iOS app Android app More

Risk-taking Is Back For Banks 1 Year After Crisis

First Posted: 11/13/09 05:12 AM ET Updated: 05/25/11 03:05 PM ET

NEW YORK (AP) -- A year after the financial system nearly collapsed, the nation's biggest banks are bigger and regaining their appetite for risk.

Goldman Sachs, JPMorgan Chase and others -- which have received tens of billions of dollars in federal aid -- are once more betting big on bonds, commodities and exotic financial products, trading that nearly stopped during the financial crisis.

That Wall Street is making money again in essentially the same ways that thrust the banking system into chaos last fall is reason for concern on several levels, financial analysts and government officials say.

There have been no significant changes to the federal rules governing their behavior. Proposals that have been made to better monitor the financial system and to police the products banks sell to consumers have been held up by lobbyists, lawmakers and turf-protecting regulators.

Through mergers and the failure of Lehman Brothers, the mammoth banks whose near-collapse prompted government rescues have gotten even bigger, increasing the risk they pose to the financial system. And they still make bets that, in the aggregate, are worth far more than the capital they have on hand to cover against potential losses.

The government's response to last year's meltdown was to spend whatever it takes to protect the financial system from collapse -- a precedent that could encourage even greater risk-taking from the private sector.

Lawrence Summers, director of the White House National Economic Council, says an overhaul of financial regulations is needed as soon as possible to keep the financial system safe over the long haul.

"You cannot rely on the scars of past crises to ensure against practices that will lead to future crises," Summers says.

No one is predicting another meltdown from risky trading in the near term. Rather, the concern is what happens over time as banks' confidence grows and the memory of the financial crisis of 2008 fades.

Will they pile on bets to the point that a new asset bubble forms and -- as happened with mortgage-backed securities -- its undoing endangers banks and the broader economy?

"We're seeing the same kind of behavior from the banks, and that could lead to some huge and scary parallels," says Simon Johnson, former chief economist with the International Monetary Fund.

Some risk-taking is good. When banks are willing to invest in companies or lend to home-buyers, that nurtures economic growth by generating employment and consumer spending, feeding a cycle of expansion.

The problem is when banks' quest for profits leads them to take on too much risk. In the case of the housing bubble, which burst last year, banks lent too freely to consumers with weak credit and wagered too much on complex financial instruments tied to mortgages. As real-estate prices turned south, so did the financial industry's health.

Because the largest banks' trading divisions make their bets with each other, their fortunes are intertwined. The collapse of one can threaten another -- and another -- if it is unable to pay off its debts.

This so-called counterparty risk is a major reason the Obama administration's regulatory overhaul plan calls for the creation of a "systemic risk regulator."

The administration is also seeking tougher capital requirements for banks, arguing that banks' buying of exotic financial products without keeping enough cash on reserve was a key cause of the crisis. Treasury Secretary Timothy Geithner has urged the Group of 20 nations -- which meets this month in Pittsburgh -- to agree on new capital levels by the end of 2010 and put them in place two years later. Geithner hasn't said how much extra capital banks should be required to keep on hand.

Data from the April-June quarter show that the banks are leaning heavily again on their trading desks for revenue.

During the fourth quarter of 2008, when the financial crisis made even the shrewdest bankers risk-averse, Goldman's trading of risky assets nearly stopped. But in the second quarter of 2009, trading revenue had climbed to nearly 50 percent of total revenue, closer to where it was two years ago before the recession began. JP Morgan's reliance on trading revenue has exhibited a similar pattern.

Also in the second quarter, the five biggest banks' average potential losses from a single day of trading topped $1 billion, up 76 percent from two years ago, according to regulatory filings.

The government hasn't just watched banks resume their freewheeling ways and prosper. It has been an enabler in the process. The Federal Reserve, the Treasury Department and the Federal Deposit Insurance Corp. -- during both the Bush and Obama administrations -- have made trillions of dollars available to the biggest banks through bailouts, low-cost loans and loss guarantees designed to stabilize the financial system.

The failure of Lehman Brothers -- the biggest bankruptcy in U.S. history -- and the panicky sales of Bear Stearns to JPMorgan and Merrill Lynch to Bank of America, also have transformed Wall Street. The surviving investment banks have fewer competitors and more market share.

Five of the biggest banks -- Goldman, JPMorgan, Wells Fargo, Citigroup and Bank of America -- posted second-quarter profits totaling $13 billion. That's more than double what they made in the second quarter of 2008 and nearly two-thirds as much as the $20.7 billion they earned in the second quarter of 2007 -- when the economy was strong.

Meanwhile, Bank of America and Wells Fargo today originate 41 percent of all home loans that are backed by Fannie Mae and Freddie Mac, according to Inside Mortgage Finance. The banks made $284 billion in such loans in the first half of this year, up from $124 billion during the same period last year.

"The big banks now are more powerful than before," said Johnson, now a professor at the Massachusetts Institute of Technology's Sloan School of Management. "Their market share has grown and they have a lot of clout in Washington."

Wall Street's recovery is also being aided by a stock-market rally that has driven the S&P 500 index up nearly 54 percent since March 9, when it hit a 12-year low.

Despite the return to profitability, these aren't the high-octane days from before the crisis. To qualify for government backing, the biggest Wall Street firms are no longer allowed to supercharge their returns by borrowing up to 30 times the value of their assets to place bets on stocks, bonds and other investments.

Businesses supported by Wall Street bankers and traders say they've also noticed changes. Namely, their customers aren't spending as much on food, drinks and entertainment as they did during the boom years.

At Fraunces Tavern, a high-end bar just around the corner from the New York Stock Exchange, the Wall Street workers who used to drink $25 glasses of port are scarce these days.

"Now we're doing happy hours," says Damon Testaverde, one of the owners of Fraunces Tavern. "We never did that. There's just less bodies around."

But one thing fundamental to Wall Street hasn't changed: Big banks and their traders are still finding creative -- some say speculative -- ways to profit.

They're still packaging risky mortgages into securities and selling them to investors, who can earn higher returns by purchasing the securities tied to the riskiest mortgages. That was the practice that helped inflate the real estate bubble and eventually spread financial pain around the globe.

In a way, the government has emboldened banks to keep selling risky securities: Since the crisis erupted, federal emergency programs have helped keep the banks from failing. But now, as the financial system recovers, the government plans to phase out these backstops -- leaving banks more vulnerable to big bets that go bad.

One investment gaining popularity is a direct descendant of the mortgage-backed securities that devastated many banks last year. To get some lesser performing assets off their books, banks are taking slices of bonds made up of high-risk mortgage securities and pooling them with slices of bonds comprised of low-risk mortgage securities. With the blessing of debt ratings agencies, banks are then selling this class of bonds as a low-risk investment. The market for these products has hit $30 billion, according to Morgan Stanley.

"It may be unpleasant to hear that the traders are riding high," said Walter Bailey, chief executive of boutique merchant banking firm EpiGroup. "But, hey, it's a pay-for-performance thing, and they're performing like mad."

And that means the return of another Wall Street mainstay: Lavish compensation.

After 10 of the largest banks received a $250 billion lifeline from the government last fall, some lawmakers were outraged that employees were being paid seven-figure salaries even though their companies nearly collapsed. A handful of top executives, including Citigroup CEO Vikram Pandit, have agreed to accept pay of just $1 this year. But the compensation of most high-performing traders hasn't changed.

Goldman spent $6.6 billion in the second quarter on pay and benefits, 34 percent more than two years ago. And Citigroup, now one-third owned by the government after taking $45 billion in federal money, owes a star energy trader $100 million.

The CEO of Goldman, Lloyd Blankfein, said at a banking conference in Germany last week that excessive banker pay works "against the public interest." He said bonuses are important to attract and retain top talent, but "misapplied, they can also encourage excess."

The Obama administration has proposed measures to diminish the risk posed by large banks. They include forcing banks to hold more capital to cover losses and trying to increase the transparency of markets in which banks trade the most complex -- and potentially risky -- financial products.

One major component of the Obama plan -- creating an agency to oversee the marketing of financial products to consumers -- will be difficult to pass in Congress. Industry lobbying against it and other proposed financial rules has been fierce.

Lobbyists for hedge funds, the large investment pools that cater to the rich, have been able to fend off proposals that would require them to register with the SEC and regularly disclose their holdings.

And they, too, are profitable again after a dismal 2008. The 1,000 largest hedge funds in Morningstar's database posted average returns of 11.9 percent through July. In 2008, those same funds lost 22 percent on average.

"Have there been changes around the edges?" says Timothy Brog, portfolio manager of New York-based hedge fund Locksmith Capital. "Absolutely. Have their been systematic changes? Absolutely not."

FOLLOW HUFFPOST BUSINESS

Filed by T.J. Ortenzi  |