Preliminary Q3 2009 Bank Stress Test Results; Looking for OTC Derivatives Reform
November 10, 2009

"It is now almost twenty years since J.P. Morgan and Company, its associates and its satellites attempted to induce Congress to create a central bank of issue instead of the Federal Reserve System. They were determined that control of the national purse should remain in New York. The theory underlying the proposed system that the several sections of the country should control their own finances was preposterous. To them it was anathema. Ten short years later the same group, represented by the same agent who had led their lost cause in Washington, took charge of the Federal Reserve System. For practical purposes the system was transformed into a central bank, and was manipulated to the very ends that its authors had sought to guard against." The Mirrors of Wall Street
Clinton Gilbert
1933

This week we feature a comment from a member of the Herbert Gold Society on the question of reforming OTC derivatives. It seems clear to us, at least, that the large New York banks are calling the shots on Capitol Hill in a way that they did in the 1920s. The hearings on OTC derivatives held before the House Financial Services Committee were so ridiculous and so slanted in favor of the large dealer banks that we held back our comments, but we commend this very well informed perspective to your attention.

Before we go to our feature, however, we want to update our readers on the preliminary Stress Index results for the US commercial banking industry in Q3 2009. Last week, when The IRA Bank Monitor had gathered some 5,000 bank CALL reports from the FDIC's central data repository, the Stress Index stood at just 6.45 vs. the preliminary stress level of 6.7 last quarter. That preliminary result for Q2 2009 was when we had some 7,000 bank CALL reports gathered, just before the FDIC press conference.

Since we initiated our automated tool for gathering FDIC CALL reports and grinding preliminary stress ratings, we've cut three weeks off of the wait time to access our Stress Ratings. But today, with 6,936 FDIC bank CALL reports in the house, we have a preliminary Stress Index score of 7.46 for Q3 2009, significantly higher than the Q2 2009 preliminary results, like 10% higher. The seemingly favorable Stress Index number last week for Q3, when we had just 5,000 banks in hand, was a head fake.

In fact, the far worse result for our Stress Index survey vs. Q2 suggests that levels of stress in FDIC insured banks are continuing to build, from multiple factors, even as the subsidies that make the large banks look less risky are being withdrawn. In Q2 2009, when we added the largest banks and all thrifts to the ratings survey, the final score was just 3.11 or less than half of the preliminary Q2 Stress Index score, which exclude the large banks.

Looking at Q3 2009, we expect to again see the subsidized money center banks push down the overall Stress Index results when all of the CALL reports are available in standardized form in about three weeks, just not as much. Thus the overall Stress Index score for the US banking industry during Q3 2009 could be significantly higher than in Q2 2009.

Click the link below to see the IRA widget that displays the preliminary Stress Index rating in real time, as the CALL reports become available on the IRA web site.

http://us1.institutionalriskanalytics.com/Widgets/Factoid.asp?view=13

Subscribers to the professional version of the IRA Bank Monitor and IRA Advisory Service can see individual Stress Ratings for banks that have submitted CALL reports to the FDIC. Contact us if you'd like more information.

Of note, this week in the IRA Advisory Service we talk about why the change in FAS 167 is good news for Well Fargo (NYSE:WFC) and Bank of America (NYSE:BAC), but really bad news for Fannie Mae, Freddie Mac and the US taxpayer. Looks like another zombie upgrade is in prospect.

OTC Derivative Reform: Watch What I Do, Not What I Say
By Herbert Gold

Those listening to the heated political rhetoric coming out of Washington in recent weeks might be forgiven for thinking that major change is coming to the over-the-counter (OTC) derivatives business. After two separate congressional committees passed legislation modeled on the Treasury Department's blueprint for OTC derivatives reform, it seemed as though some light was about to be shone on the opaque world of derivatives. Alas, as is often the case in Washington, things are not entirely as they appear.

The basic outline of the reform proposal in both the House Financial Services Committee and House Agriculture Committee versions of H.R. 3795, the "OTC Derivatives Markets Act of 2009", is the same. Following the recommendations of the Obama Administration, the bills seek to impose regulation on "swap dealers" and "major swap participants," which is to say, any entity that uses derivatives for more than hedging. These regulations are to include margin and capital requirements, the clearing of OTC trades, and, in the most radical change from current practice, pre-trade price transparency in the form of a requirement that OTC trades be done on a regulated futures exchange or a new type of market called an "Alternative Swap Execution Facility".

In each case the proposals would seem to demand a radical change in the way major banks run their vast trading operations. However, what the congressional scriveners giveth the banking lobbyists stealthily take away. In each instance the effect of the reform proposals would fall far more heavily on any potential non-bank competitors than it would on the OTC dealer banks led by JPMorganChase (NYSE:JPM).

Consider the requirement that all major swap participants and swap dealers meet certain minimum capital and margin requirements. Under the legislation as currently drafted those standards would be written by the banking regulators with regard to banks, and the CFTC and/or SEC with respect to non-banks. The "major reform", then, is that non-banks who are active in derivatives (such as hedge funds and energy companies) would for the first time be subject to capital requirements. Banks, meanwhile, would continue to be subject to the capital requirements established by their current regulators. Not much change for the banks, but a potentially very costly change for anyone who might dare compete with them in the dealer space.

In the area of clearing the banks again look poised to steal a substantial victory in terms of freedom of action from the jaws of reform. Under the legislative proposals currently under consideration the CFTC will determine which contracts are eligible for clearing. Once such a determination is made the contract must be cleared if both parties are either dealers or major swap participants. This approach, though different from current law, is in effect a ratification of an agreement the largest dealer banks have already struck with the New York Fed.

In a September 8, 2009 letter (found here http://www.newyorkfed.org/newsevents/news/markets/2009/ma090908c.pdf) the dealers expanded upon their previously agreed commitment to increase the number of contracts they would submit to central clearing. As the 15 largest dealer banks (such as JP Morgan, Goldman Sachs and Credit Suisse) proclaim to NY Fed President William Dudley: "We are writing to inform you of our commitment to increase the usage of central counterparties for clearing, which we believe will significantly reduce the systemic risk profile of the OTC derivatives market." Thus the legislation proposed by Congress will merely endorse the plan already put in place by the dealer banks.

Thus it is apparent that the new capital and margin requirements, as well as the clearing requirement, pose little threat to the banks. But there still remained one area that was open for true reform, and it was the one thing the dealer banks feared above all else: pre-trade price transparency. The Administration's proposal required that any contract that could be cleared must likewise be traded on either a fully regulated futures exchange or an Alternative Swap Execution Facility (ASEF). In either case the idea was to require banks to compete with one another by posting their bids and offers for swap contracts in an open market, where buyers and sellers could compare them.

For a long, long time, the OTC dealer banks justified keeping prices secret by claiming that liquidity would collapse if they were forced to compete. Later, when it became clear to end-users that they were getting different prices on identical trades, the banks said such differences were justified because of the relative creditworthiness of different swap customers.

But with new collateral and margin requirements, as well as central clearing, these arguments clearly don't hold any weight. Nevertheless it wasn't until the very morning of the debate on H.R. 3795 that Financial Services Committee Chairman Frank announced his support for the exchange trading/ASEF requirement. The proposal passed handily, and was adopted the next week in the House Agriculture Committee as well. Finally it looked as though competition and pre-trade price transparency might be coming to the OTC derivatives markets.

But the bank lobbyists were able to pull off their greatest trick yet. Little noticed in the debate was an amendment to the bill that defined an ASEF as an entity that "facilitates" the trading of swaps, and which includes a "confirmation facility" or "voice broker". Thus with a few simple words was a pre-trade execution requirement turned into a restatement of current business practices.

Under the new definition a bank can meet the exchange trading requirement by doing its trades on the telephone, as is done today, or even simply by later documenting that a trade took place through a "confirmation facility," which the industry has also already committed to do. Nowhere in the new definition of an alternative swap execution facility is there an actual requirement that bank customers can see and compare prices, nor actually make a trade.

But even today, with all of the attention and anger regarding OTC contracts, the major dealers continue to defy a majority in the Congress and among Buy Side investors by allowing the dealers to continue to conceal prices from public view.

In fact, in every critical area the rules for banks will not likely change if the House proposal becomes law in its current state. There is still the possibility that the bill could be corrected on the House floor, or in the Senate. But given the way in which things have progressed thus far on Capitol Hill, the smart money, as always, is with the big banks.

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