From JPMorgan Chase, Morgan Stanley And Citigroup To The Regulators: Catch Me If You Can

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Includes: AIG, C, GE, JPM, MS, PFK
by: John M. Mason

Regulations and regulators are always behind the banks. Regulations and regulators are always fighting the last war.

Headlines in the newspapers this week claimed "Nonbanks Set for Oversight" and "Regulators to Act on 2 Issues." The first of the two issues is that regulators have defined three companies as "systematically important." What this means is that these companies, all non-bank financial companies, are large enough to potentially have significant "market" effects so that they require more oversight and more capital. The companies have been named: American International Group, Inc. (NYSE:AIG), Prudential Financial Inc. (NYSE:PFK), and GE Capital a subsidiary of General Electric, Co. (NYSE:GE).

The organization doing the designating: The Financial Stability Oversight Council, an organization set up in the wake of the 2008 financial crisis.

The second issue relates to tightening the rules for the money-fund industry. The specific rule in question has to do with how money market funds value their assets. In the past these funds operated on the premise that they would not be forced to reduce the value of their shares below $1.00. Regulators would like to force these funds to float the value of their assets like other mutual funds do. The regulators are responding to the 2008 financial crisis when the Reserve Primary Fund experienced rather steep outflows of funds and "broke the buck", that is they had to lower their asset value below the "1.00" value.

These efforts by the regulators are coming almost five years after the start of the financial upheaval. The legislation following the financial crisis, the Dodd-Frank financial bill was signed into law in 2010. And, to date only about 38 percent of the rules passed in this bill have been finalized. One of the rules not put into effect yet is the highly publicized "Volcker rule" that bans proprietary trading within the banks.

So, Congress and the regulatory agencies have spent five years trying to put in place rules and regulations that they believe would have prevented the 2008 financial crisis.

Of course, the financial institutions involved have lobbied against what Congress and the regulatory agencies are trying to do. This has contributed to the lengthy time it has taken to actually implement the new rules and regulations.

But, the banks, especially the major banks, have moved on. Not only are they moving into different areas and into different technologies, they are moving back into areas that were considered to be at the center of the events of 2008 and 2009.

According to the Wall Street Journal, JPMorgan Chase (NYSE:JPM) and Morgan Stanley (NYSE:MS) are moving to create new collateralized debt obligations (CDOs). In their search for yield, some investment groups have asked these two institutions to "assemble" some of these synthetic instruments in order to earn greater returns.

The CDOs in this case would be a bundle of corporate bonds, pooled into one synthetic security in which investors could buy different "slices" of the pool based upon different risks and returns.

In the earlier financial crisis the difficulties with CDOs came from pools of mortgages or mortgage-backed bonds. As the housing collapse took place in the United States, the underlying mortgages proved to be much riskier than had been earlier perceived and as the crisis grew and the financial markets spiraled downwards, the financial damage incurred in these instruments multiplied.

The demand for securities or strips of securities has grown to such an extent that investors are now requesting financial institutions like JPMorgan, Chase and Morgan Stanley to start assembling new packages of CDOs.

Brian Reynolds, chief market strategist at Rosenblatt Securities, Inc., is quoted as saying, "Wall Street will create new, more complex, more risky structures to satisfy that demand."

That is, Wall Street banks are not going to stand still. The question always is, how far ahead of the regulators are the Wall Street banks?

You also have Citigroup, Inc. (NYSE:C), developing a new type of CDO that uses derivatives tied to the bank's portfolio of shipping companies. The impetus for this type of loan, a deal "being pitched only outside the U.S.", is Citigroup's "desire to make room on its balance sheet for new loans and hold less capital as a cushion against potential losses on the shipping loans …"

"Investors in the deal will be on the hook for some losses. In return the deal is expected to pay an annual yield of 13% to 15%, according to a person familiar with the offering."

There has also been a substantial increase in the area of Collateralized Loan Obligations (CLOs), tied to corporate debt. In Europe, there is an expectation that there will be €5 billion in CLOs issued this year and another €7 billion next year. Regulators are attempting to gain some control over these issues by requiring that the managers of the CLOs keep some "skin in the game" by holding a slice of equity, but these managers have been able to get around this requirement "by offloading that slice of equity to a larger third party. The European Bank Authority is proposing to end this practice.

Still, the demand is growing. Before the financial crisis, the European leveraged loan market for corporate buyouts was around €220 billion. Volumes are expected to increase substantially in the coming years, primarily due to increasing demand for yields.

The underlying story here is that these major banks, JPMorgan, Chase, and Morgan Stanley, and Citigroup are not going to back off from moving into these areas … as well as into other areas. Neither will Goldman Sachs (NYSE:GS) … or many more of the larger financial institutions.

If the demand is there, as Brian Reynolds said, "Wall Street will create new, more complex, more risky structures to satisfy that demand."

And the regulators? Well, as usual, the regulators will always be playing catch up.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.