Bank Exposure to Derivatives Remains a Sizable Problem, As Does the Lack of Genuine Transparency

Banks are back at it. Actually, they never left the table.

The derivatives table, that is. It turns out that not only are banks still very much engaged in the same shenanigans that had such a big hand in creating the turmoil we often call the Great Recession of 2008, their exposure today…which, in turn, means your exposure today…to the inherent and substantial risks of derivatives is greater than it was when it seemed as though the global financial infrastructure was going to completely collapse eight years ago. Additionally, regulation and disclosure remain as ham-fisted as ever, so there is little chance you will know what is really going on deep inside of your financial institution. While there are meaningful things that can be done to make the environment better for customers, investors, and even banks themselves, the necessary changes would have to occur at the level of banking DNA, so the likelihood of genuine improvement in the foreseeable future remains slim, at best.

A Reader’s Digest-Style Review of 2008

Before we talk about the present threat, it’s appropriate to review, compactly, what happened in 2008. A lot of factors conspired to bring the economy to its knees, but let’s keep things (relatively) simple, in the interest of expediency.

Broadly, it was what has been termed the housing crisis that led the way down, and the housing crisis unfolded in two, sequential steps, moving in quick succession. The first came about when a lot of folks who had mortgages that outsized their ability to pay…all reached the point of failure at roughly the same time. The second step, which turned something bad into something catastrophic, was that the derivative securities that had been created on the backs of these mortgage loans, and that had come to represent an enormous portion of many banks’ portfolios, collapsed under the incredible weight of the non-performing underlying loans, thus putting the entire financial system on the precipice.

Of course, up until things went so very bad, all looked well…and I emphasize looked. Because 100% mortgage loans were available to people with credit scores as low as 580 in the years leading up to the implosion, basically everyone could be a homeowner…except, they weren’t really homeowners. What was actually created in those days was not a new generation of homeowners in the way our parents and grandparents were homeowners, but, rather, just a new generation of hyper-extended borrowers, because, of course, you don’t actually own the house until you do so free and clear. The other part of the problem with so many of these new and highly-leveraged homeowners, in this case, had to do with their financial profiles. Indebted people with great credit are not typically a problem, but when a sizable number of people being handed significant loan balances have, at the outset, lousy credit, then you have a ticking bomb. How did that happen in the first place? A big part of your “gratitude” goes to the social engineering that was coming into vogue in the 1990’s, and, in particular, Bill Clinton’s Community Reinvestment Act, but we’ll leave that part of the discussion and move on from here.

With respect to real estate, two “main” types of derivatives became particularly relevant to the 2008 collapse: mortgage-backed securities, including those commonly known as collateralized debt obligations (CDO’s), and something else…the credit default swap.

To explain a credit default swap, let’s revisit the mortgage-backed security/CDO, for just a moment (I will use those terms somewhat interchangeably for the discussion at hand; they are not necessarily the same thing, but, again, treating them as though they are works for what we’re doing here). What makes the MBS a derivative that sort of…and I mean sort of…makes sense to most people, is that if you start with the MBS and begin peeling back the layers, eventually you end up at the underlying asset, the mortgage (to some, the real property to which the mortgage is attached is the “real” underlying asset of an MBS, but, either way, the point is that once you start digging down into a MBS/CDO to look at the guts, you eventually end up at the mortgage loans themselves, as well as the properties).

This is not the case for a credit default swap. It’s such a derivative of the underlying asset (mortgage loan or property, take your pick), that you might say it’s a derivative of a derivative. The credit default swap is basically an insurance contract, and is made available by insurance companies (of course) to investors…often hedge funds…that aren’t sold on the future greatness of the CDOs; if a collateralized debt obligation is wiped out, the credit default swap pays out.

So, this is, in very much of a nutshell, what happened in 2008: the banks, trying to make a bunch of money on the higher interest payments paid by CDO’s created from risky sub-prime mortgages (because the tradeoff with lower quality borrowers is that they pay higher interest rates, right?), owned a bunch of these derivatives in their portfolios, and when those failed, the failures, in turn, triggered massive claims by those entities that had purchased the credit default swaps against the insurance companies that issued them, companies like AIG; remember hearing about them every day on the news? The problem that the AIGs and Credit Suisses of the insurance world had in paying out the “claims” is that they had gone into this so confident that mortgage-backed securities were going to be just fine, that they didn’t bother to set aside any reserve capital in case things went bad (there were reasons for this confidence that went beyond simply cheery optimism, but, again, we’ll let that go for this discussion). We know what happened next.

It’s worth mentioning, too, that one of the principal, complicating…and, as it turned out, largely self-generated…causal factors in all of this for the financial institutions was the actions of the leading credit rating agencies; Moody’s, Standard & Poor’s, and Fitch frequently gave their highest ratings (read: investment grade ratings)to mortgage-backed securities that were comprised of risky, sub-prime paper. As for why they did so, there are several reasons, not least which is the fact that the financial institutions that were paying for these services needed to have the best ratings possible, regardless of the quality, and applied pressure, both directly and by implication, on the agencies to produce.

Talk about “be careful what you wish for.”

The bottom line is that some of the biggest financial institutions in the world…banks, insurance companies, and those that are some of each…were either completely, or mostly, in ruins, and those that were still breathing were the recipients of your tax dollars, to a degree that is still practically unfathomable.

Let me jump to the not-so-funny punch line, one that I really gave away at the outset of this piece: Despite the ravages of 2008, not only are the biggest financial institutions in the world still knee-deep in derivatives, notwithstanding supposed financial reforms, their exposure is even greater than it was back when the Great Recession exploded. How’s that for ominous?

As for the actual amount of exposure, presently, let’s put some numbers to it. Estimates have the total dollar value of derivatives…called “notional” value…at the 25 largest U.S. banks to be around a staggering $247 trillion. By comparison, these banks have “only” around $14 trillion in assets. For your added consideration, let’s note that the current gross domestic product (GDP) of the United States is about $18 trillion. In other words, the derivatives at the largest financial institutions in the world dwarf…by a LOT…anything resembling real assets.

Adding to the worry is that the governments of the world…ours, theirs, everyone’s…are now so poorly capitalized after the last disaster that even if all were on board with a bailout the next time around, there is really no dough to throw at it. That raises the specter of a bail-in (talk about ominous), where banks don’t receive taxpayer money in order to survive, but must, instead, use their own assets…including your money on deposit…to get straight.

Bottom line: Banks and other financial institutions with a lot of derivative exposure create a bunch of risk, at a variety of levels, for you.

Lack of Transparency: The Derivatives-Heavy Bank’s Partner in Crime                        

One of the collateral problems is that after all of the supposed reform that was exerted on the financial services industry following 2008, there remains a stunning lack of genuine transparency, overall, that even more sophisticated investors clearly recognize. For investors, derivatives risk and insufficient transparency live in symbiosis.

One of the clues to the persistent transparency problem can be found in the current share prices of the world’s largest banks, as compared to the book values of these same institutions. A cursory review of the financials of every major financial institution you would recognize in name reveals that, in almost all cases, share prices remain well below book: Bank of America, Deutsche Bank, Citigroup, Barclays, Royal Bank of Scotland, the list goes on and on. This telegraphs both a lack of confidence in the assets, as stated, of these institutions, as well as in the likelihood they’ll be profitable anytime soon. While this article is written only several days following the historic Brexit vote, a historical review of price/book for some time now indicates the aforementioned lack of confidence in the sector.

A big part of the problem lies, ironically enough, in the slew of new regulations themselves, the same regulations designed to enhance the transparency that has proved so elusive. A crucial mistake made by regulators following the 2008 crisis was to slather on additional, complex rules that, ultimately, acted to both make things even harder for anyone to figure out (this includes sophisticated investors as well as Johnny Lunchbuckets) and create even more legalistic nooks and crannies into which banks can hide what’s really going on inside their portfolios. 2010’s Dodd-Frank was over 800 pages in length, and if you also take into account the numerous, new regulations that Dodd-Frank mandated, as well, you have a piece of legislation that, in totality, is really tens of thousands of pages long.

Seriously?

In the end, the forthcoming-ness problem is so great that it exists at what is, essentially, a philosophical and cultural level; that is, it is about how the banking industry is perceived by those who work in it, by those who profit most fully from the way it is permitted to operate, presently. Accordingly, in order for there to be real change in terms of risk and transparency that benefits bank customers and investors, as well as the public, more generally, a culture change at the most organic level must take place – anything short of that will not yield the necessary improvements.

Fixing the Problem

The way to fix the problem, at least in terms of greater transparency (because massive derivatives exposure itself won’t be going away), is to cultivate, by hook or by crook, not just better rules, but a better culture.

As for the “better rules” part, some over the years have been very vocal about presenting some awfully common-sense ideas. One great take on how to make things better came from a 2013 article in The Atlantic entitled, “What’s Inside America’s Banks?” Written by Frank Partnoy and Jesse Eisinger, the piece helps us understand how to get back on the right track by illustrating the differences between banking regulation and culture that came about just after the Great Depression, and regulation today.

Partnoy and Eisinger point out that the first, most important, step to be taken is that the entire paradigm of disclosure must be changed, and should go back to the relatively simple days that characterized how disclosures were made nearly a century ago. The authors point out that while banking infrastructure itself was also fraught with some convolution at that time…complex investment mechanisms existed even then, don’t you know…the manner in which investors were informed of what banks were doing was much more in keeping with plainspoken English. Additionally, the nature of the rules was oriented on commonsense standards. As Partnoy and Eisinger put it, “Commercial banks were not permitted to engage in investment-banking activity, and were required to set aside a reasonable amount of capital. Bankers were prohibited from taking outsize risks.” The authors remind us, as well that this was largely the lay of the regulatory land up until the 1980’s.

In other words, not only were disclosures more straightforward, but banking regulations were built on a foundation of what might be called a reasonable man standard. Banks could stray from the center, in terms of policies and foundational portfolios, but they could not motor along while remaining hanging off the side of a cliff, in the form of off-balance sheet accounting gone haywire.

The other step that must be taken, according to Partnoy and Eisinger, is that fear of real punishment must be returned to the banking community so that those inclined to roguish behavior may be appropriately disincentivized. As the authors point out…and it is a stark mention…coinciding with the massive multiplying of the rules ostensibly designed to banks and bankers on the straight and narrow, is the reality that no senior banker from any of the biggest houses went to prison in connection with anything stemming from the 2008 mess, and, beyond that, hardly any even had to pay fines.

This situation is vastly different from that which existed in the years following the 1929 crash, when plenty of high-level bank executives were sent off to the slammer for a variety of financial misdeeds. As Partnoy and Eisinger write, “The scrutiny and continuing threat of prosecution” during that time “convinced many bank executives that they should keep their business simple and transparent, or worry about the consequences if they did not.”

Regarding derivatives and variable interest entities (VIEs), in particular, the disclosure rules remain lousy for the investor. On that point, “way back” in 2010, Partnoy and Lynn Turner…who, among a plethora of credentials, served as Chief Accountant of the Securities and Exchange Commission…authored an article plainly-titled “Bring Transparency to Off-Balance Sheet Accounting” for the Roosevelt Institute’s Make Markets Be Markets report. In the piece, the two outlined the following five principal recommendations aimed at improving derivative transparency:

  • Companies must include swaps on their balance sheets.
  • Companies must record all assets and liabilities of VIEs, in amounts based on the most likely outcome given current information.
  • Companies must report asset financings on the balance sheet (not as “sales”).                 
  • Congress should adopt a legislative standard requiring such disclosures (mere “guidance” from the accounting industry is not enough).                                                                                                      
  • Companies that fail to disclose material facts should face civil liability.

Greater transparency, accompanied by more useful enforcement, is only a part of the solution. Ultimately, the only way that true, lasting change will be effected is through an improvement in the culture. As Steve Denning pointed out in a 2013 Forbes article entitled, “Big Banks and Derivatives: Why Another Financial Crisis Is Inevitable,” cracking down on the industry and requiring better, clearer disclosures will only really work if those components are “accompanied by a paradigm shift in the banking sector that changes the context in which banks operate and the way they are run, so that banks shift their goal from making money to adding value to stakeholders, particularly customers. This would require action from the legislature, the SEC, the stock market and the business schools, as well as of course the banks themselves.”

In other words, the core of the “fixes” is the need for banking elites to be better people, and while it would be great if the relevant parties could arrive at that point of their own accord, we probably just have to assume that the greed factor at that level is so powerful, so influential…just as the ability to wield real power so typically corrupts those who land in DC as elected officials…that they will need help achieving that morally and ethically improved state in the form of an acute effort at culture change that runs from business school to the highest levels of government. Until that happens, however, ignore the massive risk to financial institutions, and, in turn, to you, from derivatives at your own peril.

The information contained here is for general information purposes only. The Financial Writer blog and Bob Yetman disclaim responsibility for any liability or loss incurred as a consequence of the use or application, either directly or indirectly, of any information presented herein. Nothing contained in this article, or any other article featured at this blog, should be construed as a solicitation or recommendation to engage in any financial transaction. You should seek the advice of a qualified professional before making any changes to your personal financial profile.

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