Bailing Out Promises

“No more bailouts!” That’s the latest campaign promise from both presidential candidates. Congressmen have claimed that regularly, too. But bailouts of the biggest banks continue. What they are bailing out may surprise you.

In Congressional hearings the biggest banks want us to believe they are like the little savings and loan portrayed in the movie It’s a Wonderful Life. What really plays inside big bank theaters is more akin to the Star Wars saga. Jamie Dimon says he possesses a “fortress balance sheet”, but JPMorgan Chase’s derivatives lurk elsewhere under U.S. accounting rules.

When a bank makes a loan, the money is out the door. The asset is on its balance sheet. But when two banks enter into a derivative contract, they are making promises to each other to exchange risk or money well out into the future. Derivatives contracts often extend longer than five years. A balance sheet shows assets, but it has little information about the bank’s derivatives.

In his book Bailout Neil Barofsky, a Democrat appointed by President Bush and retained by President Obama, described how protecting the biggest banks’ mortgage activities continues under Treasury Secretary Timothy Geithner in the Obama administration. A Federal Reserve report and an Office of the Comptroller of the Currency report show how the full faith and credit of the U.S. government also stand behind derivatives.

The Federal Reserve produces a bank holding company performance report each quarter. The report divides banks into five peer groups. Peer Group 1 comprises banks with assets of $10 billion or more. 69 banks were in that category in 2011.

Banks don’t differ wildly among peer groups when looking at loans as a percentage of total assets. But “wildly” captures how they differ when it comes to derivatives as a percentage of total assets. The Fed includes a table showing how measurements vary among the highest to the lowest readings within the peer group. In 2011 derivatives contracts comprised 1,884% of total assets for those Peer 1 banks in the 95th percentile of that group — the top 5% with the highest values in that measurement. Given that there are only 69 in that particular peer group, that may be the ratio for just one bank. The Peer Group 2 banks in their 95th percentile that same year had booked derivatives that comprised only 32% of their total assets. Peer Group 2 had 94 banks in 2011.

Even within only the largest-size peer group, Peer Group 1, the 90th percentile banks had derivatives that were 356% of assets. Those in the 75th percentile had derivatives that were only 60% of assets. The percentages of derivatives compared to assets drop quickly. The point this math is making is that derivatives activities within the banking world are highly concentrated among the largest banks.

The Office of the Comptroller of the Currency produces an excellent report on derivatives each quarter. The OCC assembles the report from the bank’s filings with the Fed and the FDIC. When Congress attempts to restrict the biggest banks’ derivatives activities, these big banks claim it will affect credit and the economy. The OCC’s derivatives report has shown for years that derivatives end-users account for only a tiny sliver of all derivatives. Nearly all are derivatives held for trading by dealers.

What really may be a shocker is to see what happened with Goldman Sachs’ derivatives  during the meltdown. Goldman set up an FDIC-guaranteed bank back in 2004, the year the SEC established its new regulatory regime for derivatives trading called Consolidated Supervised Entities. (The SEC subsequently admitted that the new regulatory regime didn’t work.) Most of the investment banks set up FDIC-guaranteed banks by that point, chartered in the state of Utah.

Goldman Sachs Bank USA (the Utah-based, FDIC-guaranteed bank) had virtually no derivatives on its books through 2007 according to its call report, the official FDIC report filed by a bank quarterly. In 2008 Goldman Sachs Bank USA had become a New York-chartered bank. It had $38 trillion of interest rate swaps on its books and had underwritten $640 billion of credit default swap insurance. While the credit insurance Goldman had guaranteed had declined to $198 billion by the end of 2011, the amount of interest rate swaps on Goldman Sachs Bank USA’s books had risen to $42 trillion.

An interesting sidelight, unless you are a taxpayer perhaps, is Graph 5A in the OCC report. What a difference a scale makes. That graph shows the top four biggest FDIC-guaranteed banks’ derivatives holdings as a percentage of their capital. The visual presentation makes them look pretty much the same. The scale for JPMorgan Chase Bank, N.A., rises to 400%. Citibank, N.A.’s scale is 250%. Bank of America, N.A.’s scale rises to only 200%. But Goldman Sachs Bank USA’s scale tops at 1,200%. It’s visually a bit deceptive. Maybe they didn’t have room for the Goldman scale. The OCC does show the underlying data to the right of the graphs with quarterly history back to the beginning of 2009 when Goldman parent first reported as a bank holding company. In the first quarter of 2009 Goldman Sachs Bank USA’s derivatives were 1,048% of risk-based capital compared to 323% for JPMorgan Chase Bank, N.A.’s fortress balance sheet. By the end of 2011 Goldman Sachs Bank USA’s derivatives as a percentage of risk-based capital had declined to 794%. Fortress JPMorgan Chase Bank, N.A.’s ratio also fell, to 256%. The FDIC stands behind that Goldman Sachs Bank USA percentage.

Mildly amusing was the OCC presentation in Graph 4 in the first quarter of 2012. Whereas they had stated in prior quarters that “Five Banks Dominate in Derivatives” — meaning five with the FDIC gurarantee, in this year’s first quarter OCC report four dominated. Yet the numbers hadn’t really changed. With all the attention on the fact that the Fed wasn’t allowing Morgan Stanley to move its derivatives into its FDIC-guaranteed bank, the OCC had removed HSBC Bank USA, N.A. from domination. The real story is at the consolidated level. The OCC’s report lists the Top 25 Holding Companies in Derivatives in their Table 2. JPMorgan Chase & Co. leads the derivatives pack with $73 trillion, followed by Bank of America Corporation with $68 trillion, Citigroup Inc. with $51 trillion, Morgan Stanley with $50 trillion and Goldman Sachs Group, Inc. with $48 trillion. As can be seen, Morgan Stanley is no slouch in derivatives trading. The Fed just favors Goldman Sachs.

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