Most Popular ArticlesReputational Risk: Living in a Derivative World
Institutional Risk Analytics
Christopher Whalen
March 1, 2010
Some boys kiss me, some boys hug me They can beg and they can plead Living in a material world Madonna - "Material Girl" Two weeks ago, we wrote about how the zero interest rate policy (ZIRP) that is being maintained by the Federal Open Market Committee is driving global deflation ('Is the Fed's Zero Interest Rate Policy Driving Global Deflation?', February 16, 2010). ZIRP is slowly re-pricing the yields on all manner of financial assets. Falling cash flow is eating away at the subsidy provided to banks by the Fed. According to the most recent Quarterly Banking Profile published by the FDIC, net-interest margin (NIM) for the banking industry "in 2009 was 3.47 percent, the highest annual average since 2005," but we already see evidence that NIM is starting to fall at some banks. More important, the corrosive effect of ZIRP on money market funds and other interest rate sensitive investors is becoming critical. While a healthy NIM is generally a good thing for banks, that is not the case today for depository institutions, money market funds, insurers and pensions laboring under the Fed's ZIRP. As the FDIC notes: "During the year, total industry assets declined by a net $731.7 billion (5.3 percent), the largest percentage decline in a year since the inception of the FDIC." The FDIC was created in 1933, BTW, during the worst days of the Great Depression. Between the charge-off of bad loans and ZIRP, banks are having great difficulty finding earning assets, thus they shrink. Even as bank securities holdings are rising in aggregate, loan portfolios and assets overall are shrinking at an accelerating pace - evidence, we believe, that deflation remains the chief threat to the global economy. As we said two weeks ago, when the Fed embraces a zero rate policy, what they are telling investors is that bonds and other rate-sensitive financial assets have no value. We've been talking about the shrinking bank balance sheet for more than 18 months and thankfully this key statistic is starting to get broad attention. Notice that there currently is a buoyant equity market, but other asset classes are literally going to hell in terms of internal credit quality - even as the Fed props up bond market prices via quantitative easing. Consider that many of the MBS which the Fed has pushed over par in terms of price are reporting losses and prepayments that, absent Fed market manipulation, would justify yields several points higher than current levels. Unfortunately the monetary economists who dominate the staff of the Fed don't really understand markets or financial institutions, and are only starting to appreciate the cash flow trap that ZIRP has created for the real economy. We hear in the credit channel that a primary reason behind the symbolic increase in the Fed's discount rate two weeks ago was the precarious position of many money market funds. The Prime Fund managed by JPMorgan Chase (JPM) is now yielding a whole 0.01%. Think about what it costs to operate that fund. Then think about how hard it must be for JPM to keep the Prime Fund from breaking the buck, especially when the yields on most Treasury collateral eligible for purchase is below 0.05%. The only way to reverse the deflation of bank balance sheets is to restructure and recapitalize institutions which are insolvent, and allow interest rates to rise to positive real levels. But Washington and the heads of the major banks are having none of it. Restructuring the big banks implies career death for the bankers and a public admission by the Fed and the Congress that the policies of the past two years were wrong. By the way, in the most recent research note published in The IRA Advisory Service we discuss why there will never be an IPO for General Motors (GM) or GMAC so long as these two entities remain separate. As we wrote yesterday: "The global auto industry is simply not profitable enough for any of the top-tier automakers to give up financing profits." Last week, IRA co-founder and CEO Dennis Santiago testified before the Los Angeles City Council on the subject of whether the city should move its business away from the larger banks. You can read the blog post by Dennis on the Huffington Post web site that describes the hearing in detail. But the hearing also illustrated how OTC derivatives are multiplying the economic pain that ZIRP is causing to interest rate sensitive investors. The Fed's current interest rate policy has caused the City of Los Angeles to go into the red to the tune of $10 million per year because of interest rate swaps sold to the city by Bank of New York Mellon (BK). That's right, thanks to Chairman Bernanke and the FOMC, and an OTC interest rate swap, the City of Los Angeles must pay $10 million per year to BK so long as the Fed continues ZIRP -- potentially until 2028. By skewing interest rates down below the true rate of inflation, the Fed has levied a tax on all of the OTC interest rate counterparties that were trying to hedge against higher interest rates. And there are literally thousands of other cities, states, public agencies and insurers around the world which are caught in the unintended consequences of ZIRP. When you recall that the Fed has been and continues to be the chief cheerleader in Washington for OTC derivatives, the implications for the global economy are truly mind boggling. Needless to say, the City of Los Angeles is not very happy with the folks at BK nor with the other large, OTC derivative dealer banks that are the chief recipients of the Fed's largess. In fact, Los Angeles is thinking about moving billions of dollars in municipal deposits as well as nearly $30 billion in pension assets away from the largest banks in order to redress the perceived wrongdoing by BK and other large banks. You can probably guess that the City of Los Angeles will be using The IRA Bank Monitor's Bank Stress Index to help them select high-quality, smaller banks to receive this new business windfall. But at IRA we believe that it is better to get even than to get mad, especially when there are billions of dollars in public funds at stake. This is why we have begun to assist public sector agencies in negotiating the repudiation of OTC derivatives positions that are causing unanticipated losses to customers like the City of Los Angeles. The message to the OTC derivatives dealers is simple: Take back the deceptive, unfair and misleading OTC contract or else the public sector client will pursues any and all options. Remember that defrauding a state agency is a felony in most jurisdictions. The fact is that with proper legal advice and support, it is possible for both public and private sector clients to force the OTC derivatives dealer banks to take back their "sacred" gaming contracts. If you know what buttons to push and which lawyer to have under retainer, it is possible to force the OTC derivative dealer bank to tear up the agreement and slither away. We know this to be true because we have helped two private sector institutions in New York achieve such a result in the past month. If your state or public sector agency or fund has been duped into entering into a OTC derivative contract that you believe was unfair and deceptive, we want to talk to you. We'll be glad to offer you our assistance in negotiating the termination of the OTC contract with your friendly OTC dealer bank. We'll even suggest some very good lawyers here in New York and around the US who do not have conflicts with the OTC derivatives dealer community. You don't think that repudiating an OTC derivative contract is possible? Think again. Ponder the fact that the 2004 "Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities" was not focused on protecting the customers from the predatory behavior of the OTC derivatives dealers, but instead on protecting the large banks from the negative reputational effects of trafficking in these gaming contracts. When enough large, public customers of JPM, Deutsche Bank (DB), Goldman Sachs (GS) and other OTC dealers say "Foxtrot Oscar" to their tormentors, the proverbial house of cards will collapse around the ears of the Federal Reserve Board. All it takes is a few large cities, states and public pension funds in the US and around the world to be willing to challenge the large OTC dealers and say that enough is enough. Incidentally, in case you did not see it, this week in the New York Times Gretchen Morgenson features the comments of two of our favorite observers of the OTC derivatives fiasco: author Martin Mayer and structured finance expert Robert Arvanitis. To read "It's Time for Swaps to Lose Their Swagger," click the link below. http://www.nytimes.com/2010/02/28/business/economy/28gret.html?ref=business "This insistence that you mustn't slow the pace of innovation is just childish. Innovation has now cost us $7 trillion," he added, referring to the loss in household wealth that has resulted from the crisis. "That's a pretty high price to pay for innovation." Amen Martin. Questions? Comments? info@institutionalriskanalytics.com About IRA Products and Services IRA offers advanced analytics for risk surveillance and investment research via subscription products such as the IRA Bank Monitor for Professionals covering the US banking industry and the IRA Corporate Monitor covering public companies. For a trial subscription or an on-line demonstration, please register here. IRA Advisory Services including our channel research and diligence support services are available to qualified clients. For more information, please contact our offices. IRA for Consumers IRA provides consumers easy to buy online reports to independently check on their banks via our How's My Bank? system. IRA on Web 2.0 For updates during the week please follow IRA www.twitter.com/IRABankMonitor.
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