Banks are Setting Us Up for Another $2.6 Trillion Hit

Special Op Ed from Money Morning

by Keith Fitz-Gerald, Chief Investment Strategist, Money Morning

Just five years after they played a primary role in engineering the worst financial crisis since the Great Depression, America’s big banks are quietly setting the world up to do it all over again.  Only this go round the costs will be far higher and the damage much worse. This time the fall could be $2.6 trillion or more.  Let me explain.

It started back in the mid-2000s. Wall Street was busy packaging low-rated subprime loans into securitized offerings that were somehow worth more than the sum of their parts.   In reality, what they were doing was little more than laundering toxic debt while raking in obscene profits along the way.

Click on cartoon for larger image.

Well here we go again…

Both JPMorgan and Bank of America are quietly marketing a new scheme designed to “transform” sub-par assets into quality holdings that will serve as treasury-quality collateral needed to meet the new capital requirements that come into effect in 2013 as part of the Dodd Frank Act.

Wall Street Is Up to Its Old Tricks

This may sound complicated but it’s not.  It works like this.  When you trade on margin like these mega-institutions do, you are required to post collateral to offset counterparty risk. That way, if the trade busts and you are unable to deliver on your side of the trade, there is recourse.

If you have a mortgage or a car loan, you know what I’m talking about. Your lender can seize both if you default or otherwise fail to meet your payment obligations.

Trading collateral works the same way. In years past, trading collateral has most commonly taken the form of US treasuries (or other securities) that meet stringent requirements with regard to ratings, liquidity, value and pricing.

However, since the financial crisis began, treasuries are in increasingly short supply. Investors and traders who have preferred safety over return are hoarding them.  Consequently, traders like JPMorgan’s London-based “whale” Bruno Iksil who want to write increasingly bigger, more sophisticated trades are in bind. They find themselves unable to trade because many times the clients they represent can’t post the collateral needed to “gun” the trades.

As you might imagine, Wall Street doesn’t like that because it means billions in profits and bonuses get lost as trading volumes drop.  So they’ve gone to the unregulated woodshed again and come up with yet more financial hocus pocus designed to circumvent rules in the name of profits.

At the same time, they’re once again hiding the true extent of the risks they are taking – and that’s the outrageous part.

These same banks that have already driven the world to the brink of financial oblivion and been bailed out once may need another $2.6 trillion dollars or more to backstop the unregulated $648 trillion derivatives playground they’ve created for themselves.

And don’t think for a minute that your money isn’t at risk either…

If you have a retirement fund, a money market fund or are invested in any sort of pension plan whatsoever, you are already involved in this game whether you signed up to play or not.  We’re talking about trillions of dollars’ worth of sovereign and agency debt. Think the United States, Japan, Italy, Spain, and Germany here along with the bets on that debt all of which has been “backed” by central bankers effectively removing the risk of failure from the financial markets and specifically from the firms engaged in these kinds of trades.

Of course, Wall Street has just pulled the wool over everybody’s eyes by marketing most of these derivatives as “insurance” against default. In reality, they are king-sized bets levered up to levels so high that they now place entire nations at risk of default, not just individual traders or institutions.

That’s because derivatives allow traders to effectively bet on directional changes in everything from interest rates to markets, and currencies. They also allow firms to effectively arbitrage the relative risks between various financial instruments or lock in specific prices on everything from bonds to commodities.

The Biggest Margin Call of All Time

Here’s where we get to the meat of the matter.  As part of new rules driven by the 2010 Dodd-Frank Act, traders will have to drive the majority of privately traded derivatives contracts through clearing houses like the Chicago based CME or the London based LCH.Clearnet which was formerly known as the London Clearing House.

Previously they didn’t because upwards of 90% of the derivatives were privately negotiated and, therefore, exempt from centralized exchange requirements including margin.  In the process, they’ll have to post additional collateral that can be “perfected” meaning seized and converted to cash in the event of a counterparty failure or default.

As reported by Bloomberg, estimates from Morgan Stanley suggest that the new requirements could mean the banks trading in derivatives have to come up with $481 billion in top rated collateral on the low side to $2.6 trillion on the high side which is what the Massachusetts based Tabb Group projects.

My own estimate is somewhere in the $4-5 trillion range because I believe the total value of the derivatives markets is still being understated by banks and trading houses not keen to let skeletons out of the proverbial closet.

And therein is the problem.  Neither the trading firms nor their clients have the additional collateral.

What’s more they likely won’t be able to get it because the vast bulk of the $33 trillion in worldwide top tier AAA or AA rated debt is already pledged as collateral or otherwise accounted for in separate transactions.  Were these banks and their clients living like the rest of us, they’d simply conclude they were “tapped out” and their resources exhausted because there would be nothing left.

But noooooo…… under the terms of both the JPMorgan and Bank of America program, clients not meeting the new collateralized quality standards can pledge other less than treasury-quality assets to the bank against a “loan” of Treasuries from the trading firm that’s then posted by the trading firm as collateral acceptable to the clearing houses.

In other words, the trading firms are going to loan treasuries to clients who are incapable of meeting liquidity requirements while accepting lower grade assets in exchange. Details are hard to come by at the moment with regard to the fees they’ll rake in, but you can bet “transforming” lemons into lemonade won’t be cheap.

This is very familiar with what happens in the commercial “repo-market” banks and trading firms temporarily pledge their assets in exchange for cash loans, what I am describing is similar. Nor is it much different than pledging your paycheck at an instant loan store. In both cases, you are pledging assets against transactions that you wouldn’t otherwise be able to conduct.

The fundamental question boils down to this : if we know that billions in improperly assessed risks led to the first blowup in 2007, how on earth could this be any different– especially with trillions now on the line?

You can’t wave your hand over a pile of less than treasury quality assets and have them suddenly, miraculously become treasury quality because they are grouped together.  Yet, this is exactly what Wall Street is doing here.

And, just like before, Wall Street’s latest scheme is expressly intended to disguise risk and circumvent the specific rules about to be put in place to prevent excess leverage from potentially destroying the world’s financial system.

Is There a Fix?

I can think of one but it’s not from a source you’d ever believe in a million years that would come out of my mouth: Fed Chairman Ben Bernanke.

Congress can’t balance its checkbook. Our politicians can’t make tough decisions. Our regulators are out lobbied and outmaneuvered at every turn.  No President can ask his nation to take its medicine regardless of party affiliation.  But Bernanke can.  Supposedly – emphasis on supposedly – he’s apolitical.

Acting under the the Fed’s dual mandates of maintaining “monetary and credit aggregates commensurate with the economy’s long run potential,” Chairman Bernanke could by pass the entire political, regulatory and lobbyist morass in one foul swoop by declaring that United States government will not back any derivatives trades or any firm that engages in them worldwide in the event of default.

Not only would this re-introduce the concept of failure into capital markets but it would do what neither congress nor our regulators have been able to do – put an immediate end to the kind of “profit at all cost regardless of risk behavior” that exemplifies everything wrong with Wall Street.

I can only imagine the disclaimer on one of those Uncle Sam posters more commonly associated with wartime military recruiting. It might read: “Counterparty beware.”

Until then, it’s investors who should be “aware.”

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About the Author

Keith Fitz-Gerald has been the Money Morning team Chief Investment Strategist since 2008. He’s a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don’t yet see or understand. In addition to being editor of the Money Map Report, Keith runs The Geiger Index, a reliable, emotion-free guide to making big money and avoiding losses, and the Strike Force service, which aims to get in, target gains, and get out clean. Learn more about Keith on our contributors page.