On July 15 Goldman Sachs reported that its second-quarter profits were the highest in 140 years. It netted $3.4 billion on $13.4 billion in revenue (78 percent of which came from trading and principal investments and 11 percent from investment banking). Exactly which trades brought in such large profits is said to be proprietary. It retained $6.6 billion as compensation—a very high ratio of pay to revenue (48 percent). Average compensation at Goldman Sachs will be $700,000 per employee, up from $661,000 in pre-crisis 2007.
JPMorgan Chase also reported record profits.
Both banks were aided by TARP loans and by FDIC guarantees; the FDIC guaranteed $28 billion of Goldman Sachs bonds (Financial Times, April 16) and $40.4 billion of JPMorgan Chase (Wall Street Journal, July 14). The FDIC guarantees allowed Goldman Sachs and JPMorgan Chase to issue their debt at very low interest rates. The New York Times (July 19) asked an interesting question: “If these companies can return to the festivities so quickly, were they really having the near-death experience they and the government claimed?” To which we might add: If taxpayers shared the downside, why shouldn’t they be sharing the upside?
How are the banks making so much money? The comptroller of the currency reports that, for the first quarter of 2009, JPMorgan Chase held $81 trillion in derivatives and Goldman Sachs held $40 trillion. U.S. commercial banks held a total of $202 trillion; the top five held $193 trillion—96 percent. On July 10, Bloomberg News reported that upward of 40 percent of the profits of the big banks is earned from fixed-income derivatives. The comptroller reports that U.S. commercial banks, for the first quarter, recorded revenues of $9.8 billion in trading cash and derivative instruments. Just two large banks, JPMorgan Chase and Goldman Sachs, hold $121 trillion of the derivatives, which amounts to 60 percent of all derivatives held by banks ($202 trillion) and almost 20 percent of all outstanding derivatives ($680 trillion).
Derivatives, we all remember, are the Doomsday Machine, or what Warren Buffett famously called the “weapons of financial mass destruction.” Most analysts think it was derivatives that destroyed the securities market and then the country’s economy. What are our banks doing with them?
Actually, what we still think of as banks aren’t banks anymore: They are gambling clubs. For example, the Wall Street Journal (June 9) reports that a credit-default swap (CDS) is available that will pay out if Citigroup defaults on its bonds within the next five years. The buyer (bettor) pays $3.45 million initially and $500,000 annually for the next four years to the seller (the house). The buyer (bettor) may have to pay $5.45 million for the right to receive $10 million if Citigroup defaults. The betting odds are about 2 to 1. What is the social purpose of that? Why are bankers making or taking bets? Worse, since Paulson, Bernanke, and Geithner used taxpayer funds in September 2008 to bail out AIG (allowing AIG to pay Goldman Sachs 100 cents on the dollar on its winning bets, which totaled $13 billion), the market now assumes the U.S. taxpayer will continue to make good all winning bets. These gambling clubs are quite exclusive. Has any reader ever seen a derivative or been asked to buy one? In our bankers’ Monte Carlo, you, Dear Reader, help to guarantee that the House will pay off.
The derivatives market is vast ($680 trillion) and opaque. Just like before the Crisis, the CDS market operates over the counter (OTC), meaning that only the two parties to the contract know what’s in it.
“Credit Default Swaps grow like mushrooms in the dark,” says Grigori Marchenko, governor of Kazakhstan’s central bank. Why is Kazakhstan’s central banker concerned about CDSs? Because they may be dragging down the country’s two major banks. Between 2004 and 2007, Western banks, including Morgan Stanley, rushed to provide financing to Kazakh banks to fund Kazakhstan’s building boom. Some of them, including Morgan Stanley, purchased CDSs to protect themselves against potential losses on the outstanding Kazakh loans. And some, including Morgan Stanley, may have bought more swaps than they had loans outstanding—meaning they would benefit if the Kazakh banks defaulted. Kazakhstan is now trying desperately to restructure her banks, but she suspects that the Western banks, including Morgan Stanley, are not cooperating. “I don’t think anyone was prepared for what has happened here,” says Mr. Marchenko. “There is a new class of financial institutions now who are speculating that BTA [and others] go into a default . . . rather than in keeping the bank as a going concern.” Goldman Sachs was an advisor to the Kazakhstan government but resigned for reasons the Financial Times calls “unclear.” Does it bother anyone that Morgan Stanley may be undermining the banks of a strategic U.S. ally?
On June 17, President Obama unveiled what he called his “sweeping overhaul” of the financial markets. The accompanying White Paper, according to the New York Times, mirrors the recommendation of the CDS Dealers Consortium, a group formed last November by the largest derivative dealers to oppose any regulation of the market that would affect their profits. Let the games continue. And just to keep things fair, the consortium recommends that some—but not all—of the derivatives should be cleared through an exchange.
Christopher Whalen, cofounder of Institutional Risk Analytics, a Los Angeles-based risk-consultancy firm, testified on June 22 to the Securities Subcommittee of the Senate Banking Committee that the Chicago Commodities Exchange has, for many years, traded futures in interest rates, currency, oil, wheat, and so on. If Southwest Airlines wants to lock in the price of gas next winter, it can buy a future. A cash price exists for this transaction on the Chicago Exchange. So there is no problem if Southwest wants to buy such an option OTC from a bank. The problem comes with credit-default swaps and collateralized debt obligations (CDOs), and other complex securitized instruments. There is no basis for pricing those. Yet OTC derivative trading is the “leading source of profits” for banks such as JPMorgan Chase, Bank of America, and Goldman Sachs. Indeed, many of their traditional banking operations “are marginal in terms of returns on invested capital.” The big banks are dependent on income from derivatives, since these instruments are the “last remaining source of supra-normal profits.” Whalen believes that, without the “excessive rents” earned on derivatives, the big banks would need to shrink dramatically.
Whalen admitted that the derivatives market itself depends on “increasing risk and then shifting that bigger risk to the least savvy market participants. . . . AIG was the most visible ‘sucker’ identified by Wall Street . . . ”
Now that AIG has left the field, who is the big sucker today?
Treasury Secretary Geithner gave testimony to the House Agriculture Committee on July 10 regarding the Obama administration’s proposal to regulate the OTC derivatives market. Geithner declared that derivatives were not the “sole or principal cause of the crisis.” He did not say what the sole or principal cause was. In fact, the only effective reform is to restore the Glass-Steagall Act, which was repealed under the Clinton administration in 1999. Glass-Steagall would close down the bankers’ Monte Carlo. The administration’s proposal, as Geithner testified, intends to legalize derivatives. Obama’s reforms do not require credit derivatives to be made fully transparent so the public can follow credit premiums like stock prices. Instead, they rely on regulation to prevent any future problem. The Obama plan even proposes installing a super-regulator to guard against “systemic risk”—an undefined term—even in nonbank institutions. Regulation, of course, is what just failed. Bernie Madoff single-handedly destroyed any credibility government regulation might have had. The banks want to continue their gambling as usual. The administration’s illusory reforms tolerate and legalize that.
The problem with the Obama reforms is that they are not based on a reasonable analysis of the cause of the crisis. Thomas M. Hoenig, president of the Federal Reserve Bank of Kansas City, said as much before the Joint Economic Committee on April 21:
It is critical that we correctly diagnose the cause of this crisis. The structure of our regulatory system is neither the cause nor the solution. These “too big to fail” institutions are not only too big, they are too complex and too politically influential to supervise on a sustained basis without a clear set of rules constraining their actions. When the recession ends, old habits will reemerge.