The Next Bomb to Go Off in the Banking Crisis Will Be Derivatives

Gunnar Larson g at xny.io
Thu Mar 16 06:49:09 PDT 2023


https://wallstreetonparade.com/2023/03/the-next-bomb-to-go-off-in-the-banking-crisis-will-be-derivatives/


By Pam Martens and Russ Martens: March 16, 2023 ~

Janet Yellen
U. S. Treasury Secretary Janet Yellen

U.S. Treasury Secretary Janet Yellen finds herself in a very dubious
position. Under the Dodd-Frank financial reform legislation of 2010, the
U.S. Treasury Secretary was given increased powers to oversee financial
stability in the U.S. banking system. This increase in power came in
response to the 2008 financial crisis – the worst financial collapse since
the Great Depression. The legislation made the Treasury Secretary the Chair
of the newly created Financial Stability Oversight Council (F-SOC), whose
meetings include the heads of all of the federal agencies that supervise
banks and trading on Wall Street. The legislation also required the
Treasury Secretary’s authorization before the Federal Reserve could create
any more of those $29 trillion emergency bailout programs for the mega
banks – which had tethered themselves to casino trading on Wall Street
since the repeal of the Glass-Steagall Act in 1999.

Yesterday, after the Swiss banking behemoth Credit Suisse had traded at an
all-time low of less than two bucks; blown out its credit default swaps to
unprecedented levels; and tanked the Dow Jones Industrial Average by more
than 700 points intraday, Bloomberg News ran this headline at 12:54 p.m. –
“US Treasury Reviewing US Banks’ Exposure to Credit Suisse.” By “exposure,”
the Treasury really means how many billions of dollars of underwater
derivatives are U.S. banks on the hook for as a counterparty to Credit
Suisse. The Treasury also has to worry about U.S. banks’ exposure to Credit
Suisse’s other major counterparties that U.S. banks do business with, even
if the banks are not direct counterparties to Credit Suisse itself.

If the U.S. Treasury Secretary and her staff at F-SOC were just yesterday
getting around to finding out which U.S. banks had counterparty exposure to
Credit Suisse’s derivatives, we are all in very big trouble. The serious
problems at Credit Suisse have been making headlines for two years,
including here at Wall Street On Parade.

In July of 2021, the law firm Paul, Weiss, Rifkind, Wharton & Garrison
released a 165-page report on the internal investigation it had conducted
for the Board of Credit Suisse into how the bank came to lose $5.5 billion
conducting highly-leveraged and dodgy derivative trades for the family
office hedge fund, Archegos Capital Management, which went belly-up in
March of 2021. The Paul, Weiss lawyers wrote:

“The Archegos-related losses sustained by CS are the result of a
fundamental failure of management and controls in CS’s Investment Bank and,
specifically, in its Prime Services business. The business was focused on
maximizing short-term profits and failed to rein in and, indeed, enabled
Archegos’s voracious risk-taking. There were numerous warning signals —
including large, persistent limit breaches — indicating that Archegos’s
concentrated, volatile, and severely under-margined swap positions posed
potentially catastrophic risk to CS. Yet the business, from the in-business
risk managers to the Global Head of Equities, as well as the risk function,
failed to heed these signs, despite evidence that some individuals did
raise concerns appropriately.”

Six months ago, Dennis Kelleher, President and CEO of the nonprofit
watchdog, Better Markets, released a statement about the deteriorating
condition of Credit Suisse, highlighting the following:

“As the financial condition of Credit Suisse continues to deteriorate,
raising questions of whether it will collapse, the world and U.S. taxpayers
should be deeply worried as multiple, simultaneous shocks shake the
foundations of economies worldwide. Credit Suisse is a global, systemically
significant, too-big-to-fail bank that operates in the U.S. and is deeply
interconnected throughout the global financial system. Its failure would
have widespread and largely unknown repercussions from the inconvenient to
the possibly catastrophic.

“That is due, in part, to the failure of the Federal Reserve to properly
regulate the activities of foreign banks that have U.S.-based operations.
The U.S. has a largely ineffective regulatory framework with gaping
loopholes that fail to include some of even the most basic safety and
soundness requirements, which incentivizes regulatory arbitrage. As a
result, the U.S. financial system and economy are needlessly threatened.

“An effective and appropriate regulatory framework for large foreign banks
that covers all of their U.S.-based affiliates should have been established
when the Fed set up so-called U.S.-based intermediate holding companies
(‘IHCs’) that they regulate. Instead, U.S.-based branches of foreign banks
(which are not consolidated within the IHC) face significantly weaker
standards than the IHC, remarkably including no specific capital
requirements in the U.S. Furthermore, the branches have significantly
weaker liquidity requirements. This has resulted in many foreign banks –
including in particular Credit Suisse – engaging in regulatory arbitrage by
shifting large amounts of assets from their IHCs to their branches,
entities that are entirely reliant on the resources of their foreign-based
parent companies. The 2008 financial collapse proved that these resources
are not available in periods of stress, which is why the U.S. bailed out so
many foreign banks operating in the U.S. The Fed should have stopped that
long ago.

“As is well-known, risks in the global financial system that materialize
elsewhere easily end up becoming risks here in the U.S. and threaten our
financial system and economy. Those risks are amplified by the
unprecedented fiscal and monetary policies attempting to address the many
unexpected shocks from the pandemic and war. The Fed must see Credit Suisse
as a warning sign and improve the regulatory framework for large foreign
banks and all banks to ensure that the American financial system and
economy are properly protected.”

Credit Suisse’s reputation has taken more hits from its involvement in the
Greensill Capital scandal and the infamous spy-gate scandal in 2019 where
the bank spied on and followed various employees.

Nervousness about Credit Suisse reached a pivotal moment in the fall of
last year. On November 30, its 5-year Credit Default Swaps (CDS) blew out
to 446 basis points. That was up from 55 basis points in January of 2022
and more than five times where CDS on its peer Swiss bank, UBS, were
trading. The price of a Credit Default Swap reflects the cost to traders,
or investors with exposure, to insuring themselves against a debt default
by the bank.

If all of this didn’t awaken Secretary Yellen from her slumber about the
contagion risks posed by a deteriorating Credit Suisse, she should have
been jolted upright on December 5 of last year when researchers for the
Bank for International Settlement (Claudio Borio, Robert McCauley and
Patrick McGuire) released an astonishing report that found that foreign
banks had secret derivative debt that is “10 times their capital.”

The report focused on the amount of derivative debt that was not being
captured through regular statistical reporting because it is held off the
banks’ balance sheets. The researchers refer to this exposure as
“staggering” and note the potential for upsets to dollar swap lines to
settle it as it comes due.

The report raises further alarm bells with this: “For banks headquartered
outside the United States, dollar debt from these instruments is estimated
at $39 trillion, more than double their on-balance sheet dollar debt and
more than 10 times their capital.” Their on-balance sheet dollar debt is
$15 trillion.

The most recent quarterly derivatives report from the U.S. regulator of
national banks, the Office of the Comptroller of the Currency (OCC), found
that as of September 30, 2022 four U.S. mega banks held 88.6 percent of all
notional amounts of derivatives in the U.S. banking system. The total
notional amount for all banks was $195 trillion. JPMorgan Chase held $54.3
trillion of that; Goldman Sachs held $50.97 trillion; Citigroup’s Citibank
held $46 trillion; and Bank of America held $21.6 trillion. Even though the
Dodd-Frank legislation required that most of these derivative trades move
to central clearing, as of September 30, 2022 the OCC report found that
58.3 percent of these derivatives were not being centrally-cleared, meaning
they were over-the-counter (OTC) private contracts between counterparties,
thus adding another layer of opacity to an unaccountable system.

For the role that Citigroup played in keeping these dangerous derivatives
inside federally-insured banks, see our December 2014 report: Meet Your
Newest Legislator: Citigroup.
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