The Root Cause Of The 2008 Financial Meltdown: Derivatives
During the financial crisis in 2008, the root cause of the meltdown was derivatives. Specifically, CDOs, or Collateralized Debt Obligations related to mortgages and CDSs, or Credit Default Swaps. Derivatives encompass a wide range of financial products: futures contracts, interest rate swaps, options contracts, foreign exchange contracts (currencies), etc. The explosive growth in derivative contracts occurred after 1999 when the Glass-Steagall Act was repealed, which allowed banks to operate as brokerage houses. Glass-Steagall, adopted in 1933, separated brokerage houses and banks in order to ensure banks would no longer be involved in risky transactions, which was the root cause of the crash that led to the Depression. I know some of you will say 1999 – It was Clinton. Take your partisan hats off before you put your foot in your mouth. As I’ve long said The problem is not the Republicans’s not the Democratsits ALL POLITICIANS! It was the Gramm-Leech-Bliley Act that repealed Glass-Steagall. Gramm, Leech and Bliley were all Republicans and the final bill was passed by the house 362 to 57 (207 Republicans for v 5 against [10 did not vote] and 155 Democrats for v. 51 against [5 not voting]). The senate passed it with a vote of 90 for and 8 against (52 Republicans and 38 Democrats voting in favor of the bill). Clinton did sign the bill into law but he essentially had no choice – the bill was virtually veto-proof (not defending him, just stating the facts).
The table below shows the growth of derivatives since the 4th quarter 1999, as well as quarter-by-quarter since the beginning of 2007 to show how the banks have addressed the issue of exposure to derivatives since the most recent crash in 2008. Please take note “ the figures in the table below are the notional value of all derivatives in $Millions, so that first figure for commercial banks represents $234.654 TRILLION.
————Commercial Banks—–Holding Cos.
Since the repeal of Glass-Steagall in 1999, the total notional value of derivatives has grown by over 700% for holdings companies and 674% for commercial banks. Even more alarming, since the third quarter of 2008 when the cracks in the financial system were clearly evident, derivatives at the commercial banks have grown from $175 TRILLION to $234 TRILLION “ a $59 TRILLION increase. To put this in perspective, the cumulative Gross Domestic Product in the United States over that same time frame (Q3 2008 through Q3 2010) was approximately $32 TRILLION.
The tables below summarize the assets and derivatives holdings for the top five banks and the top five holding companies based on the most recent report issued by the OCC for the Third Quarter of 2010 (Figures in $Millions). The A/D ratio is the asset to derivatives ratio.
JP Morgan Chase Bank NA———-$1,642,691———$77,747,170———-2.1%
Citi National Assn————————$1,209,221———$51,410,415———2.4%
Bank of America NA———————$1,489,198———$50,467,838———3.0%
Goldman Sachs Bank USA—————-$96,105———$42,777,908———0.2%
HSBC USA National Assn—————-$189,731———-$3,872,488———-4.9%
Totals for Top 5—————————-$4,626,946——-$226,275,819———-2.0%
All Banks (1,105 Banks)—————$10,690,635——-$234,654,564———-4.6%
Excluding Top 5 (1,100 Banks———$6,063,689———-$8,378,745———72.4%
JP Morgan Chase & Co.————$2,141,595———–$78,660,494—————2.7%
Bank of America Corp.—————$2,341,160———–$72,310,369—————3.2%
Goldman Sachs Group, Inc.———-$908,860———–$48,458,241—————1.9%
Totals for Top—————————-$8,216,267———$290,772,595—————2.8%
Top 25 Holding Companies——-$13,668,715———$304,998,518—————4.5%
Excluding Top 5————————-$5,452,448———-$14,225,923————-38.3%
The top 5 banks currently hold 96% of all derivatives for the 1,105 Banks reporting. The top 5 holding companies have 95% of all derivatives.
Why would banks and holdings companies (whose primary asset is a bank), increase their risk to such a high level?
There are a number of factors but it all boils down to one issue “ GREED! Revenues are what generate the bonuses. For the first three quarters of 2010, total trading revenue in derivatives for commercial banks was $19.036 Billion, and remember, 5 banks control 96% of all derivatives held by commercial banks. For the first three quarters of 2010, total trading revenue in derivatives for holding companies was $53.434 Billion. As with the banks, the top 5 holding companies control the vast majority of the market (95%). For some (Bank of America, JP Morgan, Citi), trading revenues from derivatives represented approximately 5% of total gross revenues, but for others, such as Goldman Sachs, trading revenues from represented over 50% of total gross revenues. Clearly, the underlying motive behind the increase in derivatives is not necessarily the prudent operation of the company or the safety and security of their customers; it is revenues; and it is revenues that generate the outrageous salaries and bonuses at these organizations.
Under the accounting standards for banks, assets essentially represent loans “ not deposits. The deposits are categorized as a liability on the balance sheet. Assets were used in the tables above as these figures were readily available from the OCCs report (they don’t list deposits). In most cases, a bank’s assets will approximate the value of their deposits (within 10 or 20%). A spot check of several banks confirmed this and if you want more evidence, just scan the FDIC website for Banks Failures and look at the press releases, which list assets and deposits.
The top five banks hold $226 TRILLION in derivatives and have $4.6 Trillion in assets; an asset to derivatives ratio of 2.0%. Again, the value of deposits typically approximates the value of assets. Could a 2% adverse excursion wipe out the value of the deposits at these institutions?
According to the OCC’s report, this is highly unlikely. They have a measure of the risk involved called Value at Risk (VaR). I won’t get into all of the details of this but the report says a bank’s capital requirement for market risk is based on its VaR measured at a 99% confidence level and assuming a 10-day holding period. Banks back-test their VaR measure by comparing the actual daily profit or loss to the VaR measure. The VaR for the five major holding companies ranges from 0.04% to 0.1% of their total equity. So there is truly little risk involved in trading these massive amounts of derivatives.right?
In Q2 2008, the OCC’s report listed the VaR for 3 of the major holding companies. JP Morgan had a VaR of $150 Million; Citigroup had a VaR of $255 Million; and Bank of America had a VaR of $88 Million; $493 Million for all three. Collectively, these 3 holding companies had $168.090 Trillion in derivatives (notional value). How can this be “ just $493 MILLION in risk with $179.385 TRILLION? The answer is hedging. If a bank takes a position in a derivative, they may hedge all or a portion of that position with a counter-party to eliminate possible losses or reduce the possible losses to a level they deem acceptable. So In spite of the huge derivatives holdings at these three companies, the actually had very little at riskâ€¦right? WRONG!
Under the TARP program established at the behest Treasury Secretary Hank Paulson, Bank of America received $45 BILLION in bailout funds; Citigroup also received $45 BILLION; and JP Morgan received $25 BILLION; Collectively $115 BILLION. Yet, they claimed there was only $493 MILLION at risk! So while they were 99% confident that there VaR was $493 Million, the missed the mark by over 99% – but it is far worse than that. The $115 BILLION in TARP money does not include â€œbackdoor bailouts. One highly publicized incident of a backdoor bailout was Goldman Sachs. In addition to receiving $10 BILLION in TARP funds, Goldman Sachs received a payment $13 BILLION from AIG who was a counter-party in some of their transactions. Actually, Goldman received the $13 BILLION from us, the taxpayers, since we spent $185 BILLION baling out AIG. Whether or not BAC, JPM or Citi received backdoor bailouts I cant say “ and they’re not saying “ but I suspect they did receive backdoor monies in addition to the TARP funds they received. And it doesnâ€™t stop there. The Federal Reserve took $TRILLIONS in securitized mortgage obligations and other packages of garbage at face value as collateral for loans to various banks in order to provide the banks with a cash infusion. What the true value of these packages were is anybody’s guess but here again, it’s probably a safe assumption to say they were worth far less than â€œface value that the Fed lent money on and in order to fully assess the value of the bailouts, any reduction in the face value of these pledged securities should be considered.
But the banks have learned from this and they now have a much better handle on risk right? In Q2 2008, JP Morgan, Bank of America and Citigroup had a VaR of $453 Million and total derivatives of $179.385 TRILLION. Based on the OCC’s most recent report for Q3 2010, JP Morgan, Bank of America and Citigroup had collectively INCREASED their derivative holdings to $200.482 TRILLION, yet the VaR DECREASED to $475 MILLION.
We have become desensitized to the astronomical figures thrown around by our political leaders and corporate heads. First it was Millionsâ€¦then they spoke in $10 of Billionsâ€¦then $100 of Billions and now it’s $Trillionsâ€¦so before I end this, I wanted to put a little perspective on these figures. In 1998, Long Term Capital Management blew up to the tune of $4.6 Billion, which sent shock waves around the financial world. If we adjust this figure by the CPI, Long Termâ€™s loss would be equivalent to $6.14 Billion in 2010 dollars.
Folks, there are $305 TRILLIONâ€¦let me say it again $305 TRILLION in Derivatives floating around the top 25 holding companies out there. The primary asset for these holding companies is either a bank or an insurance company.
The question is not will it happen again “ the question is WHEN it will happen?
I am 99% confident it WILL happen again – I am 99% confident that the scale of the collapse will be MUCH LARGER than the most recent collapse in 2008 “ and I am 99% confident we will be in FAR WORSE SHAPE to deal with the collapse in light of the massive amounts of debt that countries have accumulated during this most recent collapse.
If you are interested in investigating this for yourself, the link below will direct you to the OCCâ€™s quarterly reports for derivatives.
Quotes by Brooksley Born former Head of the CFTC:
“I think we will have continuing danger from these markets (derivatives) and that we will have repeats of the financial crisis. It may differ in details, but there will be significant financial downturns and disasters attributed to this regulatory gap over and over until we learn from experience.”
In reference to LTCM………..
“I was told that the very large hedge fund was almost collapsing, that it had $1.25 TRILLION in notional value of over-the-counter derivatives, and it only had $4 BILLION in capital to support that enormous investment, and that the markets had turned against it, … so that it was going to default in a very major way, leaving the counterparties in the derivatives contracts — who happened to be the big OTC derivatives dealers — in the lurch in a major way.”