Are Derivatives Accounting Rules Helping The Big Banks Cook Their Books?

Includes: BAC, C, GS, HSBC, JPM
by: John Slater

Profits do not mean the same thing for the major banks as they do for ordinary businesses. If you manufacture or distribute widgets, calculating your profit on a sale is pretty straightforward. What did it cost to acquire or make the widget? What did you sell it for? The difference is profit. For a broker/dealer it works pretty much the same way. What did the bond cost me? What commissions did I pay? The difference is profit.

Now consider the case of the major money center banks. Thanks to the repeal of Glass Steagall they are in the position to act not only as a broker dealer, but also as a principal, holding the financial instruments they create in their long-term investment book. During the heyday of the mortgage securitization boom, this permitted the banks to package bundles of mortgages into mortgage-backed securities (MBS), booking a hefty spread in the process. The MBSs could then be repackaged as collateralized debt obligations (CDO) and the CDOs could then be re-repackaged an infinite number of times as synthetic CDOs thanks to the magic of credit default swaps.

At each step of the process the bank earned a hefty origination spread, the investment bankers, brokers, lawyers and a myriad of consultants and rating agencies made their commissions and fees and everyone was happy, at least as long as the securities could be pawned off to some Norwegian village north of the Artic Circle. At some point the music stopped and the Norwegians went back to hunting reindeer, but not so the bankers.

Thanks to the repeal of Glass Steagall the banks were able to find new customers for the convoluted structures their well-oiled machines were churning out by the hundreds: they held them on their own books. By booking the securities at “retail” this process enabled the banks to continue reporting record profits right up to the day when the world learned that the Emperor had no clothes. Not only were the profits they had booked imaginary, so were many of the securities on which they had been based.

Thankfully, that insanity is past us. Or is it? The securitization market may be closed, but the big banks are engaged in a bubble of even more epic proportions. Take a look at the chart below tracking the growth of the financial derivatives market. The total notional derivatives exposure of the four largest derivatives market participants, JP Morgan (NYSE:JPM), Goldman Sachs (NYSE:GS), Citibank (NYSE:C) and Bank of America (NYSE:BAC), was $235 trillion as of June 30, 2011. We’ll refer to these as the TBTFs (too big to fails). From the end of 2008 to June 30, 2011, a period of very sluggish economic growth, their notional derivative exposure was up 35%.

Derivative Notionals by Type of User Insured U. S. Commercial Banks

Source: Comptroller of the Currency, OCC’s Quarterly Report on Bank Trading and Derivatives Activities – Second Quarter 2011 (.pdf)

We’ve written about derivatives before. In articles we posted April 7 and April 8 2009 we questioned whether the U. S. understood what it was really taking on by bailing out the largest Wall St. banks. Obviously that risk has continued to grow at a very rapid rate since the bailout.

Besides the growth of this market at a rate far higher than underlying economic growth, the chart reveals something interesting: almost all derivatives exposure is for trading accounts, with only nominal exposure to end user contracts. In other words, almost all of this activity amounts to casino gambling. What’s not apparent from this chart is that there are only four players at this table. From the end of 2008 to June 2011 the derivatives market share of the five largest players, the TBTFs plus HSBC (HBC) (in a very distant fifth place with 1.2% of the market) grew from 93.7% to 96%.

You might ask, what supports this growth? During the first six months of 2011 the TBTF holding companies booked trading revenues from these activities of $37 billion – enough said. The more interesting question is, where did these revenues come from? That’s where things get interesting. To make things a little easier to understand, let’s assume a simpler market where two parties decide to trade something basic, say apples and oranges.

Let’s assume for now that the prices of apples and oranges is fixed in the outside market so there is no inflationary profit to be made in the apple/orange market. While one of the participants may outsmart the other and make a profit at his expense, the market wide profit in the apple/orange market must be zero. Increase the number of market participants to four and there is still no way for all four market players to profit. If someone wins, someone else must lose.

At this point someone is ready to jump in and say derivatives are different, that I just doesn’t understand the complexities of the market, or the accounting or whatever. If so, I may be in pretty good company. It became painfully obvious after the 2008 crash that the CEOs of some the largest financial institutions in the world did not understand the accounting implications of the hundreds of billions of mortgage securities on their books.

So let’s consider how this might work in the world of derivatives. First, let’s consider what a derivatives transaction entails. At the end of the day these are insurance transactions. You’re concerned that interest rates are going up. I agree that at some point in the future, say five years out, I’ll cover the risk that rates will rise past a certain point. If rates don’t rise, I pocket the insurance premium you paid me. If they do rise, I will lose not only my insurance premium, but potentially a lot more, as happened to the banks with the credit default swaps in 2008.

That’s where notional risk comes in. Potentially, I’ve got a huge amount to lose if all my bets go wrong. In theory, the TBTFs could lose three to four times the world’s GDP. That would be a tough margin call to meet. But we’re assured that’s not something to worry about because all the exposures are covered by bets the players have made on the other side of the same trades.

Based on the apple/orange example, it’s hard to see how anyone makes money if the books are truly matched. For every winner there must be a loser. Yet, we are told that the TBTFs made $37 billion writing derivatives contracts in the first half of 2011. So how might that happen? How could all the players in a market make money from trading? One example is a rising market. Gold prices have risen over six hundred percent over the past ten years. In a market like that it’s pretty easy to imagine that everyone in the market was making money. Of course, everyone made money for a while trading tulip bulbs as well.

With derivatives it's hard to imagine that there’s some sort of bull market driving the profitability of the traders. So let’s consider another possibility. Imagine the following fable. Giuseppe Borgia is a trader at Banco Ponzi (BP), a fictional global bank that participates in the derivatives market. It’s November and Giuseppe hasn’t had a particularly good year so he’s worried about his bonus.

Giuseppe calls his friend Henri at Groupe Pyramide (GP) and suggests a trade. If Henri will buy a five year $1 billion swap from BP on the 10 year U. S. Treasury, BP will buy an identical contract from GP. Since each bank uses a sophisticated risk analysis model that demonstrates that the risk based pricing of the contract predicts a profit of 3%, over the life of the agreement, each participant can book a profit of $30 million and Giuseppe and Henri can each enjoy a very fine Christmas indeed.

You might say “Wait! surely the accountants, or the due diligence people, or management, or the regulators will figure this out and prevent it from happening.” If the market were as simple as my example, they would, but imagine that instead of Giuseppe and Henri, we are dealing with a highly complex market where hundreds of traders at four banks trade among each other every day. Instead of a blatant fraud like the one in our example, we witness aggressive trading behavior where the participants think that they are working to outsmart the market and are well paid for doing so.

But at the end of the day, the result is the same, thousands of contracts, each individually enabling the traders to book a profit under the accounting rules that govern their activities, but collectively generating the same result, a matched book of business that is priced on the participants accounting records to include the “profit” each player recorded when they put on the trade.

Of course, the problem with such a market is that when the trades unwind someone must take a loss. To offset these losses, additional trades must be booked. And for the market participants to continue to generate net profits the market must continue to grow, eventually at an exponential rate. Since the profits are book profits, not cash, you might ask where the cash comes from to cover the bankers’ bonuses, $2500 dinners, town cars and other costs entailed in operating such an expensive operation. In the absence of another candidate, the only mark still at the table would appear to be Uncle Sam, in the form of the FDIC and the Federal Reserve that serve as the liquidity sources of last resort for the TBTFs.

So let’s hope my little fable turns out to be just that. Perhaps I just don’t understand the accounting. Perhaps there are other players at the table and the bill is really being paid by Saudi Princes, hedge fund titans or Russian oligarchs. If not, it looks like the American taxpayer better get ready to pick up one more chit and this one is going to be a real doozy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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