U.S. Government Is Now a Major Counterparty to Wall Street Derivatives

By Pam Martens and Russ Martens: April 21, 2016 

President Obama Walking in Cross Hall at the White House. (Official White House Photo by Pete Souza.)

President Obama Walking in Cross Hall at the White House. (Official White House Photo by Pete Souza.)

According to a study released by the Federal Reserve Bank of New York in March of last year, U.S. taxpayers have already injected $187.5 billion into Fannie Mae and Freddie Mac, two companies that prior to the 2008 financial crash traded on the New York Stock Exchange, had shareholders and their own Board of Directors while also receiving an implicit taxpayer guarantee on their debt. The U.S. government put the pair into conservatorship on September 6, 2008. The public has been led to believe that the $187.5 billion bailout of the pair was the full extent of the taxpayers’ tab. But in an astonishing acknowledgement on February 25 of this year, the Government Accountability Office, the nonpartisan investigative arm of Congress, issued an audit report of the U.S. government’s finances, revealing that the government’s “remaining contractual commitment to the GSEs, if needed, is $258.1 billion.”

This suggests that somehow, without the American public’s awareness, the U.S. government is on the hook to two failed companies for $445.6 billion dollars. And that may be just the tip of the iceberg of this story.

The official narrative around the bailout of Fannie and Freddie is that they were loaded up with toxic subprime debt piled high by the Wall Street banks that sold them dodgy mortgages. While that is factually true, the other potentially more important part of this story is the counterparty exposure the Wall Street banks had to Fannie and Freddie’s derivatives if the firms had been allowed to fail.

The New York Fed’s staff report of March 2015 concedes the following:

“Fannie Mae and Freddie Mac held large positions in interest rate derivatives for hedging. A disorderly failure of these firms would have caused serious disruptions for their derivative counterparties.”

Exactly how big was this derivatives exposure and which Wall Street banks were being protected by the government takeover of these public-private partnerships that had spiraled out of control into gambling casinos?

According to Fannie and Freddie’s regulator of 2003, OFHEO, “The notional amount of the combined financial derivatives outstanding of Fannie Mae and Freddie Mac increased from $72 billion at the end of 1993, the first year for which comparable data were reported, to $1.6 trillion at year-end 2001.”  A 2010 report from the Federal Reserve Bank of St. Louis updates that information as follows:

“Fannie and Freddie presented considerable counterparty risk to the system through its large OTC derivatives book, similar in spirit to Long Term Capital Management (LTCM) in the summer of 1998 and to the investment banks during this current crisis. While often criticized for not adequately hedging the interest rate exposure of their portfolios, Fannie and Freddie were nevertheless major participants in the interest rate swaps market. In 2007, Fannie and Freddie had a notional amount of swaps and OTC derivatives outstanding of $1.38 trillion and $523 billion, respectively.

“The failure of Fannie and Freddie would have led to a winding down of large quantities of swaps with the usual systemic consequences. The mere quantity of transactions would have led to fire sales and invariably to liquidity funding problems for some of Fannie and Freddie’s OTC counterparties. Moreover, counterparties of Fannie and Freddie in a derivative contract might need to re-intermediate the contract right away, as it might be serving as a hedge of some underlying commercial risks. Therefore, due to counterparties’ liquidating the existing derivatives all at once and replacing their derivative positions at the same time, the markets would almost surely be destabilized due to the pure number of trades, required payment and settlement activity, and induced uncertainty, and the fact that this was taking place during a crisis.”

Did the bailout of Fannie and Freddie save the same cast of characters on Wall Street as were saved under the bailout of AIG (which funneled more than half the money out the backdoor  to Wall Street banks and hedge funds who were counterparties to AIG)?

According to Fannie and Freddie’s prior regulator, OFHEO: “At year-end 2001, five counterparties accounted for almost 60 percent of the total notional amount of Fannie Mae’s OTC derivatives, and 58 percent of Freddie Mac’s.” The report also notes that “The market for OTC derivatives is highly concentrated among a small number of dealers, primarily brokerage firms and commercial banks that are counterparties for at least one side of virtually all contracts. The largest dealers include JPMorgan Chase, Citigroup…Deutsche Bank, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley Dean Witter.”

According to a current report from the Office of the Comptroller of the Currency, those same banks (minus Deutsche and Lehman) account for the vast majority of derivatives in the U.S.

Lehman Brothers filed for bankruptcy one week after the government placed Fannie and Freddie into conservatorship. Merrill Lynch was taken over by Bank of America the same week. If you’re looking for a potential list of names of Wall Street players that needed a quick bailout of Fannie and Freddie, the above list is an excellent start.

Matt Taibbi reported at Rolling Stone three days ago that the government has been fighting a pitched battle to keep 11,000 documents pertaining to Fannie and Freddie under seal in a court case. You can rest assured that some of those documents relate to Fannie and Freddie derivatives and counterparties. But that pile of 11,000 documents pales in comparison to the 25 million documents the Justice Department withheld from the public when it settled its case against Citigroup in 2014 for $7 billion. What the public got instead was a meaningless 9-page statement of facts.

Thanks to Occupy Wall Street and Senator Bernie Sanders, the public knows two concrete things about Wall Street: banks got bailed out, we got sold out and, the business model of Wall Street is fraud.

But until we have a President in the Oval Office who believes that the citizens of a genuine democracy deserve the right to sift through the documents of the most epic fraud in the history of financial markets so they can reach their own conclusions, all we really have are slogans, including the one that says we live in a democracy.

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