“Don’t fight the Fed!”
That’s the second-best known maxim in financial markets after “buy low, sell high.” But if market participants “don’t fight the Fed,” Federal Reserve actions that differentiate between Too Big To Fail banks may add to systemic risk.
What makes these huge banks systemic is their interconnectedness, particularly through derivatives. Weakness in one can be transmitted to other derivative counterparties. Why make one weaker than its peers? This is why the Fed’s uneven treatment of Goldman Sachs’s and Morgan Stanley’s derivatives is puzzling.
Dodd-Frank calls all banks with assets greater than $50 billion “systemic.” My July 1st post showed how derivatives trading makes the biggest of the banks really wacko crazy systemic.
Examining the big banks’ derivatives activities in their regulatory reports over the past few years has been more like a journey than an investigation. Two research paths on the subject of derivatives eventually merged, with strange observations along the way.
On the first path, I was tracking the biggest banks’ derivatives credit exposures. I had used these risk measures in my book published in 2010 to compare their size measured by their derivatives trading as contrasted with their asset bases. Bank of America and JPMorgan Chase may have been the largest in recent years by assets, but Goldman was consistently the largest derivatives-trading bank.
A bank’s derivatives “credit equivalent amount” measures credit exposure to counterparties. Will they fulfill these promises of future performance? How much might a counterparty owe if all its derivatives contracts were unwound? The credit equivalent amount (CEA) is used as part of risk-based capital calculations by U.S. regulators to capture derivatives credit risks. It can be found on line 54 in the off-balance-sheet exposures section of the risk-based capital calculation (Federal Reserve report FR Y-9C, Schedule HC-R). It’s a single number, hopefully calculated fairly similarly from bank to bank. You can find this report by clicking on the bank holding company’s name in the Fed’s list of the top bank holding companies.
One could blog all day on the significance of this single number. It drives the amount of capital set aside to cover derivatives trading risk. This blog post, however, focuses on the uneven regulatory picture.
Here are the quarterly credit equivalent amounts for the six largest U.S.-headquartered banks from 2009 through 2012. (Click on the PDF link below.)
Quarterly-Derivatives-Credit-Equivalent-Amounts-thru-2012.pdf (37.5 KiB, 900 hits)
When I first tracked this, the relative size of Goldman’s derivatives in the first quarter of 2009 stuck out, with Morgan Stanley’s not much smaller. These two firms are very much about trading. They had very large derivatives credit exposures. Over time, the CEAs declined. This could be attributed to interest rate declines, lower perception of risks (or volatility) as the markets calmed down and portfolio reductions due to regulatory pressures.
But something happened at Morgan Stanley in the first quarter of 2011. A number doesn’t drop from $239 billion to $86 billion without something significant to explain it. Their derivatives notional amounts hadn’t changed dramatically. They weren’t getting out of the business. However, Morgan Stanley had published a few press releases talking about how they were moving some credit derivatives to organized exchanges. I blogged on this issue in June of 2012.
I first called the company to inquire, but received no response. Not surprising as I no longer have institutional credentials being a private citizen. I related my findings to the Fed and received a response from them (no name attached) on August 12, 2011, saying they were aware of the issue and were working to resolve it. As noted in the earlier blog post, Morgan Stanley increased its regulatory capital $44 billion in the third quarter of 2011 to account for the restatement. Its third quarter earnings release attributed the change to treatment of collateral underlying over-the-counter derivatives. They had received a notice from the Fed in October 2011 regarding the collateral treatment. At the time it seemed unusual for just one bank to pursue what may be regarded as aggressive regulatory capital accounting practices. Might the Fed have initially allowed Morgan Stanley’s practice, changing its view when the public paid attention? Why would the Fed have allowed lower capital percentages against derivatives risk for a single bank? The world moved on.
The second research path began when I read an article in Bloomberg in October 2011 about the Fed overriding the FDIC and allowing Bank of America to move Merrill Lynch’s derivatives contracts from the Merrill Lynch subsidiary into the FDIC-guaranteed Bank of America, N.A. — the banking subsidiary carrying the federal government’s deposit guarantee. This seemed astounding, giving derivatives trading the protection of a federal guarantee. The FDIC guarantee, established in 1933, was intended to build trust in a commercial bank to prevent bank runs by depositors so that the bank’s loans didn’t have to be called. Its goal was supporting lending, not trading.
The Office of the Comptroller of the Currency publishes quarterly derivatives reports with useful comparative data and charts. The reports have a table for the largest derivatives balances for the FDIC-insured banks and a table for the largest derivatives balances for the Fed-regulated bank holding companies. If one divided the amount of derivatives in Bank of America N.A. (the U.S. FDIC-guaranteed bank) by the amount of derivatives in the Bank of America holding company (the whole global company), the percentage was, in fact, what was reported. Since derivatives were the hidden side of the financial bubble, what was happening with the other biggest banks?
I did the same type of calculation for the largest banks for several time periods. First, I calculated the third quarter 2011 percentages for the other largest banks, the same period as in the article. Goldman Sachs’s percentage was even higher, and it was supposed to be purely an investment bank. Then I went back in time to the first quarter of 2009 and then to the end of 2011. Goldman Sachs and Morgan Stanley had been made bank holding companies regulated by the Fed after the demise of Lehman Brothers and subsequent market meltdown. These two huge investment banks began their reporting to the Fed in the first quarter of 2009. Had the percentages increased over time from the beginning of 2009 to the end of 2011? The answer was yes, except for Morgan Stanley.
One other question arose in my mind. What had been the percentages of derivatives within FDIC-guaranteed banks back in 1998 when Congress was debating the elimination of Glass-Steagall barriers between investment and commercial banking? Maybe the derivatives were already booked in the FDIC-guaranteed bank for other big banks. This wasn’t so easy to compute due to mergers.
Here are some of those calculations — for 1998, 2009 and 2011, including some of the merged predecessors of today’s biggest banks. (Click on the PDF link.)
Percent-Derivatives-in_FDIC-Bank-vs-BHC-SELECT-thru-2011.pdf (64.8 KiB, 924 hits)
As an earlier post revealed, Goldman’s derivatives are now 100% in their FDIC-guaranteed bank, according to their regulatory filings. This is rather stunning since Morgan Stanley still has only six percent of its derivatives in its FDIC-insured bank as of the end of 2012 despite its having the fourth largest derivatives portfolio among the bank holding companies regulated by the Fed. The notional amount of Goldman’s derivatives portfolio at year-end 2012 was $44 trillion and Morgan Stanley’s $45 trillion. Pretty much the same size.
Did the Fed intend to allow lower amounts of regulatory capital for Morgan Stanley because it wasn’t allowing it to move its derivatives into a higher-rated, federally-protected subsidiary? The higher credit rating on the banking subsidiary might have led to lower collateral requirements for the derivatives contracts that were allowed to be moved. Was there a regulatory hitch that prevented the Fed from allowing the derivatives contracts to be moved due to Morgan Stanley’s ownership of a retail broker/dealer? If that were the case, why would a purely institutional investment bank like Goldman get better treatment than a more retail-oriented investment bank like Morgan Stanley? Its institutional clients are more sophisticated. A cynic might say that as sophisticated financial players they pay more attention to the benefits of federal guarantees. JPMorgan Chase has a strong retail (little guy) sector, too, and its derivatives are largely in its FDIC-insured banking subsidiary. Moving the derivatives contracts into the federally-protected banking subsidiary is undeniably favorable. The Bloomberg article mentioned that derivatives counterparties had requested the move in the Bank of America/Merrill Lynch case.
As Blanche Lincoln experienced during the Dodd-Frank legislative debates, this is one of the biggest hornets nests in downsizing the Too Big To Fail banks. JPMorgan Chase’s two major predecessors always had their derivatives in the FDIC-insured bank. Since JPMorgan Chase is now actively an investment bank as are Citigroup and Bank of America, why shouldn’t all of the investment banks have the same privileges? The answer is that the Fed and Congress have it backwards. Derivatives should be moved not only out of the FDIC-insured banking subsidiary, but also out of any financial organization associated with the FDIC deposit guarantee. Once the federal foot is in the door, the markets know it’s party time regardless of lip-service to “no more bailouts.”
The joke may be on the American public and taxpayer. Sophisticated financial players rely upon the assumption that derivatives will once again be protected by the federal government as they were in 2008. If a large bank like these Too Big To Fail banks were to falter and need more equity capital to improve its capital ratios, it isn’t the FDIC-insured banking subsidiary or any sister derivatives-trading subsidiary that would issue the stock. It is the holding company itself, sitting on the top of the ownership pyramid, that issues stock. Not Citibank, N.A., but Citigroup. Not Goldman Sachs Bank USA, but The Goldman Sachs Group, Inc. Any investor in its stock would be investing in all the subsidiaries and nooks and crannies of the whole organization, not just its federally-insured bank.