Big Banks and Derivatives: Why Another Financial Crisis Is Inevitable

Steve Denning
Articulo tomado de:
http://www.forbes.com/sites/stevedenning/2013/01/08/five-years-after-thefinancial-meltdown-the-water-is-still-full-of-big-sharks/
Remember Jaws? In 1975, the small town of Amity was on the eve of the Fourth
of July weekend, a time of celebration of the founding of this marvelous
country. But just before the celebration was about to begin, a vicious shark
attack occurs. Concerned about losing the money from the holiday tourist
trade, the mayor and townsfolk ignore the warnings to keep people out of the
water. But then after another shark attack, and yet another, the towns
leadership finally grasps the peril, but not before more disasters occurred.
Jaws, writes John Whitehead, wasnt just a simple story about sharks. Instead, it
was a social commentary about how a love of money can blind us to averting
preventable disasters.
Fast forward to the financial meltdown of 2008 and what do we see? America
again was celebrating. The economy was booming. Everyone seemed to be
getting wealthier, even though the warning signs were everywhere: too much
borrowing, foolish investments, greedy banks, regulators asleep at the wheel,
politicians eager to promote home-ownership for those who couldnt afford it,
and distinguished analysts openly predicting this could only end badly. And
then, when Lehman Bros fell, the financial system froze and world economy
almost collapsed. Why?
The root cause wasnt just the reckless lending and the excessive risk taking.
The problem at the core was a lack of transparency. After Lehmans collapse,
no one could understand any particular banks risks from derivative trading and
so no bank wanted to lend to or trade with any other bank. Because all the big
banks had been involved to an unknown degree in risky derivative trading, no
one could tell whether any particular financial institution might suddenly
implode.
Since then, massive efforts have been made to clean up the banks, and put in
place regulations aimed at restoring trust and confidence in the financial
system. But the result in terms of dealing with the basic problem, according to
a terrific article by Frank Partnoy and Jesse Eisinger in The Atlantic entitled
Whats Inside Americas Banks? is failure.
Another global financial crisis is on the way
Financial reform didnt work. Banks today are bigger and more opaque than
ever, and they continue to trade in derivatives in many of the same ways they
did before the crash, but on a larger scale and with precisely the same
unknown risks.

Ignoring warning signs has inevitable consequences. We ignored them before

and we saw what happened. We can say this with virtual certainty: if we
continue as now and ignore them again, the great white shark of a global
financial meltdown will gobble up the meager economic recovery and make
2008 look like a hiccup.
We cant say when this will happen. We cant say which bank or which
particular instrument will trigger the debacle. What we can say with virtual
certainty is that if we continue as now is that it will happen. Because the scale
of the trading is larger, and because the depleted government treasures are
not well placed for another huge bailout, the impact will be worse than 2008.
Todays financial scandals are mere sideshows
Thus the biggest risk we face is not the stories of repeated wrongdoing by the
banks that are still making headlines, such as:

Trading gone awry: JPMorgans [JPM] loss of $6 billion from trading

activities of which CEO Jamie Dimon was blissfully unaware.
Price fixing at LIBOR. Many of the biggest banks now stand accused
of manipulating the worlds most popular benchmark interest rate, the London
Interbank Offered Rate (LIBOR).
Foreclosure abuses. Just this week, big banks agreed two
settlementstotaling $20.15 billion for foreclosure abuses.
Money laundering: Accusations of illegal, clandestine bank activities
are also proliferating. Large global banks have been accused by U.S.
government officials of helping Mexican drug dealers launder money (HSBC),
and of funneling cash to Iran (Standard Chartered).
Tax evasion: Two Swiss banks were involved in Switzerland-based. In
2009, UBS [UBS] helped 20,000 U.S. taxpayers with assets of about $20 billion
hide their identities from the IRS. Now, the oldest Swiss bank, Wegelin & Co.
has been indicted on criminal charges for helping U.S. taxpayers avoid taxes
on at least $1.2 billion for a nearly ten years.
Misleading clients with worthless securities: Only after the
financial crisis of 2008 did people learn that banks routinely misled clients,
sold them securities known to be garbage, and even, in some cases, secretly
bet against them to profit from their ignorance.
The worlds scariest story: trading in derivatives
Bad as these scandals are and vast as the money involved in them is by any
normal standard, they are mere blips on the screen, compared to the risk that
is still staring us in the face: the lack of transparency in derivative trading that
now totals in notional amount more than $700 trillion. That is more than ten
times the size of the entire world economy. Yet incredibly, we have little
information about it or its implications for the financial strength of any of the
big banks.
Moreover the derivatives market is steadily growing. The total notional value,
or face value, of the global derivatives market when the housing bubble
popped in 2007 stood at around $500 trillion The Over-The-Counter
derivatives market alone had grown to a notional value of at least $648 trillion
as of the end of 2011 the market is likely worth closer to $707 trillion and
perhaps more, writes analyst Jenny Walsh in The Paper Boat.

The market has grown so unfathomably vast, the global economy is at risk of
massive damage should even a small percentage of contracts go sour. Its size
and potential influence are difficult just to comprehend, let alone assess.
The bulk of this derivative trading is conducted by the big banks. Bankers
generally assume that the likely risk of gain or loss on derivatives is much
smaller than their notional amount. Wells Fargo for instance says the concept
is not, when viewed in isolation, a meaningful measure of the risk profile of
the instruments and many of its derivatives offset each other.
However as we learned in 2008, it is possible to lose a large portion of the
notional amount of a derivatives trade if the bet goes terribly wrong,
particularly if the bet is linked to other bets, resulting in losses by other
organizations occurring at the same time. The ripple effects can be massive
and unpredictable.
Banks dont tell investors how much of the notional amount that they could
lose in a worst-case scenario, nor are they required to. Even a savvy investor
who reads the footnotes can only guess at what a banks potential risk
exposure from the complicated interactions of derivatives might be. And when
experts cant assess risk, and large bets go wrong simultaneously, the whole
financial system can freeze and lead to a global financial meltdown.
In 2008, governments had enough resources to avert total calamity. Todays
cash-strapped governments are in no position to cope with another massive
bailout.
Wells Fargo: is this good bank extremely safe?
The article in The Atlantic clarifies whats going on by exploring whats going
on inside what is arguably the safest and most conservative bank: Wells Fargo
[WFC].
Last year, I had written an article about the case for considering Wells Fargo as
a a good bank.
Wells does what banks are supposed to do: take deposits and then lend the
money back out. Interest margin drives half its revenues. Fees from mortgages,
investment accounts and credit cards generate the other half. I couldnt care
less about league tables, says Wells CEO Stumpf. Im more interested in
kitchen tables and conference room tables. By operating a bank like a bank,
the article says, Stumpf has at once made Wells exceedingly profitablefor
2011 the banks net income jumped 28% to $15.9 billion, on $81 billion in
revenueand extremely safe. The value of Wells Fargos shares is now the
highest of any U.S. bank: $173 billion as of early December 2012.
Wells Fargo: large scale trading in derivatives
But among the startling disclosures in the article in The Atlantic from
examining the footnotes in its most recent annual report are:

The sheer volume of proprietary trading at Wells Fargo suggests that

this bank is not what it seems.

A large part of that trading is not in safe conservative things like

equities or bonds but in derivativesthe things that almost blew up the
economy in 2008.

These derivatives are hidden under seemingly the benign headings.

The scale of this trading is breath-taking.
The benignly labeled activity customer accommodations has
derivatives on its books with notional risk of $2 trillion. That number,
assuming it is accurate, can make any particular trading loss appear
minuscule.
A lower circle of financial hell: special purpose entities redux
Ever heard of variable interest entities aka VIEs? If not, you are not alone.
They are phenomena that reside in what The Atlantic calls an even lower circle
of financial hell than proprietary trading. They are basically a new label for
special-purpose entities i.e. the infamous accounting devices that Enron
employed to hide its debts. These deals were called off-balance-sheet
transactions, because they did not appear on Enrons balance sheet.
The article likens variable interest entities to a horror film, which the specialpurpose entity has been reanimated The problem is especially worrisome at
banks: every major bank has substantial positions in VIEs.
As of the end of 2011, Wells Fargo, the extremely safe bank, reported
significant continuing involvement with variable-interest entities that had
total assets of about $1.5 trillion. The maximum exposure to loss that it
reports is much smaller, but still substantial: just over $60 billion, more than
40 percent of its capital reserves. The bank says the likelihood of such a loss is
extremely remote. As The Atlantic comments: We can hope.
Worse: Wells Fargo excludes some VIEs from consideration, for many of the
same reasons Enron excluded its special-purpose entities: the bank says that
its continuing involvement is not significant, that its investment is temporary or
small, or that it did not design or operate these deals. (Wells Fargo isnt alone;
other major banks also follow this Enron-like approach to disclosure.) The
presence of VIEs on Wells Fargos balance sheet is a signal that there is
$1.5 trillion of exposure to complete unknowns.
Other banks are even riskier
Thus it turns out that Wells Fargo isnt so much an extremely safe bank in
absolute terms but rather a bank that isnt doing as much risky stuff as the
other big banks. One reason Wells Fargo is trusted more than other big banks
is that its notional amount of derivatives is comparatively small Its just
somewhat less involved in derivatives than other banks. The amount of its
notional involvement in proprietary trading in derivatives amounts to only
about half the size of the entire US economy.

By contrast, at the end of the third quarter of 2012, JPMorgan

had$72 trillion in notional amount on its booksalmost five times the size of
the U.S. economy, or about the size of the entire world economy.
But even at the lower levels of trading by Wells Fargo, the numbers are so large
that they put Wells Fargos seemingly immense capital reserves$148 billion
as a mere drop in an ocean of potential losses.
Wells Fargo declined to answer questions from the journalists from The Atlantic.
Their response to requests for clarification was to suggest re-reading the
unhelpful sections of the annual report. They also declined to answer: How
much money would Wells Fargo lose from these trades under various
scenarios?
Ironically, Jamie Dimon has been proven right when he made light of the $6
billion trading loss at JPMorgan last year. Compared to the scale of these
potential losses, and the financial crisis that lies ahead, a loss of $6 billion is
merely a tempest in a teacup.
How does Wells Fargo make money?
The Atlantic also finds worrying issues in how Wells Fargo does make money.
Scouring through Wells Fargos annual report, seemingly safe conservative
categories turn out to involve proprietary trading:

Almost $1.5 billion of the seemingly safe interest income comes from
trading assets;
Another $9.1 billion results from securities available for sale.

One billion dollars of the banks seemingly safe non-interest income

are net gains from trading activities.

Up and down the ledger, abstruse, all-embracing categories appear:

other fees earned from related activities, other interest income, and just
plain other. The income statements other catchalls collectively amounted
to $6.6 billion of Wells Fargos income in 2011.
Meanwhile in this world of shell games and mind-boggling numbers, big losses
can go unremarked. Buried in a footnote on page 164 of Wells Fargos annual
report is the admission of a trading loss of $377 million loss on trading
derivatives related to certain CDOs, or collateralized debt obligations went
unremarked, because of bigger losses for instance at JPMorgan. Wells Fargos
massive CDO-derivatives loss was a multi-hundred-million-dollar tree falling
silently in the financial forest. To paraphrase the late Senator Everett Dirksen,
$377 million here and $377 million there, and pretty soon youre talking about
serious money.
Specialists and hedge funds as much in the dark as the public
Public confidence in banks is now at a record low. According to Gallup, in the
late 1970s, around 60 percent of Americans said they trusted big banks a

great deal or quite a lot. In June 2012, less than 25 percent of respondents
told Gallup they had faith in big banks.
But its not just public confidence. Specialists are equally bewildered. The
Atlantic cites:

Ed Trott, a former Financial Accounting Standards Board member, when

asked whether he trusted bank accounting, he said, simply, Absolutely not.

Several financial executives told The Atlantic that they see the large
banks as complete black boxes.

A chief executive of one of the nations largest financial institutions

considers banks uninvestable, a Wall Street neologism for untouchable.

Paul Singer, who runs the influential investment fund Elliott Associates,
wrote to his partners this summer, There is no major financial institution
today whose financial statements provide a meaningful clue about its risks.

Arthur Levitt, the former chairman of the SEC, lamented to us in

November that none of the post-2008 remedies has significantly diminished
the likelihood of financial crises.

A recent survey by Barclays Capital found that more than half of

institutional investors did not trust how banks measure the riskiness of their
assets.

When hedge-fund managers were asked how trustworthy they find risk
weightingsthe numbers that banks use to calculate how much capital they
should set aside as a safety cushion in case of a business downturnabout
60 percent of those managers answered 1 or 2 on a five-point scale, with 1
being not trustworthy at all. None of them gave banks a 5.

A disturbing number of former bankers have recently declared that the

banking industry is broken, including Herbert Allison, the ex-president of
Merrill Lynch and former head of the Obama administrations Troubled Asset
Relief Program, Philip Purcell (ex-CEO of Morgan Stanley Dean Witter), Sallie
Krawcheck (ex-CFO of Citigroup), David Komansky (ex-CEO of Merrill Lynch),
and John Reed (former co-CEO of Citigroup) and Sandy Weill, another ex-CEO
of Citigroup. The Atlantic notes that this newfound clarity typically follows
their passage from financial titan to rich retiree.

Bill Ackman, one of the nations highest-profile and most successful

investors, lost almost $400 million betting on the recovery of Citigroup [C].
Last spring, Pershing Square sold its entire stake in Citigroup, as the banks
strategy drifted, at a loss approaching $400 million.
Wall Street doesnt trust big banks
Wall Street already reflects its distrust of the big banks. Even after a run-up in
the price of bank stocks this fall, many remain below book value, which
means that the banks are worth less than the stated value of the assets on
their books. This indicates that investors dont believe the stated value, or
dont believe the banks will be profitable in the futureor both.

The reality is that even an ostensibly simple and extremely safe bank like
Wells Fargo impossible to understand. Every major banks financial statements
have some or all of these problems; many banks are much worse.
Regulation hasnt worked
In the wake of the recent financial crisis, the government has moved to give
new powers to the regulators who oversee the markets. But the net result of
the effort to regulate the big banks is almost as stupefying as the amounts of
money involved. Draft Basel III regulations total 616 pages. Quarterly reporting
to the Fed required a spreadsheet with 2,271 columns. 2010s Dodd-Frank law
was 848 pages and required regulators to create so many new rules (not fully
defined by the legislation itself) that it could amount to 30,000 pages of legal
minutiae when fully codified. What human mind can possibly comprehend all
this?
Complex accounting rules have thus made the problem worse. Clever bankers,
aided by their lawyers and accountants, find ways around the intentions of the
regulations while remaining within the letter of the law. Because these rules
have grown ever more detailed and lawyerlywhile still failing to cover every
possible circumstancethey have had the perverse effect of allowing banks to
avoid giving investors the information needed to gauge the value and risk of a
banks portfolio.
What to do: more clarity and actual sanctions
Some experts propose that the banking system needs more capital. Others call
for a return to Glass-Steagall or a full-scale breakup of the big banks. These
reforms could help, but none squarely addresses the problem of opacity, or the
mischief that opacity enables.
The Atlantic suggests that a starting point is to rebuild the twin pillars of
regulation that Congress built in 1933 and 1934, in the aftermath of the 1929
crash. First, there must be a straightforward standard of disclosure for Wells
Fargo and its banking brethren to follow: describe risks in commonsense terms
that an investor can understand. Second, there must be a real risk of
punishment for bank executives who mislead investors, or otherwise perpetrate
fraud and abuse.
The Atlantic argues that these two pillars dont require massively complicated
regulation. The straightforward disclosure regime that prevailed for decades
starting in the 1930s didnt require extensive legal rules. Nor did vigorous
prosecution of financial crime.
However it does require political will-power. The decision not to prosecute UBS
for criminal tax fraud in 2009, when a smaller bank was so prosecuted, sends a
clear signal that the large banks are not only too big to fail and too complex to
manage. They are also too big to punish.
The Atlantic suggests a grand bargain: simpler rules and streamlined
regulation if they subject themselves to real enforcement.

A paradigm shift in banking

Rules and penalties can only take us so far. Nothing significant is likely to
change until the dynamic of the financial sector changes. The SEC and the
courts can pursue the banks with court cases and penalties, but they will
always be confronted with time-wasting legal defenses, as well as time lags
between the invention of new ways to fleece customers and the discovery and
proof of those methods.
The financial sector is in effect an extreme example of the shareholder value
theory run amok. Pursuit of profit not only undermines the banks themselves
and ultimately the global economy as a whole.
Regulation and enforcement will only work if it is accompanied by a paradigm
shift in the banking sector that changes the context in which banks operate
and the way they are run, so that banks shift their goal from making money to
adding value to stakeholders, particularly customers. This would require action
from the legislature, the SEC, the stock market and the business schools, as
well as of course the banks themselves.
Ultimately, change is for the banks own good. Without it, investors will
continue to worry about which bank will be the next Lehman Brothers, while
the rest of us can only brace ourselves for the next inevitable financial
cataclysm.