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Today's Bank Bailout Risk: Why Didn't We Stop This?

12/17/2013 06:07 am ET | Updated Feb 21, 2014

JPMorgan's "London Whale" episode exploded the myth that managers of too-big-to-fail banks have risk under control. The London-based Chief Investment Office that unexpectedly lost $6 billion in 2012 due to oversized derivatives trades reported directly to CEO Jamie Dimon.

As traders increased their losing position, Dimon courted Congress and preened for the media to thwart the Volcker Rule that would limit this sort of proprietary trading. The losses wiped out years of earnings for the huge banking unit within the bank behemoth.

Dimon later explained: "In hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored." Dimon understated the situation. JPMorgan broke securities laws. Revelations of JPMorgan' worst practices in risk management and misleading disclosures resulted in an admission of wrongdoing and a $920 million SEC fine. JPMorgan shifted blame to "rogue" traders, but the systemic problem seems to be rogue management.

Dimon is now spending billions on an army of accountants and other "risk professionals" to examine JPMorgan. Yet this flurry of activity will not improve the bank's core risk knowledge, because the global banking system has enormous systemic hidden risk. Dimon's debacle is not an isolated case.

"The AIG of the World Is Back"

Kyle Bass, founder of Hayman Capital Management, announced during his March 2013 talk to the Chicago Booth's Global Markets Initiative that he is bearish on Japan and has engaged in trades that will pay off in an extreme scenario:

I have 27 year-old kids selling me one year jump risk in Japan for less than one basis point. Five billion dollars' worth at a time.

Mr. Bass said his aggregate position grew to $500 billion, or one-half trillion dollars. He could potentially lose his estimated $50 million investment, but his downside is limited, and his potential upside is enormous. He did not provide details of the trades or provide the formula for calculating his potential payout. Based on his presentation, the tail-risk trades may pay-off if there is sudden and dramatic weakening of the yen or a spike in Japan's interest rates. The trades may not work out for him this year, but Bass observed: "The AIG of the world is back".

Shortly after Bass put on his trade, bank traders asked the hedge fund manager to close out his position. They explained they ran a new model with better stress tests, and the trades were riskier than they first thought. Bass declined, even though he could have made a quick profit. He'd rather harpoon a whale.

Bass isn't the only speculator to put on huge risky transactions with banks. But unlike the others, he spoke about it publicly and ridiculed the folly of his bank counterparties. (Bass comments on the trades after 52:47 minutes in this clip.)

The AIG Financial Products debacle was a contributing factor to the September 2008 financial crisis. AIG's multifaceted taxpayer-funded bailout -- and subsequent support programs from the Federal Reserve and U.S. Treasury -- mounted to over $180 billion. Among other problems, AIG owed tens of billions to bank counterparties, after it wrote credit default swap protection on suspect collateralized debt obligations for mere single digit basis points.

In August 2007, I challenged AIG's accounting in a Wall Street Journal article written by David Reilly. AIG failed to show material losses for these trades. Instead, AIG wrote down nothing at all, claiming it would never experience a loss. By February 2008, AIG was cited for material weakness in accounting for mark-to-market losses. By September 2008, AIG was in dire need of cash.

At the end of 2012, Treasury claimed U.S. taxpayers made $5 billion on the massive AIG bailout. But there was another material weakness in accounting for taxpayers' so-called profit. The Federal Reserve had gifted Treasury more than 500 million shares of AIG, and AIG also received valuable preferential tax treatment. Taxpayers put capital at risk, and received not merely a negative risk-adjusted return, but an absolute negative return. Taken as a whole, taxpayers lost money.

Banks House Invisible Hedge Funds with Inadequate Capital

Citigroup was the largest financial institution in the world. As I mentioned in an earlier commentary: "Citigroup received the most bailout money of any U.S. bank. Between TARP, the FDIC, and the Federal Reserve, Citigroup got a total of $476.2 billion in cash and guarantees." No one has been held accountable for material omissions in its pre-crisis disclosures. Citigroup's share price is less than 10 percent of its pre-crisis share price. This former finance titan would trade at a little over $5 per share as of the December 13, 2013 close, if we hadn't done a 1:10 reverse stock split. It was just too depressing to see the former U.S. flagship trading at a single digit price, so it is now trading above $50 per share, because we multiplied the price by ten.

Banks house invisible hedge funds. It is the job of bank managers to expose and even prevent these risks, but most bank managers seem to lack the will or the competence to uncover them. Perhaps the long-time habit of giving bailouts to banks has made bank managers lose their edge.

The U.S. did not enforce existing securities laws, so no one should have confidence that new Dodd-Frank rules will have any meaningful impact. The U.S. banking system seems to have captured its regulators, Congress and the Treasury. Previously I mentioned there are alternatives to the Treasury bailouts that do not violate the spirit of democracy. Perhaps we'll keep this in mind next time.