How Much Risk is the Treasury Really Assuming from Financial Institutions?

What does it really mean to talk about saving “the banks”? The Treasury would like us to have a mental picture of Jimmy Stewart in It’s a Wonderful Life, protecting the savings and mortgages of the good citizens of Bedford Falls. In truth, for all material purposes, the current Public Private Investment Plan (PPIP) is about saving four mammoth financial institutions considered too big to fail: Bank of America, Citicorp, J. P. Morgan Chase, and Wells Fargo.

These financial behemoths, each as large as a significant number of the world’s national economies, bear as much relationship to the Bedford Falls Building and Loan as a rowboat does to the Titanic. For public consumption, however, it is convenient for the Treasury to continue to describe its efforts as a rescue of “the banks”; rescuing hydra-headed financial giants just doesn’t have quite the same ring. Additionally by lumping these institutions under the category of “banks” the Treasury can continue the fiction that the bailout is about “getting the banks lending again.”

Notwithstanding this fiction, as we showed last week, even Secretary Geithner has abandoned the pretense that the PPIP program is about encouraging direct bank lending in the traditional sense of taking deposits and making loans, admitting that the primary purpose of PPIP is to restore the strength of these wholesale institutions so that they can restart the private securitization markets that fueled the credit bubble earlier in the decade. So here’s the plan. Just remove the toxic assets from the books of the financial giants and the system will be restored to its former picture of robust health. Hopefully the PPIP will be sufficient to fund the fix. If not the Treasury can use its proposed new liquidation authority, invest few hundred billion dollars more to fill the gaps and sell the freshly minted “clean” institutions to the capital markets for a premium.

On its face, this appears to many to be a rational bet. With the survival of the financial system at stake, risking a few hundred billion more to clean up the banks would indeed be far less costly than another liquidity crisis like that surrounding the Lehman collapse. Unfortunately this calculation omits one major element of risk that has the potential to increase the cost of the bailout beyond even the capacity of the Treasury to fund: i.e. the derivatives portfolios of the major banks.

Last week the Comptroller of the Currency – Administrator of National Banks issued its quarterly report on Bank Trading and Derivatives Activities – Fourth Quarter 2008. In reviewing the report, several things become quickly apparent:

1. Derivatives Trading is a really big business; the notional amount of all derivatives positions at all U. S. commercial banks and trust companies that participate in this business was slightly more than $200 Trillion on December 31, 2008. That’s more than three times Gross World Product which the CIA estimates to have been a little over $62 Trillion in 2008.

2. Over 93.7% ($188 Trillion) of this gross exposure was held by only four bank s, J. P. Morgan Chase, Bank of America, Citibank and Goldman Sachs. One institution, J. P. Morgan Chase, accounted for $87 Trillion of the total exposure or approximately 140% of Gross World Product.

3. While the bulk of the exposure ($181 Trillion) was in the “traditional” derivatives markets, interest rate and FOREX swaps, almost $16 Trillion was in Credit Default Swaps, up from $1 Trillion in such transactions five years earlier.

4. What had once been a very profitable business for the major banks, turned decidedly sour in 2008, with net reported trading losses of $836 million for the year as compared with profits of $5.5 Billion in 2007 and $18.8 Billion in 2006. Drilling down to the details, Credit Default Swaps generated losses for the banks in 2008 of $12.6 Billion, more than offsetting gains for the year in Interest Rate and Foreign Exchange trading.

The OCC report provides a lengthy explanation as to why the notional amounts dramatically overstate the risk posed to the system by these contracts. First, the real credit exposure is not the notional amount of the contract, but the amount that the market has moved from the strike price of the swap: i.e. the net amount the counterparty would be obligated to pay to true up the contract based on current market conditions. This is referred to as the Gross Positive Value (GPV) of the contracts. Since this GPV is in effect an unsecured claim against another financial institution, it represents a credit risk to the holder of the claims. At yearend total GPV held by U. S. commercial banks was $7.1 Trillion. Actual credit exposure was much lower, however, as the holders have the legal right to set off this exposure against certain of their counter exposures to the obligor institutions (Gross Negative Fair Values).

The netted credit exposure was estimated to be only $800 billion. Added to this was Potential Future Exposure of $782 Billion based upon the amount by which the contracts could move in favor of the obligee banks to generate a Total Credit Exposure of $1.58 Trillion. For the top five derivatives trading banks (the four above plus the U. S. operations of HSBC) total credit exposure averaged 489% of the institutions’ Risk Based Capital at the end of the fourth quarter. At one bank, Goldman Sachs, credit exposure was more than 1000% of Risk Based Capital. To be fair this calculation does not take into account pledged collateral backing a portion of the credit risks, which the OCC estimates as typical averaging 30-40% of the exposure amounts, so actual credit exposure was presumably somewhat lower.

By now, your head may be swimming a little. Mine certainly was as I worked to puzzle this out. These are very large numbers. Notwithstanding the OCC’s implication that all of this exposure is well managed and under control, I am reminded that we heard similar assurances with regard to subprime loans and CDOs, not to mention AIG's Credit Default Swap portfolio. The closest analog we can observe (AIG Financial Products) does not provide much comfort. Apparently AIG FP had Credit Default Swap exposure of $440 Billion out of total derivatives exposure of $1.6 Trillion. To date the AIG mess has cost the Treasury/Fed approximately $170 Billion to clean up. With bank Credit Default Swap exposure in the aggregate reported at 36 times AIG’s CDS exposure, how much risk are the Treasury/Fed/FDIC actually assuming if they take on the unsecured debts of the big banks as they seem increasingly committed to do? While I draw some comfort from the OCC’s explanation of netting and other factors limiting bank exposure on these volatile instruments, I am left with the nagging concern that there may ultimately be more risk here than meets the eye. Absent more facts to the contrary, I’m reminded of the immortal words of Judy Garland as Dorothy Gale, "Toto, I've a feeling we're not in Kansas anymore."

Disclosure: No Positions

Comments

[ArkansasAngie:]

Thanks for the homework.

I'm thinking these 4 entities and their management need to be disbanded.

The jokes up and it wasn't funny.

Whatever the real numbers are you can bet you bottom dollar that they are incorrect. Between lying with statistics and inaccurate numbers in the first place, the actual numbers are more likely higher than lower.

Apr 08 08:31 AM

[Harry Tuttle:]

Geithner is the wrong man for the job. He grew up thinking these banks were managed by the best and brightest. His mentor, Summers was responsible for the repeal of Glass-Steagall and for allowing the CDS market to be "self-regulated." These two factors were instrumental to create this problem.

They work for the banks because doing otherwise would be recognizing that everything they have believed up until now is wrong. Few people have the intellectual honesty needed to admit that.

In addition, they both know where they are likely to end up once their "service" to the country is complete. Look at Bob Rubin.

Apr 08 11:36 AM

[nova:]

It appears that the entire US financial & government cartel continues is fraudulent and criminal activities.

By saving this criminal enterprise, the US economy will gain good nothing but will regenerate a dangerous vampire back to life.

It becomes crystal clear that a failure to rejuvenate this monster is in the best interests of America and its people.

Apr 08 12:05 PM

[nova:]

[a corrected version]

It appears that the entire US financial & government cartel continues it fraudulent and criminal activities.

By saving this criminal enterprise, the US economy and the political system will gain nothing good but will regenerate a dangerous vampire back to life and save corrupt politicians this monster feeds and controls.

It becomes crystal clear that a failure to rejuvenate this monster is in the best interests of America and its people.

Apr 08 12:12 PM

[Larrysyr:]

These numbers are extremely confusing (do you suppose that's intentional in the way the system was set up???). I'm having a lot of trouble lining up the 36 times exposure. Is that 36 times $440 billion, (which would equal $15.8 trillion, rather than the listed amount of $1.58 trillion)?

I was almost comforted by the $1.58 trillion exposure (at least it's a ballpark...) until I ran that simple calculation. Warren Buffet was right when he called these things "financial instruments of mass destruction."

Apr 08 02:53 PM

[Chris B:]

Aw heck... too much thinking. Let's just let the banks fail and start the next depression. How much would that cost the government in lost revenue? $50 Trillion over 10 years? That's not so bad, is it?

Apr 08 03:03 PM

[aarc:]

Big business for the 4 mentioned banks.

The United States practically has a cartel in derivatives. They control the whole world.

China will control the consumer products for the next decades if not for the whole 21st century.

Japan and Korea have taken up the automobile business.

Is there any ocean frighter ever built in the US for decades now?

Taiwan and India are now trying to gang up on computers, computer components, and software production. Who knows, Intel and Microsoft might lose their global dominance in a few decades time. The United States will become a net importer of technology if not already doing so.

Without the banking and finance sectors; the United States will be left with high-end military hardware and software exports as a sole source of income - the global merchant of death?

This newfound potential source of tremendous profits (and losses) has shown it's promise and peril within less than 2 decades.

The complexity of these instruments will prevent many nations from wrestling the market away from the US with ease.

And since most of those securities are based on trust; the United States will have to show the whole world they stand by it's products come thick or thin.

Extremely risky at best. Highly profitable at most.

Like the airplane, nobody would want to fly in an airplane. Now, air travel is almost as indespensable as car travel.

Magellan was never expected to come back trying to prove the world was round instead of being flat. He would certainly had fallen off the edge after several years of absence.

I think there is no other country in the world capable of handling such a risky venture such as the derivatives.

No wonder the government is doing everything within it's powers and means. They must have seen the future of the USA and it does not look good being just a merchant of death the whole world can depend upon.

Apr 08 05:01 PM

[John Slater:]

Total CDS exposure (notional value) is $15.9 Trillion. The OCC's estimate of credit risk to the banks from all derivatives ($200 Trillion notional value) is $1.58 Trillion. And yes it is very confusing. Let's hope all of this is less confusing to the banks and their regulators than the CDO/subprime markets were.


On Apr 08 02:53 PM Larrysyr wrote:

> These numbers are extremely confusing (do you suppose that's intentional
> in the way the system was set up???). I'm having a lot of trouble
> lining up the 36 times exposure. Is that 36 times $440 billion,
> (which would equal $15.8 trillion, rather than the listed amount
> of $1.58 trillion)?
>
> I was almost comforted by the $1.58 trillion exposure (at least it's
> a ballpark...) until I ran that simple calculation. Warren Buffet
> was right when he called these things "financial instruments of mass
> destruction."

Apr 08 06:46 PM

[1worldcurrency:]

Fine article. That collateral is no doubt perfectly valued using the "significant judgment" of the smartest guys in the room.

Being unregulated instruments, no doubt the OCC knows the exact amount of notional outstanding. No one on Wall Street would ever lie.

Apr 09 05:04 AM

[pockyclips ...:]

The multinational pirate banks will hold us hostage until they get near face value for their toxic junk.

Apr 09 08:18 AM

[Larrysyr:]

Thanks for the clarification. Indeed I think you are right that we're not in Kansas any more.

I'm not really comforted by the OCC's estimate of a $1.58 trillion net risk. If the banks' actual risk is 36 times AIG's, and it has already cost $170 billion to bail out AIG, my naive brain comes up with an actual total cost of $6.1 trillion to clean up this mess. The difference could be that the banks collectively have a higher proportion of netted contracts than AIG alone had, but given the opacity and confusion in this area, I wouldn't place too much faith on any of these estimates.

My naive brain also wonders how the "geniuses" creating these instruments could overlook the net exposures they were generating. If casinos operated this way, Las Vegas wouldn't exist. But casinos apparently CAN manage their loss exposures quite profitably. Where are the actual "geniuses"?


On Apr 08 06:46 PM John Slater wrote:

> Total CDS exposure (notional value) is $15.9 Trillion. The OCC's
> estimate of credit risk to the banks from all derivatives ($200 Trillion
> notional value) is $1.58 Trillion. And yes it is very confusing.
> Let's hope all of this is less confusing to the banks and their regulators
> than the CDO/subprime markets were.

Apr 09 12:07 PM

[Living4Divi...:]

JS - I appreciate the time you put into this to derive down to the actual risks. Please help me try to make sense of all of it.

My basic question is this: if the US Govt could write a big check to clean all of this up and make the problem go away, what would the dollar amount of the check be?

You said: "At yearend total GPV held by U. S. commercial banks was $7.1 Trillion...The netted credit exposure was estimated to be only $800 billion. Added to this was Potential Future Exposure of $782 Billion."

In essence are you saying that this check would have to be $800 billion today, and perhaps another $782 Billion in the future? If so, this is a trivial problem. The Govt has spent Trillions already to prop up the banks and the Fed has expanded its balance sheet by $7T or more to guarantee loans or introduce liquidity. What's another 1.582T more ??

The fact is that the Govt/Fed/FDIC already owns AIG. The Govt is already on the hook for many loans and also owns all of AIGs derivatives. The Govt/Fed/FDIC already owns Fannie and Freddie - these are the two largest banks in the world (by loan porfolio value) - if Fannie and Freddie had any swaps - the govt is also on the hook for the derivatives.

Just curious - what pct of the 1,5 Trillion is attributable to GOEs (Govt Owned Entities)?

Anyhow - it's a non problem - just write another check.

Apr 09 01:16 PM