By Pam Martens and Russ Martens: July 3, 2017
We have frequently called out the New York Times for running sycophantic articles on the big, mean, untamed Wall Street banking behemoths which just happen to be one of its home town’s largest industries and source of the biggest paychecks, which, in turn, boost its real estate markets, restaurants and retail sales – not to mention its own ad revenues. According to the Federal government’s Bureau of Labor Statistics, financial activities represented 468,600 jobs in New York City as of April 2017. According to a report from the New York State Department of Labor on New York City’s largest industries, as of 2014 the “average annual wage ($404,800) paid in the securities and commodity contracts industry is nearly five times the all-industry average annual wage ($84,752) for 2014.”
But today, the New York Times’ Editorial Board has joined Wall Street On Parade in expressing skepticism about the Federal Reserve giving a green light on the stress tests for 34 banks last week. After sounding the alarm about the Trump administration’s plans to roll back Obama-era reforms of Wall Street, the New York Times editorial raises the following concerns:
“It’s entirely possible that the system is more fragile than the Fed’s stress tests indicate. By the Fed’s calculations, capital held by the nation’s eight largest banks was nearly 14 percent of assets, weighted by risk, at the end of 2016.
“Alternative calculations of capital, including those that use international accounting rules rather than American accounting principles, put the capital cushion much lower, at 6.3 percent. The difference is largely attributable to regulators’ differing assessment of the risks posed by derivatives, the complex instruments that blew up in the financial crisis and that still are a major part of the holdings of big American banks.
“The passing grades on the Fed’s stress tests pave the way for banks to pay their largest dividends in almost a decade. The hands-down winners will be shareholders and bank executives, who could see their stock-based compensation packages expand further.
“But without continued bank regulation, and heightened vigilance of derivatives in particular, the good fortune of bank investors and bank executives is all too likely to come at the expense of most Americans, who do not share in bank profits but suffer severe and often irreversible setbacks when deregulation leads to a bust.”
We have only two quibbles with this editorial: the tenor is not strong enough and its assertion that “It’s entirely possible that the system is more fragile than the Fed’s stress tests indicate” is false. It’s absolutely certain that the system is more fragile. Here’s how we know.
Two years after the Dodd-Frank financial reform legislation was signed into law on July 21, 2010, the largest U.S. bank, JPMorgan Chase, was caught using billions of dollars of depositors’ life savings to gamble in exotic derivatives in London. If reporters at the Wall Street Journal and Bloomberg News had not gotten wind of the massive market-moving trades by the so-called “London Whale,” which grabbed the attention of regulators, who knows how deep the losses might have been. As it was, the bank was forced to concede at least $6.2 billion in losses.
According to the assessment of Senator Carl Levin, who chaired the Senate’s Permanent Subcommittee on Investigations at the time and issued a 307-page extensive report on the matter, JPMorgan “piled on risk, hid losses, disregarded risk limits, manipulated risk models, dodged oversight, and misinformed the public.” And that was two years after the passage of the Dodd-Frank financial reform legislation which Republicans in Congress now want to water down further.
According to London Whale documents released by the Senate’s Permanent Subcommittee on Investigations, as of the close of business on January 16, 2012, JPMorgan’s Chief Investment Office, which had overseen the gambles in London, held $458 billion notional (face amount) in domestic and foreign credit default swap indices. Of that amount, $115 billion was in an index of corporations with junk bond ratings, which the bank was not allowed to own. To get around that, according to the Office of the Comptroller of the Currency (OCC), JPMorgan “transferred the market risk of these positions into a subsidiary of an Edge Act corporation, which took most of the losses.” An Edge Act corporation refers to the ability of a bank to obtain a special charter from the Federal Reserve. By establishing an Edge Act corporation, U.S. banks are able to engage in investments not available under standard banking laws.
In 2013, the OCC released its cease and desist consent orders against JPMorgan Chase. Alarmingly, the OCC found that the largest bank in the U.S. had “engaged in unsafe or unsound banking practices” and had “deficiencies in its internal controls.” Again, this conduct occurred after the so-called financial reform legislation was in place.
The OCC detailed the following failings by the bank:
“(a) The Bank’s oversight and governance of the credit derivatives trading conducted by the CIO were inadequate to protect the Bank from material risks in those trading strategies, activities and positions;
“(b) The Bank’s risk management processes and procedures for the credit derivatives trading conducted by the CIO did not provide an adequate foundation to identify, understand, measure, monitor and control risk;
“(c) The Bank’s valuation control processes and procedures for the credit derivatives trading conducted by the CIO were insufficient to provide a rigorous and effective assessment of valuation;
“(d) The Bank’s internal audit processes and procedures related to the credit derivatives trading conducted by the CIO were not effective; and
“(e) The Bank’s model risk management practices and procedures were inadequate to provide adequate controls over certain of the Bank’s market risk and price risk models.”
In order to rid the public of the threat that derivatives would once again lead to a massive taxpayer bailout of financial firms as occurred in 2008, the Dodd-Frank legislation promised that derivatives would be “pushed out” of the FDIC-insured commercial bank. What happened instead was that in December 2014, Citigroup used its muscle to repeal that provision of the Dodd-Frank legislation by having an amendment tacked on to the must-pass spending legislation that would keep the country running. According to data in the December 31, 2016 report on trading and derivatives from the OCC, the concentration of risk from derivatives and the sheer quantity of derivatives dwarfs the situation during the crash of 2008.
The OCC writes that “A small group of large financial institutions continues to dominate derivative activity in the U.S. commercial banking system. During the fourth quarter of 2016, four large commercial banks represented 89.3 percent of the total banking industry notional amounts…” Those four banks are JPMorgan Chase with notional derivatives of $47.5 trillion; Citibank N.A. (the banking unit of Citigroup which received the largest taxpayer bailout in U.S. history in 2008) with notional derivatives of $43.9 trillion; Goldman Sachs Bank USA at $34.9 trillion; and Bank of America with $21.1 trillion.
Last November, the Congressional watchdog, the Government Accountability Office (GAO), found the following regarding the Fed’s stress tests:
“The Federal Reserve also has not conducted analyses to determine if its single severe supervisory scenario is sufficiently robust and reliable to promote the resilience of the banking system against a range of potential crises. Such analyses—including performing sensitivity analysis involving multiple scenarios—could help the Federal Reserve understand the range of outcomes that might result from different scenarios and explore trade-offs associated with reliance on a single severe supervisory scenario.”
In March of 2016, a research report from the Office of Financial Research (OFR), a unit of the U.S. Treasury created under the Dodd-Frank financial reform legislation, came to more alarming conclusions.
OFR researchers Jill Cetina, Mark Paddrik, and Sriram Rajan found that the Fed’s stress tests are measuring counterparty risk for the trillions of dollars in derivatives held by the largest banks on a bank by bank basis. The critical problem, say the researchers, is the contagion that could spread rapidly if one mega bank’s counterparty was also a key counterparty to other systemically important Wall Street banks. The researchers warn:
“A BHC [bank holding company] may be able to manage the failure of its largest counterparty when other BHCs do not concurrently realize losses from the same counterparty’s failure. However, when a shared counterparty fails, banks may experience additional stress. The financial system is much more concentrated to (and firms’ risk management is less prepared for) the failure of the system’s largest counterparty. Thus, the impact of a material counterparty’s failure could affect the core banking system in a manner that CCAR [one of the Fed’s stress tests] may not fully capture.”
If the New York Times wants to genuinely sound the alarm bells before the next implosion on Wall Street creates another economic crisis in the U.S. and its own home town, it needs to take a more strident tone using the mountain of evidence that readily exists showing that Wall Street has been anything but reformed.