MUST READ – THE RESULT OF THE CREDIT CRISIS: GREATER COUNTERPARTY RISK

The credit crisis was an excellent opportunity to squash the problem of “too big to fail” in the U.S. banking sector.  As Meredith Whitney previously noted, it would have been more beneficial to reduce the size of the stronger players in the arena and create thousands of small(er) power players.   Instead, we’ve actually increased the risks in the U.S. banking sector by merging together broken banks and giving fewer banks more powers.

It’s no secret that a handful of banks control the overwhelming majority of bank assets in this country.  One of the primary problems that became obvious as a result of this orgy of power was counterparty risk.  Lehman, a relatively small firm in comparison to some of its competitors, actually threatened the well being of the entire system because their tentacles were intertwined in the entire sector.  It became apparent for the first time in decades, that these firms were too large and the well-being of every investor and citizen was too dependent on their well-being.  What was the U.S. government’s resolution to this issue?  Create even greater counterparty risks. A recent IMF report details the increased risks in the banking sector:

The global OTC derivatives market is very concentrated with about ten bank dealers responsible for about 90 percent of trading volume (Fitch 2007).7 It is useful to note that the counterparty liabilities of Lehman (as per their last 10Q filing on July 10, 2008) was about $24 billion. This is a useful gauge when comparing counterparty liability exposure of the five key U.S. banks and how they have evolved over the past year. The counterparty liability exposures of the five major banks changed over the course of the crisis:

• Citibank’s counterparty liability exposure decreased significantly to $17 billion as of end-March 2009, relative to $126 billion as of March 2008, largely due to continuing concerns on having Citi as a counterparty (see Figure 2).

• Goldman Sachs’ counterparty risk to the financial system is the largest, at $91 billion as of end-March 2009, relative to around $100 billion as of March 2008; the change is noteworthy since others have gained or stabilized their market share only due to mergers. In other words, Citi and Goldman symbolize two extremes:  Citi has been viewed as an unreliable counterparty (with its CDS spreads going over 600 bps prior to the stress test results), while Goldman has strengthened its position since it registered to be a ‘bank,’ and one of the first to repay TARP funds.

• JPMorgan’s exposure to OTC derivatives payables was about $86 billion at end-March 2009, compared to $68 billion as of March 2008. This was partially due to the absorption of Bear Stearns and WAMU, but markets also suggest the ‘too-close-to-Fed’ factor as being crucial for JPMorgan gaining business.

• Bank of America/ Merrill Lynch appears to have almost tripled its counterparty risk exposure to $77 billion as of end-March 2009, relative to March 2008, but this sizeable increase is due to the merger with Merrill Lynch; comparing figures below, BoA and Merrill Lynch had about $88 billion in derivatives payable a year ago.

• Morgan Stanley’s exposure has fallen slightly from $69 billion as of end-March 2008 to $54 billion as of end-March 2009.

In merging together the failed firms the government has actually increased the overall counterparty risk in the system.  The firms in existence now are more threatening than they ever were.  If you thought Merrill was too big to fail just imagine what B of A is now that they’ve swallowed Merrill and TRIPLED their counterparty risk.

Even worse, the resolution of merging these failed firms is having the same impacts on liquidity and lending that it did in Japan when they allowed failed firms to merge and earn their way out of the crisis.  The IMF elaborates on the problem and how we’ve actually reduced global liquidity by increasing the counterparty risks of the largest U.S. banks:

The aversion to deal with some large complex financial institutions (LCFIs) due to their counterparty risk has implications for global liquidity. This is because collateral flows, within the financial system has fallen significantly and adversely impacted global liquidity (i.e., funding and trading liquidity). This largely stems from LCFI clients avoiding their high grade collateral to flow freely within the LCFIs, or LCFIs themselves locking up collateral in their balance sheets. This section shows anecdotal evidence of a sizeable drop in global liquidity from reduced rehypothecation, reduced securities lending and from sizeable hoarding of cash/cash equivalent by LCFIs. The fair value of securities received as collateral, which can be pledged (or rehypothecated) by major LCFIs, has fallen by about $2.5 trillion since end-2007, (compare Nov 07 with Nov 08 in Table 1).  Such collateral was mostly posted by clients of the LCFIs (especially hedge funds). Since the freezing of Lehman’s assets in the United Kingdom, hedge funds have been opting not to rehypothecate their collateral and prefer segregated accounts or triparty custodian arrangements where they retain ownership of their margin that was posted as collateral.

Lending, the cornerstone of our fractional reserve banking system, has actually collapsed under the increasing risks.  As firms fight to survive they are actually hoarding cash and increasing lending standards:

Securities lending by custodians is also down sizeable. The number is at least $1 trillion if we include other leading custodians such as Citigroup, HSBC etc. Table 2 shows the decline among the top three global custodians―Bank of New York, State Street and JPMorgan since end-2007.

There is also evidence of a sizeable hoarding of cash or cash-equivalent by LCFIs. The typical reason provided by them is succinctly illustrated by Goldman Sachs’s in its recent 10Q, page 135:

“Our most important liquidity policy is to pre-fund what we estimate will be our likely cash needs during a liquidity crisis and hold such excess liquidity in the form of unencumbered, highly liquid securities that may be sold or pledged to provide same-day liquidity.  The U.S. dollar-denominated excess is comprised of only unencumbered U.S. government securities, U.S. agency securities and highly liquid U.S. agency mortgage-backed securities, all of which are eligible as collateral in Federal Reserve open market operations, as well as overnight cash deposits. Our non-U.S. dollar-denominated excess is comprised of only unencumbered French, German, United Kingdom and Japanese government bonds and overnight cash deposits in highly liquid currencies.”

Most large banks annual reports suggest that high-grade and liquid collateral is very much desired and kept on their books, although lower quality and less liquid collateral that is acceptable to the Fed and ECB has been deposited with them to raise cash via the various facilities offered by these central banks….If the cash holdings with all the major LCFIs are counted, such cash holdings reach $1.5 trillion.

In conclusion, several key points can be made. First, collateral flow (especially high-grade liquid collateral) within the financial system has fallen significantly and adversely impacted global liquidity. This is the risk capital and balance sheet capacity that may have otherwise been applied to proprietary trading, market-making and arbitrage activities that are integral to global liquidity. Second, since the velocity of collateral is greater than one, pledged collateral, repo markets and cash hoarding would have ‘turned-over’ more than once, if deployed effectively by the markets. Thus, the impact of the figures mentioned in Tables 1–3 on global liquidity (about $5 trillion) is much greater than seems apparent from the figures alone and may have implications for monetary policy in some countries. We suggest that the counterparty risk associated with (some) LCFIs last year was a key reason why collateral was not put to full use.

However, counterparty risk has not abated in the past year, and has perhaps concentrated further post-Lehman. Counterparty risk continues to loom large and has not abated over the past year since Bear Stearns absorption by JPMorgan. LCFIs with large counterparty liabilities that have been considered weak (e.g., Citi) relative to others (e.g., Goldman) have either lost derivative business to stronger derivative players or, have had to come up with sizeable cash or cash equivalent to reduce their derivatives payables position. Furthermore, global liquidity has suffered as a result of LCFI clients avoiding their high grade collateral to flow freely within the LCFIs or LCFIs themselves locking up collateral in their balance sheets.

In a nutshell, we’ve kicked the can down the road rather than confront and deal with the actual problem at hand: the size of the largest players in the U.S. banking system and the entire system’s dependence on them.   I hammered on the government and regulators for months during the credit crisis.  I begged them to confront the problems head on rather than kicking the can down the road as Japan did.  Force the losers to  lose and reduce everyone’s dependence on a few large banks.  Letting the banks attempt to earn their way out of the crisis was not an option.  It wasn’t worth the potential long-term risks.  Unfortunately, we’ve settled on that option and effectively solved none of the problems that became apparent when Lehman failed.

You think the credit crisis is over?  Sure, this portion of it might be over, but these banks and their non-performing assets are just one more ticking time bomb waiting to go off and when the next banking bomb explodes we’ll be even more dependent on a handful of large banks.  Whether that is this year, next year or next decade is unknown, but there is no question that the problem of “too big to fail” still looms and threatens the well-being of not only every investor in the world, but the entire global financial system.