides the FDIC — Goldman Sachs Bank USA

My final example of regulators reporting, but not acting is a look at Goldman Sachs’ call reports from their FDIC-guaranteed bank, Goldman Sachs Bank USA. This bank was established in 2004 when the SEC had approved its Consolidated Supervised Entities new regulatory regime allowing investment banks to expand their riskiest trading activities. Goldman Sachs Bank USA was first chartered in Utah as an industrial bank. Most of the investment banks created one after the demise of Glass-Steagall.

In 2008 during the meltdown, Goldman Sachs Bank USA’s charter was changed to New York state. Huge amounts of its derivatives including credit derivatives were moved into this FDIC-guaranteed bank, where they remain. Here are the numbers. No interest rate derivatives in 2007. $38.6 trillion in interest rate derivatives in 2008. $41.7 trillion at the end of 2011. No credit default swaps in 2007. $640 billion of credit default swaps in 2008. They’d declined to $198 billion at the end of 2011. (Wouldn’t we all like to know what risk this brilliant firm is retaining?) Nearly all derivatives were classified as being held for trading purposes. How would Franklin Roosevelt behave in present-day Washington?

One has to look no further than Mr. Geithner’s speech to a Federal Reserve Bank of Chicago conference on October 1, 2004, on “Systemic Financial Crises — Resolving Large Bank Insolvencies” to see how thoroughly this very intelligent and experienced federal official understood all the structural issues. He’d never actually run a bank or any portion of one. He was President of the New York Fed at the time. He did nothing to halt the growth of the systemic bomb and pretty much only protected the largest banks after their rescue by taxpayers. The Obama administration in fact brought on Paul Volcker, an admired former Fed Chairman who strongly believed the biggest banks needed to be broken up. They then proceeded to work against his recommendations.

The financial meltdown in 2008 is much more about trading than sheer asset size. The growth in asset size provided political clout, but trading created the truly systemic risk of interconnected huge banks. With residential mortgage securitization, the biggest trading firms first sold prime mortgages. Then they added subprime, Alt-A and liar loans to the securitization volumes crossing their trading desks. These sales were facilitated by the “reps and warranties” provided by the sales desks to repurchase the securities if they aren’t as represented, promises now backed by the U.S. government’s view that these banks are systemic.

Derivatives were the other major way to break up risks, then repackage and trade them. They expanded in global volume from $95 trillion in 2000 to over $600 trillion at the end of 2011.

Our nation’s biggest banks created a superhighway of risk, backed by the U.S. taxpayer. They continue  to collect the tolls.