Is there a future for bank earnings?

Posted on December 14, 2011 by

Received wisdom has it that banking is moribund in the US.  Growth is permanently stalled due to a combination of regulatory moves that limit fees (on credit and debit cards and deposit overdrafts), painfully low interest rates that compress margins, and a sluggish economy.  Regulatory uncertainty about potentially dramatic reductions in trading profits depending on the outcome on the Volker Rule cloud the picture further.   European exposures are worrisome as well.  On top of that, core common equity capital requirements are being increased by a factor of 3-4 times pre-crisis levels.  The biggest issue is the ultimate liability banks will have on litigation stemming from their pre-crisis sales of mortgages and securities. It is no wonder that banks’ stock prices are depressed.

While that is not a pretty picture at all, let us not lose sight of what is still pretty good underlying profitability potential, despite the regulatory changes.  Once rates return to somewhat more normal levels, and the wave of litigation subsides, profits can improve substantially even if we do not make any heroic assumptions about growth, revenue offsets to the regulatory restrictions on fees, or an early return to health for the mortgage markets. 

Let us use the following, fairly conservative assumptions, and assume no meltdown in Europe:

  • Litigation charges and loan repurchases due to faulty “reps and warranties” are eliminated
  • The net interest margin is rolled back to each bank’s 2Q 2010 level
  • Fees are reduced by the estimated impact of the Durbin amendment governing debit card fees; regulatory restrictions will not be able to be offset by new fees.
  • Loan loss levels for corporate loans and unsecured consumer loans return to 0.75% and 5.0%, respectively; mortgage losses continue at half the bank’s 2011 rate (still astronomically high by historical standards).
  • Provisions cover current period write-offs
  • Costs of managing foreclosed properties abate
  • Trading income remains at 2Q 2011 levels—not stellar but also not the depressed levels of subsequent quarters.  This assumes no draconian long term effects of the Volker Rule, although trading revenues never return to heyday levels
  • No ability to offset consumer fee reductions with new fees
  • No growth of earning assets
  • No efficiency gains
  • Equity levels are increased to the fully phased in Basel III levels

I use the 2Q 2011 revenues and expenses as a base because they reflect the full effect of the credit card and overdraft fee reductions, and include moderate trading revenues as opposed to severely depressed levels in the second half of 2011.

The result is that the profitability measures for the strongest of the top four commercial banks provide an acceptable level of ROE, in the 13-15% range.  That is not nearly the returns reached pre-crisis but enough to warrant valuations at 10-20% above stated book value.  The weaker banks would need to get their cost of funds down by 60-80 bp and improve the efficiency of their operations and their capital to reach those levels of ROE.  I did not assume that would happen, although the banks are working on it and may well be successful.

For the four banks as a whole, pretax earnings improve by $44.4 billion, to $119 billion, due to:

  • Annual net interest revenues improve by $12.7 billion, or 8%.  These revenues are partially  offset by a $4.2 billion reduction in fee income as the debit card legislation takes effect. 
  • During the nine months ended September 30, 2011, the banks took charges for rep and warranty liabilities of $18.6 billion, and recorded  litigation and other mortgage related expenses of $10.5 billion. The amounts exclude Citigroup’s litigation costs, which are not disclosed.  Nor do they include the elevated operating costs of servicing delinquent mortgages except in the case of Bank of America, which has indicated that they run at about $1 billion a quarter.   On an annualized basis, if such charges were absent, pretax income would be $38.7 billion higher.
  • Net charge-off would be lower but reserve reversals would no longer benefit earnings, so provisions are a bit higher, by $2.8 billion.

 

                       

Profitability ratios for JPMorgan and Wells Fargo, measured as a pretax return on revenues, return to pre-crisis levels of 39%.  Because equity levels required on fully phased in Basel III rules would be higher than in the 2Q of 2011, and 2-3 times higher than pre-crisis, the ROE would be only 13-15% for JPMorgan and Wells.  For Citigroup and Bank of America, which suffer from a higher cost of funds and high operating costs (for Citi these include undisclosed litigation costs), the ratios are much lower:  the pretax return on revenues is 28% and 24%, respectively, and the ROE’s are 8% and 5%.  Clearly, these firms have more work to do to address their idiosynchratic issues to get their returns on revenues up.  They would need to reduce their capital requirements under Basel III as well in order to achieve the 13-15% ROE’s of their rivals.

Current stock prices reflect PE multiples of 4-6 on those forward, normalized earnings. If we assume that JPMorgan and Wells trade at a PE of 8 given low growth prospects, the price appreciation for JPMorgan would be substantial at 66%. It would be less for Wells given that its price has held up better than others’, and its earnings have not been as depressed.  Assuming lower PE’s of 6 for the less profitable banks, the price appreciation for Citi and Bank of America would be 32% and 66%, respectively, assuming no efficiency improvement; they would sell at steep discounts to book value. Efficiency improvements and a commensurate multiple expansion would then merit much greater appreciation.

Investing in these institutions is not for the faint of heart.  Given the litigation overhangs and the fragile state of global markets, there can be much near term volatility.  But assuming this country will still require banks ( a reasonable assumption), and they do not collapse in the interim (a less sanguine assumption), one day their profitability will normalize and they will merit higher prices.

 

               

Posted in Uncategorized | Tagged , | Leave a comment

Mortgage Litigation By States To Weigh On Fourth Quarter

Posted on October 24, 2011 by

The Attorneys General of the 50 states appear to be closing in on a settlement with the major mortgage lenders with respect to improper procedures in originating and servicing
loans.  The settlement could be $20-25 billion, to be apportioned among the largest mortgage servicers according to the quality of the loans they originated. Using the amount of loans in bank’s servicing portfolios that are in process of foreclosure as a proxy for the loan quality, the settlement could be divided among the banks as shown in the table below.  Bank America would be hardest hit, thanks to its Countrywide unit, with a $9.5 billion charge.  Assuming that the charges would not be tax deductible, they would reduce Tier 1 common capital ratios by about 50-70 bp for Bank America, JPMorgan and Wells Fargo. On the other hand, Citigroup is very little affected, given the size and quality of its servicing portfolio.  The amounts are manageable for all, although Bank America would be meaningfully behind the others in their Tier 1 common ratio.

A settlement could be positive news for the sector not only because it puts to rest one major element of the litigation overhang. It could come with a release from certain potential private investor litigation involving improper foreclosures and origination
processes. Also, the moneys will be used to provide relief to struggling borrowers, lowering their rates and providing debt forgiveness.  This could be a first step in reviving the
mortgage market by reducing the overhang of potential foreclosures.

Posted in Uncategorized | 2 Comments

The Volcker Rule: Fixing Problems We Don’t Have

Posted on October 11, 2011 by

One would hope that the Volcker rule, which will have far-reaching effects on the financial services industry on these shores, is founded on a sound understanding of what went wrong during the crisis and how to prevent a recurrence. It targets proprietary trading, or trading for a bank’s own account as opposed to market making, as the culprit. But what if the massive bank losses that heralded the recession were not generated by proprietary trading, but by activities that will remain permissible? Namely, what if the trading losses were the result of underwriting activities, which must remain permissible for the health of the financial system? Then the very disruptive legislation will prove to have been sadly misguided.

Proprietary trading is notoriously difficult to define or track. Proprietary positions, meaning trades where the risk is for the bank’s own account, can be of three types, but only the first two will be restricted:
• Clean proprietary positions: put on by traders with no client contact
• Gray area: trades that are the result of a transaction made to accommodate a client but are maintained on balance sheet for a longer period either because no market exists or to speculate on price appreciation.
• Underwriting positions: positions in securities that raised financing for clients. The securities are intended for distribution to investors, which can take some time.
Underwriting remains a permissible activity under the Volcker rule. While underwriting positions are proprietary in the sense that they do not result from very short-term holdings characteristic of market making inventory positions, they are not speculative in nature, but rather necessary to the process of intermediating credit. However, when markets become dislocated, the distribution process stalls, and banks get caught with “hung” underwriting positions that may be illiquid for an extended period of time. Historically, “hung” positions have caused large losses at institutions. Other permissible trading activity is market making, which involves taking on short-term inventory positions to facilitate client transactions, or hedging client positions.

Contrary to popular belief, the greater part of the losses in 2007-8, particularly at the three banks most severely hit (Citigroup, the then independent Merrill Lynch, and UBS), were not in fact the result of proprietary trading. They originated instead in the underwriting activities of these banks. Therefore, they would have been permissible had the Volcker rule been in place.

Before the crisis, Citigroup, Merrill and UBS were the leaders in underwriting mortgage CDO’s. Underwriting structured transactions involves accumulating a “warehouse” of loans or securities sufficient to fill out a pool of assets of a size that can be distributed in the marketplace. Then it involves converting this pool into a series of securities, each bearing a different portion of the risks of this pool. Both the “warehouse” and the securities, as underwriting assets, are held in the trading portfolio, and changes in market value of these positions are reported as trading income or loss. These gains/ losses are indistinguishable to readers of financial statements from real proprietary trading losses.

Given that the trading losses were concentrated in these three underwriters, it stands to reason that many of their losses were in fact underwriting losses. In the US, of the $151 billion of trading losses on so-called “legacy assets” (meaning primarily mortgage-related assets and leveraged loans) reported in 2007-8 by the six large banks, $113 billion, or 75% were at Citigroup and Merrill Lynch/Bank America. Indeed, their annual reports clearly describe the ways in which their securitization structuring and loan syndication businesses generated those “legacy assets”. Only Morgan Stanley indicates that many of its $10 billion of losses on mortgage securities and leveraged loans during those years were on proprietary trading positions.

Even the GAO report (
http://www.gao.gov/new.items/d11529.pdf
) on proprietary trading found only $10.5 billion of net losses in 2007-8 from the type of trading positions that can be cleanly identified as proprietary. It mentions that one institution had two quarterly losses totaling $10.5 billion during that period, so likely that institution was Morgan Stanley.

The onerous part of the Volcker rule has to do with the gray area of proprietary activities that are a part of market making activities but are difficult to separate out or even define. How large could losses from such activities have been? If identifiable proprietary losses in 2008-9 were $10.5 billion and underwriting-related losses were $113 billion, that leaves only about $39.5 billion of the remaining “legacy asset” losses as potential candidates for proprietary losses of the more difficult to identify type. Split six ways over two years, that is not the magnitude of loss that would sink any one of those large institutions. It is also good to remember that total trading losses over the two years were only $63 billion for the six firms, meaning that the rest of the trading operations generated $98.5 billion of trading income including any gray area losses from legacy assets.

If the problems of proprietary trading have been misidentified, then the chances of the solutions proposed by the Volcker rule being à propos are slim. The rule will impose huge expenses in rewriting computer tracking systems and staffing compliance organizations. It may also have an impact on the liquidity of certain markets that will disadvantage investors and render the financial system more, rather than less unstable. Given that the US is alone on this, and that no other country is following suit, an important part of the US economy, the financial services industry, is placed at a disadvantage. Policymaking may be better off thinking about how to improve underwriting risk management, both for trading and for bread and butter lending, than addressing a problem that didn’t exist.

Posted in Uncategorized | Tagged | 4 Comments

Bank of America disclosures point to further losses for mortgage bankers

Posted on January 4, 2011 by

The question of how much banks may owe investors in mortgage loans sold by the major mortgage banks (Bank of America, Wells Fargo, JPMorgan, Citigroup and Ally) is taking a step closer to closure, but the answer to that question spells further big losses. Bank of America today announced $3 billion of additional charges in the fourth quarter to settle claims by Fannie Mae and Freddie Mac that it had breached “representations and warranties” in loans sold by its affiliate, Countrywide, to these agencies between 2004 and 2008—the years during which lax underwriting was rampant. If we use this settlement as a guide for the the collective losses of the five banks in question, additional losses would be $19 billion.

The two interesting points about the Bank of America charges are what they do not cover:
           • The settlement with Freddie Mac covers all current and future claims. The one with Fannie Mae covers only currently outstanding claims and was much lower as a proportion of claims as a result.
          • The settlement covers only claims by the two government agencies. It does not cover claims by private insurers or by private investors. On this point, Bank of America pointedly sidestepped questions about whether there would be additional provisions in the fourth quarter to cover these other constituents, or reserves for litigation by investors in securitizations arranged by Bank of America and Merrill Lynch. From this we can infer that there will be such charges.

The cumulative losses Bank of America has taken over the past few years against the remaining $559 billion of loans sold to the government agencies amount to $6.3 billion, or 1.1%. If we adjust that percentage for differences in the five banks’ loan portfolio quality, as measured by the percentage of loans in process of foreclosure, and applying it to the entire $5.5 trillion of loans these banks service for the government agencies, insurers and private investors, we would get a total of $41 billion of losses. Taking into consideration the $8 billion of losses they took through the third quarter of 2010, the $11 trillion of reserves they had amassed, and Bank of America’s $3 billion announced provision for the fourth quarter, that means $19 billion of losses to go. That sum includes $8 billion of additional losses for Bank of America, which has the largest, and the worst performing portfolio thanks to its acquisition of Countrywide.

The estimate would be much higher if we used Bank of America’s experience with the Freddie Mac exposure, starting at 1.9% of the portfolios and adjusting for portfolio quality. We hesitate to do so because of management’s assertion that they included estimates of losses on future claims by Fannie Mae in their reserving actions, and because the Fannie Mae portfolio contained a lower proportion of Countrywide-originated loans.  It may also be that the experience with that agency is different from that with Freddie Mac, even though on the surface the delinquency levels in the two portfolios are not materially different. For example, Fannie Mae settled with Ally Bank on $84 billion of loans for a premium of .55%.

This loss estimate is quite crude and assumes that the loss rate will be the same on the loans sold to private investors as on those sold to the government agencies. Such loans account for about 35-40% of total loans sold for most banks, except for Wells Fargo, which had sold predominantly to the government agencies. There has been very little loss history on this class so far, because the investors had to amass a 25% interest in the securities to be allowed to sue. That kind of stake has only been achieved recently. The banks have not taken any reserves to date against this class of loans because of the difficulty of estimation.
An additional category of problems is that the investment banking arms of the banks had packaged loans, securitized and then sold them. There could be additional litigation charges for these. JPMorgan had recorded a $750 million reserve for litigation in the third quarter. Others will likely follow in the fourth quarter.  None of these estimates include charges for allegations of improper foreclosures or the costs of modifying loans, which are other dimensions of banks’ legal and regulatory issues.

Look for much more disclosure of exposures, and likely a fair proportion of the $19 billion of losses to be reported in the fourth quarter.

Posted in Uncategorized | Tagged , | Leave a comment

Muddy thinking mucks up economic recovery

Posted on October 14, 2010 by

Policymakers attempting to right the economy are producing a plethora of contradictory actions that work against each other instead of a reasoned, consistent policy. One area in which this is visible is anything touching the banking industry, which is a critical player in any recovery. The desire to punish those that have been fingered as the instigators of the economic downturn at times overwhelms the desire to get on with the recovery, and certainly sends contradictory signals.

The principal issue is that US needs banks to be in a position to lend. For that, banks need four conditions:
• sufficient capital
• creditworthy customers who want to borrow
• clear rules of engagement on loan contracts
• clearing up of a mountain of problem loans that are now distracting managements

Unfortunately, none of these conditions are present:
• Capital rules are in flux due to Basel initiatives and US legislative uncertainty that will not be clarified until at least early 2011. Banks may need to conserve capital by reducing risk assets to meet requirements that de facto may raise the bar on common equity capital 3-fold. Anger over bailouts of too big to fail banks threatens to require supplemental capital for big banks, oblivious to the fact that these banks originate a disproportionate amount of the loans in the country because of their capability to originate and distribute.

• There is no consistent view on what kind of borrowers should be deemed creditworthy. The backlash against banks for having been foolhardy enough to have lent to subprime customers or dodgier corporations has made banks recoil against making more such loans, at least for the time being. That has created a dearth of credit for such firms, and a public outcry against bank stinginess in granting credit. How are we to get deleveraging on the part of consumers, especially those least capable of handling debt, at the same time as we get increased lending to consumers?

Nor is there a consistent policy on encouraging borrowers to access capital to grow their businesses. There is no economic policy to encourage investment. Also the psychological atmosphere is negative, with a constant barrage of confidence-destroying views on the economy propounded by those who gain by them—politicians seeking election and newsmen wanting a story.

• Contract laws are essentially being rewritten as financial guarantors like Fannie Mae and Freddie Mac try to push back on their guarantees on technical grounds, foreclosures on homes are made more difficult and the time required to foreclose has stretched out beyond 18 months after the borrower stops paying. The current fracas about foreclosure procedures rests at least in part on technicalities rather than substance. The requirements to make serious attempts to restructure loans also open up to question previously sacrosanct principles of loan contracts. In part, the nation is conflicted about whether it wants to give defaulting consumers a free ride in recognition of their financial difficulties, or it wants to limit the cost to all taxpayers for the irresponsibility of deadbeats.

• The continuing turmoil over how to resolve mortgage loans is delaying closure on what is now the largest area of problem loans, and the ability of the housing market to reach a market clearing price that would set the stage for price recovery.

Even monetary policy is buffeted by the conflicted thinking around banks. In the debate over another round of quantitative easing, there are still those who are more worried about inflation—even though all signs now point to the greater of the two evils which is deflation—than about the need to restore confidence in the economy. The concern over extended periods of loose money leading to bubbles 
http://online.wsj.com/article/SB10001424052748704763904575550090298620152.html
 is also misplaced at this time. It conflicts with the view that banks are being too cautious to lend. Certainly there are no signs of bubbles now, almost three years into a period of lower rates, and the problem appears to be more one of deflation than irrational exuberance.

Until these conflicting policies are resolved by good debates on what kind of a banking industry we really want, rather than on how we want to punish banks, and what are the real responsibilities of lenders and borrowers, we will have needless and protracted muddling.

Posted in Uncategorized | Leave a comment

Large US Banks Scrape By Under Basle 3

Posted on September 13, 2010 by

The new so-called Basel 3 standards for capital levels the Basel Committee of international banking regulators issued today (
http://www.bis.org/press/p100912.htm
)  should not be problematic for the largest US banks.  Even though some of the new adjustments required to the measurement of capital likely have a greater impact on US banks than their global peers—namely the requirement that mortgage servicing rights and deferred tax assets be deducted from common equity—my estimates indicate that the common equity component of Tier 1 regulatory capital will be reduced by anywhere from 0-19% for these institutions, leaving them at or only slightly below the new requirements for Tier 1 capital, which will be 7% for Tier 1 common equity and 8.5% for the traditional Tier 1 equity ratio, which includes hybrid instruments.  The new standards would be phased in over the next five years, but I would expect that banks will strive to meet them in the near term as still jittery markets may react badly to any perceived shortfall.  While the news is good, it is not so good as to justify immediate reductions through dividend increases for most institutions.  For one thing the simple leverage measure, while difficult to estimate from public data, is likely to be a constraint.  For another, the largest, systemically important institutions, are to be subjected to higher standards, to be determined by the home country regulators.  In any case, banks typically like to keep a buffer of about 1 percentage point over the regulatory requirements just to be sure that they do not have to scramble to ensure that they remain in regulators’ good graces.

                                 Current          Adjusted        % Impact

                                 Tier 1             Tier 1

                                 Common       Common

Bank America              8.01%          6.52%                   19%

Citigroup                        9.70%          8.16%                  16%

Goldman Sachs           12.53%        12.53%                   0%

JPMorgan                       10.29%        9.09%                    12%

Morgan Stanley              9.37%         7.59%                    19%

Wells Fargo                      7.15%         7.07%                     6%

The new rules create a standard for Tier 1 common equity (Tier 1 capital minus hybrid instruments) of 4.5% by 2017, and raise minimum total Tier 1 capital standards from 4% to 6%.  An additional required conservation buffer of 2.5% brings the common equity requirement to 7%, and total Tier 1 to 8.5%.  This buffer is meant to be allowed to be eroded in periods of stress, though the penalty of restrictions on dividends and bonuses will likely makes banks avoid such an event. 

Not only are the capital levels set higher, but the instructions about how to calculate capital are significantly detrimental to US banks relative to international peers. Deferred tax assets, mortgage servicing rights and minority interests in financial institutions must be deducted from capital if they exceed 15% of  Tier 1 common in aggregate (subject to a further restriction that no component may exceed 10% on its own).  In addition, gains or losses on available for sale securities and cash flow hedges will no longer be adjusted out. While the partial inclusion of the first three factors is a significant softening of the Basel Committee’s original stance, the deductions could shave up to 19% from the capital measures of the big six banks.  The hardest hit are Bank America and Morgan Stanley at 19%; the least affected is Goldman Sachs.  The others experience a 6-16% impact.  US banks have significant deferred tax assets, because of their policies of making loan loss provisions earlier than they can be expenses for tax purposes, as well as tax loss carryforwards stemming from losses in recent years.  However, some banks, like Citigroup, had already been deducting most of their DTAs from regulatory capital, so the additional deductions should not have a major impact.  More significant for the four large mortgage banks (JPMorgan, Bank America, Wells and Citi) are the deductions of mortgage servicing rights.  Minority investments in financial subsidiaries are large for Bank America, Citigroup and Morgan Stanley.  Unrealized losses on securities are currently a major impact for Citi, though that could change over time.

Banks are not likely to take these rules lying down.  They could take steps to alter the impact of these deductions, for example by selling off their minority interests, as Bank America has already indicated regarding its Black Rock joint venture.  They could also move away from servicing mortgages themselves.  Deferred tax assets could also be whittled down in the next few years as loan losses and tax loss carryforwards are realized.  So the news could be better than these early estimates show.  In particular, Wells Fargo and Bank America, who come out right around the 7% Tier 1 capital ratios after these adjustments, should have no trouble meeting those levels through such adjustments and earnings retention.

The proposed leverage ratio of 3% Tier 1 capital for book assets plus off-balance sheet exposures remains a significant problem, however, depending on how the off balance sheet exposure is calculated.  A quick calculation of the standardized add-ons for derivatives plus the notional values of credit derivatives sold, commitments and letters of credit could balloon the balance sheet substantially, so for these institutions, the leverage ratio could remain the constraint.

Posted in Uncategorized | Leave a comment

Financial Reform Legislation Misses the Mark on Derivatives

Posted on June 28, 2010 by

The provisions of the financial reform legislation initially proposed by Sen. Blanche Lincoln that would require banks to spin off a portion of their derivatives activities into separately capitalized subsidiaries are at best a nonevent and at worst a needless cost to US banks that will hamper their competitiveness in the global arena and drive business abroad. What they will not do is reduce risk in the financial system, or risk to the taxpayer if a derivatives subsidiary were to careen towards failure.

I say they may be a nonevent because it is unclear whether banks will need to conduct their derivatives dealing activities in a materially different way as a result of the legislation. Firstly, the legislation does not affect the biggest part of the derivatives business, which is the plain vanilla interest rate and currency derivatives. Furthermore, if all that will be required is that derivatives instruments be booked in a separate subsidiary, but the management an operational aspects can remain the same, then the disruption of the business will be minimized. After all, Morgan Stanley and Goldman Sachs, as securities firms, have long housed their derivatives portfolios in such separate subsidiaries with no apparent ill effects. Bank holding companies historically only housed theirs in their regulated bank subsidiaries because the Glass Steagall Act permitted them to and because, under Basel regulatory capital rules, banks who dealt with other banks needed less capital than those who dealt with holding companies.

If, on the other hand, derivatives will need to be walled off in separately managed desks, the damage could be significant. The issue is that currently, the various derivatives desks at banks are integrated with the desks that handle the cash instruments such as bonds, equities, and currencies that most closely resemble the derivatives. This facilitates client service because clients frequently buy cash and derivative instruments in tandem. For example, a client may buy a stock and at the same time sell a covered call option, or buy a bond and protection on the credit risk through a credit derivative. Risk management is also integrated in that the risks of the cash and derivatives instruments are similar and may in some cases be offsetting so that hedging is easier. Separating the operations means that client convenience could suffer. With that could come a loss of business. Global competitors could leap into the breach. Operating costs could increase if duplicative management structures and risk management systems are required. Hedging costs would increase if some of the natural hedges resident in the cash instrument portfolios need to be replicated.

The question of whether more capital will need to be raised depends on how different the capital requirements will be from those that govern banks’ current derivatives exposures. Currently, banks hold capital for what is called counterparty risk—the risk that the clients who are losing money on their investment and therefore owe the bank money—could default. They also hold capital for the market risk—that the value of their total portfolio could decline. Given that the legislation would force much of the portfolio onto clearinghouses—where the clearinghouse becomes the counterparty—counterparty risk should be substantially reduced. That statement of course assumes that the clearinghouse is itself a highly creditworthy counterparty. Market risks have tended to be very small for dealers because, in contrast to AIG, whose derivatives losses were at the heart of the financial crises, dealers tend to remain substantially hedged so that portfolio values should not be very variable. The real issue is whether clients will be satisfied that their exposure to the counterparty risk of a walled off subsidiary of a bank holding company will be adequately covered by capital requirements calculated under current rules. Likely, the answer is a resounding no.

The spinoffs may actually increase systemic risks. If large derivatives subsidiaries that are failing are prevented from receiving help from their banking affiliates, they could fail more frequently. The mere fact that depositors’ funds are not endangered, which seems to be the drift of the legislation, is not the issue. The derivative subsidiaries’ systemic importance would require that they be rescued to maintain orderly markets and to prevent them from dragging down the bank and holding company. Their default would affect not just sophisticated investors but important industrial companies. Thus, taxpayers might be even more at risk than if the derivatives business had stayed within the bank.
The derivatives part of the legislation is therefore oddly wrong-footed. It is a reaction against the AIG losses that were at the heart of the financial crisis. However, it fails to understand that AIG’s business was fundamentally different from that of the large bank derivatives dealers. AIG was not a dealer that balances long and short positions; it took long positions linked to mortgage markets. And it did not maintain sufficient liquidity to meet margin calls, whereas dealers have access to huge balance sheets or banking institutions. Failure to understand the source of problems results in poor solutions. The unintended consequences are rife.

Posted in Derivatives, Financial reform | Leave a comment