Quietly, the Fed Releases Its Financial Stability Report and Lines Up a Scapegoat

By Pam Martens and Russ Martens: November 7, 2022 ~

Fed on InflationOne minute after the stock market closed on Friday, the Federal Reserve mailed out a link to its newly-released Financial Stability Report to folks who have signed up to get press releases from the Fed.

For those of you who have been reading our reports on the Fed for years – its unaccountable money printing and bailouts of Wall Street, the opaque activities of the trading floors owned by the New York Fed, its unchecked conflicts of interest, and its brazen, and as yet unprosecuted, trading scandal – you might suspect that the Fed would have pulled a lot of punches in its “Financial Stability Report.” You would be correct.

On the topic of derivatives, which remain the greatest risk at the mega banks on Wall Street, the word “derivatives” is mentioned just eight times in the report – with little clarity. For Wall Street On Parade’s multitude of warnings on the actual risks posed by derivatives, see our “Related Articles” below.

Another key risk to financial stability in the U.S. is the “interconnectedness” of the mega banks on Wall Street. This means that if one mega bank becomes insolvent or starts to teeter – as Citigroup did in 2008 – the systemic contagion spreads to the other mega banks that are counterparties to its derivatives, which in turn infects the entire financial system.

The word “interconnected” appears just four times in the Fed’s Financial Stability Report. The following text provides a picture of what the Fed would rather not talk about in any depth.

“Disruptions to economic activity or financial markets abroad can affect the United States through several channels. A pullback in risk-taking worldwide may cause further declines in asset prices and tighter credit conditions abroad and in the United States. Some U.S. investors would incur losses on foreign exposures, and foreign financial institutions would likely reduce lending to U.S. businesses. Foreign investors could sell Treasury securities and other safe U.S. assets, potentially adversely affecting financial-market functioning and the transmission of monetary policy. Foreign official holders might sell reserves to defend home currencies, and private holders might sell Treasury securities in the context of a widespread surge in demand for dollar cash buffers. Broader pressure on large internationally active foreign banks could — if sufficiently severe — result in material spillover to U.S. financial stability through strains on dollar funding markets (in which foreign banks are large participants) and interconnectedness with U.S. banks, although the effects would be mitigated by the resilience and sound capitalization of the U.S. banking system. More generally, modern financial markets are interconnected, so stresses abroad could lead to strains in U.S. markets and challenges for U.S. financial institutions.”

The above paragraph provides a window into how the Fed is planning to spin the next financial meltdown to shift blame away from its own failed supervisory role of the mega banks. The Fed wants Congress and the public to believe that it has followed the mandates of the Dodd-Frank financial reform legislation of 2010 and has reined in the risks of the mega banks that took down the U.S. economy in 2008. So the Fed writes: “…the resilience and sound capitalization of the U.S. banking system….” But the Fed also wants to have a scapegoat lined up to point the finger at when things blow up, so it adds: “More generally, modern financial markets are interconnected, so stresses abroad could lead to strains in U.S. markets and challenges for U.S. financial institutions.”

The simple question is why hasn’t the Fed used its regulatory powers to restrict and reform these tight linkages of interconnectedness. The Office of Financial Research has been warning federal regulators about this serious problem for at least the past seven years. In a report it released on February 12, 2015, its researchers wrote:

 “…the default of a bank with a higher connectivity index would have a greater impact on the rest of the banking system because its shortfall would spill over onto other financial institutions, creating a cascade that could lead to further defaults. High leverage, measured as the ratio of total assets to Tier 1 capital, tends to be associated with high financial connectivity and many of the largest institutions are high on both dimensions…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.”

The report specifically called out five banks – which, today, remain the largest holders of derivatives among U.S. banks:

“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.”

When the Financial Crisis Inquiry Commission (FCIC) released its final report on the details of the 2008 financial crash – the worst since the Great Depression – there was a revealing quote from former Fed Chairman Ben Bernanke, who wore blinders during the lead up to the crisis, oversaw an unprecedented secret bailout, and then battled the media in court for more than two years in a failed effort to keep the details behind a dark curtain. The FCIC wrote the following regarding the interconnectivity threat from Citigroup:

“The firm’s various regulators watched the stock price, the daily liquidity, and the CDS spreads with alarm. On Friday, November 21, the United Kingdom’s Financial Services Authority (FSA) imposed a $6.4 billion cash ‘lockup’ to protect Citigroup’s London-based broker-dealer. FDIC examiners knew that this action would be ‘very damaging’ to the bank’s liquidity and worried that the FSA or other foreign regulators might impose additional cash requirements in the following week. By the close of business Friday, there was widespread concern that if the U.S. government failed to act, Citigroup might not survive; its liquidity problems had reached ‘crisis proportions.’ Among regulators at the FDIC and the Fed, there was no debate. Fed Chairman Bernanke told the FCIC, ‘We were looking at this firm [in the fall of 2008] and saying, ‘Citigroup is not a very strong firm, but it’s only one firm and the others are okay,’ but not recognizing that that’s sort of like saying, ‘Well, four out of your five heart ventricles are fine, and the fifth one is lousy.’ They’re all interconnected, they all connect to each other; and, therefore, the failure of one brings the others down.’”

Bernanke had allowed the supervision of Citigroup to be farmed out to the New York Fed. For how that worked out, see our report: As Citigroup Spun Toward Insolvency in ’07 – ’08, Its Regulator Was Dining and Schmoozing With Citi Execs.

And, most recently, adding to the insult to our senses on Bernanke’s role in the 2008 financial crash, he was awarded the Nobel Prize in Economics. (You can’t make this stuff up.) Fortunately, Robert Kuttner remains fearless in his assessment of such matters.

Related Articles:

Fed Chair Powell Telegraphs the Perfect Storm for Wall Street’s Megabanks: Rapid Rate Hikes Hitting $234 Trillion in Derivatives

JPMorgan Chase’s Derivatives Spike by $14 Trillion in First Quarter to Six-Year High of $60 Trillion

This Time Will Be Different: One or More Corporations Will Blow Up from Derivatives along with Global Banks

New Study: Wall Street Banks Are Doubling Down on Risk by Selling Credit Default Swaps on their Risky Derivatives Counterparties

AIG Was Brought Down by Derivatives in 2008. It Just Spun Off a Company Whose Prospectus Mentions Derivatives 371 Times

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