Derivatives is one of the dirty words of the financial crisis. Though these often-risky bets were blamed by many for helping fuel the credit crunch and the downfall of Lehman Brothers and AIG, it seems that Wall Street has yet to learn its lesson.
U.S. commercial banks earned $5.2 billion trading derivatives in the second quarter of 2009, a 225 percent increase from the same period last year, according to the Treasury Department.
More than 1,100 banks now trade in derivatives, a 14 percent increase from last year. Four banks control the market: JPMorgan Chase, Goldman Sachs, Bank of America and Citibank account for 94 percent of the total derivatives reported to be held by U.S. commercial banks, according to national bank regulator the Office of the Comptroller of the Currency.
The credit risk posed by derivatives in the banking system now stands at $555 billion, a 37 percent increase from 2008. "By any standard these [credit] exposures remain very high," Kathryn E. Dick, the OCC's deputy comptroller for credit and market risk, said in a statement.
The complex financial instruments, which take the form of futures, forwards, options and swaps, derive their value from an underlying investment or commodity such as currency rates, oil futures and interest rates. They are designed to reduce the risk of loss for one party from the underlying asset.
Trading in an unregulated $600 trillion market, they were partly blamed for igniting the financial crisis a year ago. The New York Times reported earlier this month:
Derivatives drove the boom before 2008 by encouraging banks to make loans without adequate reserves. They also worsened the panic last fall because they inherently tie institutions together. Investors worried that the collapse of one bank would lead to big losses at others.
The Obama administration has included oversight of derivatives as part of its overhaul of financial regulations. Wall Street is fighting back as it seems to have returned to its much-criticized practices.
Last Thursday former Fed chairman Paul Volcker, who now heads the White House Economic Recovery Advisory Board, warned lawmakers about the danger lurking behind derivatives.
Testifying on Capitol Hill, Volcker discussed how "opaque trading in complex derivatives [have] become so large relative to underlying assets" and how "more and more complex financial instruments limit the transparency of markets," he said.
"As a general matter, I would exclude from commercial banking institutions, which are potential beneficiaries of official (i.e., taxpayer) financial support, certain risky activities entirely suitable for our capital markets," he added.
But the OCC argues that derivatives trading is not inherently risky, explaining that banks are trading these instruments every minute of every day with institutions more creditworthy than a typical borrower.
"The system has always worked on derivatives," says Kevin M. Mukri, an OCC spokesman. "You have higher-quality counterparties -- higher quality than in any other line of business."
Furthermore, "the purpose of derivative trading to to mitigate risk -- not increase risk," he says. "Without derivatives it would be a very hectic marketplace."
Yet some well-respected investment banks seem to be exposed to significant risk, judging by their credit exposure from derivatives contracts.
Goldman Sachs, formerly a pure investment bank, is now a bank-holding company regulated by the Federal Reserve. It owns Goldman Sachs Bank, an FDIC-insured depository. The bank has about $20 billion in total risk-based capital -- in short, the money it has to cover creditors in case they go belly-up. But the bank has about $186 billion in total credit exposure from its derivatives contracts.
Much of that $186 billion could be backed up by collateral -- banks with at least $100 billion in assets held a combination of cash, bonds and securities against 63 percent of their total net credit exposure as of June 30. But the OCC doesn't break that down by institution, and Goldman Sachs doesn't disclose it either. Nonetheless, the bank's exposure to derivatives losses is about nine times the amount of capital it has set aside.
"It's extraordinary for a commercial bank," says Dean Baker, co-director of the Center for Economic and Policy Research, a Washington D.C.-based think tank. "And it really gets down to the central point with Glass-Steagall -- what's the separation here between government-insured deposits and speculative investment banking activity? You'd be very hard pressed to find out with Goldman right now."
Glass-Steagall, a Depression-era banking law that prohibited commercial banks from engaging in the investment business, was essentially repealed in 1999. Some economists have pointed to the repeal as the central cause behind the financial crisis.
"Given Goldman Sachs's history as a securities firm, as opposed to being... a traditional commercial bank, you would expect that our derivatives exposure is higher than our exposure to other assets," says company spokesman Samuel Robinson. "It's much higher [because] we don't have a lot of these other assets."
Goldman Sachs announced that it would become a bank holding company last September, less than a week after Lehman Brothers declared bankruptcy. Coming under the Federal Reserve's protective umbrella gave the firm "access to permanent liquidity and funding," Lloyd C. Blankfein, chairman and CEO of Goldman Sachs, said at the time.
Baker says that now that the firm is a bank holding company, the bank's exposure to losses from derivatives contracts (compared to available capital) poses particular problems. Now, "the public is on the hook for that. If they run into trouble they could go to the Fed and borrow at the discount window [and] they have access to the FDIC's special lending [program]," he explains. Goldman Sachs has issued about $25 billion in FDIC-backed debt as of June, according to regulatory filings.
"You're having the protections for what's supposed to be relatively boring commercial banking applied to risky investment banking. It's a real serious problem," Baker says.
Robinson says that the firm's exposure to potential losses from its derivatives deals, as defined by the OCC, is misleading. "It includes a regulatory-defined measure ... which in aggregate does not represent the firm's ... risk exposure," he says. For example, it doesn't factor in hedges against potential losses or collateral put up by counterparties.
"You can have an exposure that's fully hedged, but the hedging benefit does not appear anywhere in the [OCC's] analysis," Robinson says.
Last October Goldman received a $10 billion taxpayer bailout, which it repaid in June. The federal government earned $1.4 billion on its investment.
JPMorgan Chase has about three times the amount of their capital exposed in derivatives deals; Citibank about double. For comparison's sake, if all commercial and industrial loans held by U.S. banks went bust the banking system has just enough capital set aside to cover those losses.
Not all banks are so heavily invested in derivatives. PNC's exposure (relative to capital) is at 28 percent, and U.S. Bank, the country's sixth-largest by deposits, comes in at seven percent.
"It's tough to think of the world without derivatives," Mukri says. "And it's not a pleasant world either."