By Pam Martens and Russ Martens: August 16, 2023 ~
Yesterday, the Dow Jones Industrial Average took a tumble of 361 points by the closing bell. Numerous headlines attributed the big decline to a weakening economy in China. But the actual trigger for angst among traders was a headline at 5:30 a.m. EDT yesterday at CNBC. The headline read: “Fitch warns it may be forced to downgrade dozens of banks, including JPMorgan Chase.”
JPMorgan Chase is not just the biggest bank in the United States in terms of assets and deposits. It is the biggest bank in terms of its derivative exposure. According to the federal regulator of national banks (those operating across state lines), the Office of the Comptroller of the Currency (OCC), as of March 31, 2023, JPMorgan Chase Bank had assets of $3.2 trillion and derivative exposure of more than $59 trillion notional (face amount).
The OCC report also makes the following frightening statement: “A small group of large financial institutions continues to dominate trading and derivatives activity in the U.S. commercial banking system. During the first quarter of 2023, four large commercial banks represented 89.0 percent of the total banking industry notional amounts and 66.5 percent of industry net current credit exposure (NCCE).”
And now Fitch is sending a message to the market that it may have to downgrade those big four banks. What could possibly go wrong?
The four commercial banks the OCC is referring to are JPMorgan Chase, Goldman Sachs Bank USA, Citigroup’s Citibank, and Bank of America.
But if you look at the OCC’s breakdown of derivative exposure at the bank holding company level, a fifth bank emerges – Morgan Stanley – which somehow manages to remain below the radar on its derivatives – until things blow up.
These five bank holding companies hold $238 trillion of the total of $285 trillion in derivatives held by the top 25 bank holding companies with exposure to derivatives, according to the latest OCC report. To express that another way, 84 percent of the danger of derivatives blowing up as they did in 2008 is concentrated at just five U.S. banks out of the 4,096 federally-insured commercial banks in the U.S.
Unfortunately, the bad news doesn’t end there. Back in 2010 when the Dodd-Frank financial reform legislation was passed, banks were supposed to do two important things with their dangerous exposure to derivatives. They were required to “push out” the derivatives to another unit of the bank holding company, other than the federally-insured bank, so that this unit could be wound down if the derivatives blew it up. Citigroup was able to get this Dodd-Frank reform repealed in a sneaky maneuver in 2014.
Dodd-Frank also was heralded as forcing the mega banks to move these dodgy derivatives to being centrally-cleared in order to bring stability and transparency to this dangerous market. Instead, the latest report from the OCC notes that “In the first quarter of 2023, 40.5 percent of banks’ derivative holdings were centrally cleared…” meaning that 59.5 percent of derivatives are still an opaque black hole, also known as OTC (over-the-counter) derivatives.
It is assumed by savvy derivative traders that if a counterparty to a derivatives contract gets a credit downgrade, that counterparty may well have to cough up more collateral on its open derivative trades. Just how much additional collateral the bank might have to post raises the specter of liquidity issues. But since the terms of these private derivative contracts are opaque to the market, nobody, including regulators, can readily assess what the full impact of a credit downgrade would be.
One way to get a little market color is to see how the mega derivative banks traded on the day the Fitch news came out. The chart above shows that the two mega banks taking the biggest tumble yesterday were, indeed, two of the five with the largest exposure to derivatives: Bank of America (ticker BAC), closed down 3.20 percent, and JPMorgan Chase (JPM), closed down 2.55 percent.
Back on June 27, when Fitch lowered the credit rating on the operating environment (OE) for U.S. banks by one notch (from AA to AA-) it warned that if it had to take the rating down further in the future it might have to cut the credit rating on some banks as well. It wrote at the time:
“We do not expect the lower OE score to negatively impact the ratings of U.S. banks, although it reduces ratings headroom. As indicated in a previous report published in February 2023, whereas a one-notch downgrade of the OE score would not necessarily result in bank issuer rating actions, a multi-notch downgrade would revise Fitch’s financial performance benchmarks for banks and would lead to lower financial profile scores, all else equal.”
The last time Fitch took a rating action on JPMorgan Chase was on September 19, 2022. Its long-term issuer default rating was affirmed at AA- and its Derivative Counterparty Rating was also affirmed at AA-.
Unfortunately, the banking industry environment has dramatically deteriorated since the fall of 2022, as has negative news surrounding JPMorgan Chase.
In the span of seven weeks this spring, running from March 10 to May 1, the second, third, and fourth largest bank failures in U.S. history occurred. In order of size, those were: First Republic Bank (May 1), Silicon Valley Bank (March 10) and Signature Bank (March 12). (The largest bank failure in U.S. history, Washington Mutual, occurred in 2008 during the financial crisis.)
Doing significant reputational damage to JPMorgan Chase since its last Fitch rating action in September of 2022 is the fact that three federal lawsuits have been filed against the bank alleging that it played a key role in perpetuating the sex trafficking operation of the late Jeffrey Epstein, over the span of the more than 14 years that it kept him as a client, by funneling to him more than $5 million in hard cash (sometimes as much as $40,000 to $80,000 a month), when it knew or should have known that he was using that money to pay off victims, accomplices and recruiters of underage sex slaves. The bank also held accounts for some of his victims and accomplices and transferred millions of dollars from Epstein into these accounts. None of these transactions resulted in the bank filing the legally-mandated Suspicious Activity Reports (SARs) to law enforcement, despite the fact that dozens of internal emails at the bank have turned up during discovery showing that numerous compliance and money-laundering personnel at the bank were aware of Epstein’s revolting history of sex with minors.
The three lawsuits, one filed by Epstein victims, one by the Attorney General of the U.S. Virgin Islands where Epstein owned his own island and compound, and one by two pension funds on behalf of JPMorgan Chase shareholders, have been making headlines for months and raising serious governance issues about the largest federally-insured bank in the United States. The bank has already admitted to an unprecedented five criminal felony counts since 2014 – raising the question as to just how accurate that AA- rating is from Fitch.
The official report from the Financial Crisis Inquiry Commission, following an in-depth investigation of the 2008 financial collapse, had this to say about the role of derivatives:
“OTC derivatives contributed to the crisis in three significant ways. First, one type of derivative—credit default swaps (CDS)—fueled the mortgage securitization pipeline. CDS were sold to investors to protect against the default or decline in value of mortgage-related securities backed by risky loans…
“Second, CDS were essential to the creation of synthetic CDOs. These synthetic CDOs were merely bets on the performance of real mortgage-related securities. They amplified the losses from the collapse of the housing bubble by allowing multiple bets on the same securities and helped spread them throughout the financial system…
“Finally, when the housing bubble popped and crisis followed, derivatives were in the center of the storm. AIG, which had not been required to put aside capital reserves as a cushion for the protection it was selling, was bailed out when it could not meet its obligations. The government ultimately committed more than $180 billion because of concerns that AIG’s collapse would trigger cascading losses throughout the global financial system. In addition, the existence of millions of derivatives contracts of all types between systemically important financial institutions—unseen and unknown in this unregulated market—added to uncertainty and escalated panic, helping to precipitate government assistance to those institutions.”
It is nothing short of a national disgrace that Congress and the U.S. Department of Justice have done so little since 2008 to rein in the dangerous — and unconscionable — activities of the mega banks on Wall Street.