U.S. Financial System Rests on 5 Mega Banks; and They Tanked Yesterday

By Pam Martens and Russ Martens: August 6, 2019 ~

BusinessWeek Cover, May 13, 2002

BusinessWeek Cover, May 13, 2002

By the closing bell of yesterday’s broad stock market selloff, the Dow Jones Industrial Average, which had been down over 900 points in the afternoon, closed with a loss of 767 points or 2.90 percent. The Standard and Poor’s 500 Index closed even deeper in the red with a loss of 2.98 percent.

But those losses looked mild compared to what happened to four of the biggest banks on Wall Street yesterday. Bank of America, parent of the giant retail brokerage chain, Merrill Lynch, closed with a loss of 4.42 percent. Morgan Stanley, which had been pummeled in the big bank selloff in December, lost 3.87 percent while Goldman Sachs was not far behind with a loss of 3.67 percent. The bank with the most foreign exposure and a monster bailout in 2008, Citigroup, which in a fair and efficient market would have led the bank declines, lost 3.59 percent. (JPMorgan Chase, whose CEO, Jamie Dimon, has attempted to brainwash the market with the mantra that the bank has a “fortress balance sheet,” came in exactly in line with the S&P 500, losing 2.98 percent.)

Equally noteworthy, two of the insurance companies that the Office of Financial Research (OFR) says are interconnected through derivatives to Wall Street’s mega banks, also sustained large losses yesterday. Lincoln National lost 3.75 percent while Ameriprise Financial lost 3.58 percent.

The Office of Financial Research was created under the Dodd Frank financial reform legislation of 2010 to address the reckless conduct of Wall Street in the leadup to the 2008 financial crash, the largest economic upheaval since the Great Depression. Its purpose is to “shine a light in the dark corners of the financial system to see where risks are going, assess how much of a threat they might pose, and provide policymakers with financial analysis, information, and evaluation of policy tools to mitigate them.” (Apparently, the Trump administration would rather keep those corners in darkness because it has been gutting the budget of the OFR and sacking its staff.)

The 2017 Financial Stability Report from the OFR carried this warning to the markets:

“…some of the largest insurance companies have extensive financial connections to U.S. G-SIBs [Global Systemically Important Banks] through derivatives. For some insurers, evaluating these connections using public filings is difficult. Insurance holding companies report their total derivatives contracts in consolidated Generally Accepted Accounting Principles (GAAP) filings. Insurers are required to report more extensive details on the derivatives contracts of their insurance company subsidiaries in statutory filings, including data on individual counterparties and derivative contract type. But derivatives can also be held in other affiliates not subject to these statutory disclosures, resulting in substantially less information about some affiliates’ derivatives than required in insurers’ statutory filings.”

The simple translation of the above paragraph is that a replay of the implosion of a giant insurance company as a result of being Wall Street’s patsy for derivative exposures, as happened to AIG in 2008, is still possible. AIG received a $185 billion bailout, half of which went out the back door to pay off its derivative debts and securities lending agreements to Wall Street mega banks and their foreign counterparts.

What happens to these Wall Street mega banks is critical to the financial health of the U.S. economy. That’s because Congress has failed to break up these banks into manageable pieces. They now control the vast majority of dangerous derivatives while at the same time holding the vast majority of Federally-insured/taxpayer-backstopped deposits, which represent the life savings of average Americans.

To underscore just how concentrated this risk is, researchers at the Office of Financial Research wrote the following in a February 2015 report:

“The larger the bank, the greater the potential spillover if it defaults; the higher its leverage, the more prone it is to default under stress; and the greater its connectivity index, the greater is the share of the default that cascades onto the banking system. The product of these three factors provides an overall measure of the contagion risk that the bank poses for the financial system. Five of the U.S. banks had particularly high contagion index values — Citigroup, JPMorgan, Morgan Stanley, Bank of America, and Goldman Sachs.”

According to the Office of the Comptroller of the Currency (OCC), the bank holding companies of those same five banks as of March 31, 2019 were sitting on unthinkable levels of derivatives: in notional (face amount) of derivatives, JPMorgan Chase held $58.7 trillion; Citigroup held $51.5 trillion; Goldman Sachs Group had $50.8 trillion; Bank of America held $37.9 trillion while Morgan Stanley sat on $35 trillion. These five banks represented 86 percent of all derivatives held by the more than 5,000 Federally-insured banks in the U.S.

And there is growing concern that nothing useful or productive is being done with these derivatives but that they are being used to provide unsavory profits and to manipulate capital requirements at the big banks.

In another report from the OFR in 2015, researchers Jill Cetina, John McDonough, and Sriram Rajan, exposed how the Wall Street mega banks were gaming their capital requirements by using derivatives as “capital relief trades.” The report broke the news that JPMorgan Chase’s infamous London Whale trades, which lost its depositors $6.2 billion from high risk derivative trades in London, was an attempt at a capital relief trade that backfired. The researchers write:

“JPMorgan Chase & Co.’s losses in the 2012 London Whale case were the result of CDS [Credit Default Swap] usage which was undertaken to obtain regulatory capital relief on positions in the trading book.”

On June 24 of this year, U.S. Securities and Exchange Commission (SEC) Chairman Jay Clayton, U.S. Commodity Futures Trading Commission (CFTC) Chairman J. Christopher Giancarlo, and U.K. Financial Conduct Authority (FCA) Chief Executive Andrew Bailey issued the following joint statement regarding the credit derivatives markets:

“The continued pursuit of various opportunistic strategies in the credit derivatives markets, including but not limited to those that have been referred to as ‘manufactured credit events,’ may adversely affect the integrity, confidence and reputation of the credit derivatives markets, as well as markets more generally.  These opportunistic strategies raise various issues under securities, derivatives, conduct and antifraud laws, as well as public policy concerns.”

To translate, regulators in the U.S. as well as on the other side of the pond are aware that credit derivatives are being used to manufacture corporate defaults in order to collect windfall payments by credit derivative buyers. Conversely, financial institutions that have sold credit derivative protection are stalling the onset of a credit default until after the derivative contract has expired in order to avoid making the windfall payments. In either situation, there is a strong case that fraudulent market manipulation is occurring and the person on the other side of the derivative trade is being defrauded.

Last month, the U.S. Commodity Futures Trading Commission (CFTC) took the unprecedented step of posting a Youtube video (see below) indicating it was aware of multiple methods that Credit Default Swap (CDS) buyers and sellers were using to game the market. The CFTC speakers were so keenly aware of the tactics that they even posted graphics explaining the “scheme” play by play.

CFTC Chairman J. Christopher Giancarlo states this in the video: “In the last two and a half year period, we’ve observed 14 strategies, seven of which have occurred in just the last six months.”

Is this what Federal regulation of Wall Street has been reduced to – posting a Youtube video to warn miscreants that we know what you’re doing instead of actually arresting and prosecuting the individuals who are gaming the market?

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