The Fed Pretends to Send a Warning to Wall Street’s Mega Banks on Derivatives and Counterparty Risk

[Gunnar Larson]

https://wallstreetonparade.com/2024/02/the-fed-pretends-to-send-a-warning-to-wall-streets-mega-banks-on-derivatives-and-counterparty-risk/


By Pam Martens and Russ Martens: February 29, 2024 ~

Taming the Megabanks, Book JacketOn Tuesday, the Vice Chair for Supervision
at the Federal Reserve, Michael Barr, delivered a speech at a risk
management conference in Manhattan. Barr’s objective was to convince
conference attendees that the Fed has its eye on the ball when it comes to
Wall Street mega banks and their counterparties who are sitting on the
opposite sides of derivative trades totaling tens of trillions of dollars.
(Yes, trillions.)

The most illuminating and dangerous elements of Barr’s speech are what he
didn’t say.

To remind attendees of what could happen if counterparty risks were not
managed properly, Barr cited Long Term Capital Management (LTCM) and
Archegos Capital Management.

LTCM was a hedge fund stocked with the so-called “smartest men in the
room,” including two Nobel laureates, who fed mathematical formulas into
computers that generated trades using astronomical levels of leverage. Of
course, this resulted in the brainiacs blowing up the firm in the fall of
1998 during the Russian debt crisis, putting their counterparties – the big
trading houses on Wall Street – at grave risk. The New York Fed had to
corral the big boys on Wall Street into its conference room and hammer out
a multi-bank bailout of the teetering hedge fund.

What happened at Archegos can best be summed up with our headline of 2021:
Archegos: Wall Street Was Effectively Giving 85 Percent Margin Loans on
Concentrated Stock Positions – Thwarting the Fed’s Reg T and Its Own Margin
Rules.

LTCM occurred in 1998, before Sandy Weill, the Bill Clinton administration,
Robert Rubin, the New York Times and the Federal Reserve had ushered in the
most dangerous banking era in U.S. history by repealing the Glass-Steagall
Act and allowing the trading casinos on Wall Street to merge with giant,
federally-insured, deposit-taking banks. This explosive situation continues
to this day, as do the never-ending Fed bailouts.

The biggest explosions in U.S. banking history from derivatives and
insolvent counterparties were, of course, neither LTCM or Archegos. They
were Lehman Brothers and AIG – both of which owned federally-insured banks
at the time of their demise in 2008, thanks to the repeal of the
Glass-Steagall Act in 1999. Lehman Brothers filed for bankruptcy on
September 15, 2008. The U.S. government seized control of AIG the following
day and “made over $182 billion available to assist AIG between September
2008 and April 2009” according to a report by the Government Accountability
Office (GAO). $90 billion of the $182 billion went in the front door of AIG
and out the back door to pay 100 cents on the dollar on credit derivative
trades that had been made between a dodgy unit of AIG and the major trading
houses on Wall Street.

According to documents released by the Financial Crisis Inquiry Commission
(FCIC), at the time of Lehman Brothers’ bankruptcy it had more than 900,000
derivative contracts outstanding and had used the largest banks on Wall
Street as its counterparties to many of these trades. The FCIC data shows
that Lehman had more than 53,000 derivative contracts with JPMorgan Chase;
more than 40,000 with Morgan Stanley; over 24,000 with Citigroup’s
Citibank; over 23,000 with Bank of America; and almost 19,000 with Goldman
Sachs.

Below is a share price chart of what derivatives contagion looked like on
Wall Street in 2008.

This Is What Wall Street's Systemic Contagion Looked Like in 2008

So why was Michael Barr not talking about 2008, Lehman Brothers, AIG or the
insanely interconnected trading houses on Wall Street in his speech on
Tuesday?

It’s because, as we reported on February 13, Barr has allowed five Wall
Street mega banks to hold $223 trillion in derivatives today, 83 percent of
all derivatives at 4,600 banks in the U.S.

For more than two decades, both Republican and Democratic administrations
in Washington have shown a sycophantic subservience to tolerating the
catastrophic level of derivatives at the Wall Street mega banks while
simultaneously allowing them to own federally-insured, taxpayer-backstopped
commercial banks.

This sycophantic tolerance has existed despite repeated warnings from
academics and federal researchers. As far back as 2016, researchers have
been sounding the alarms on counterparty risk and the failure of the Fed’s
stress tests to properly measure that risk.

In a report issued in March 2016 by the Office of Financial Research (OFR),
a federal agency created under the Dodd-Frank financial reform legislation
of 2010, the OFR brought the illusory nature of the Fed’s oversight of
counterparty risk into focus.

The OFR researchers who conducted the study, Jill Cetina, Mark Paddrik, and
Sriram Rajan, found that the Fed’s stress tests are measuring counterparty
risk for the trillions of dollars in derivatives held by the largest banks
on a bank by bank basis. The real problem, according to the researchers, is
the contagion that could spread rapidly if one big bank’s counterparty was
also a key counterparty to other systemically important Wall Street banks.
The researchers write:

“A BHC [bank holding company] may be able to manage the failure of its
largest counterparty when other BHCs do not concurrently realize losses
from the same counterparty’s failure. However, when a shared counterparty
fails, banks may experience additional stress. The financial system is much
more concentrated to (and firms’ risk management is less prepared for) the
failure of the system’s largest counterparty. Thus, the impact of a
material counterparty’s failure could affect the core banking system in a
manner that CCAR [one of the Fed’s stress tests] may not fully capture.”
[Italic emphasis added.]

In Barr’s speech on Tuesday, he stated that “…alongside this year’s stress
test results, we will publish the aggregate results of several exploratory
analyses, including analysis of the resilience of the globally systemically
important banks to the simultaneous default of their five largest hedge
fund counterparties.”

But according to an OFR study released in July 2021, it’s not hedge funds
where banks have the largest counterparty risk. It’s corporations.

For just how long this insidious behavior between the Fed and the Wall
Street mega banks has been going on, we suggest reading the seminal book on
the subject, Arthur Wilmarth’s Taming the Megabanks: Why We Need a New
Glass-Steagall Act.
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