Much bank business is with other banks

A big part of bank business these days is just banks doing repo, derivative, hedging and trading deals with each other.

This is a point reporter David Reilly makes in the Wall Street Journal’s Heard on The Street column today, and it echoes a similar remark a week ago by Adair Turner, chairman of the Financial Services Authority which regulates financial services in the UK.

“Major bank balance sheets are now dominated by claims against other banks and other financial institutions,” said Turner.

This unseen interconnectedness drives regulators to bail out the biggest players in a crisis, as we discovered in 2008, and critics like Turner are questioning whether the benefit to banks is worth the cost to society.

Some of these deals sound a lot like schemes from the savings and loan era 25 years ago, for example:

– In “dead horses for dead cows,” developers bought each other’s real estate to pump up property values. Today bankers buy each other’s credit default swaps and collateralized debt obligations.
– In “cash for trash,” thrifts lent borrowers more money than they needed and required the borrower to use it to buy a troubled property on the thrift’s books. 

– In “cash for trash,” thrifts lent borrowers more money than they needed and required the borrower to use it to buy a troubled property on the thrift’s books. Today bankers make repo loans to borrowers, who use that money to buy troubled mortgage securities on the banks’ books and then use the troubled securities to collateralize the original repo loan from the bank. Or bankers get a repo loan from a trust, using troubled real estate loans as collateral, so the trust can turn the bad loans into AAA-rated securities, and the bankers can use the repo loan to buy them, so the bankers can use the AAA securities as collateral for other repo loans.

 From Reilly’s report this morning:

In a recent report, Credit Suisse analyst David Zion estimated S&P 500 companies would show $7.5 trillion in derivative assets, if they weren’t netted off against liabilities. Of these assets, about 98 percent, or about $7.37 trillion, are held by financial firms. The biggest nonfinancial holders, by comparison, are utilities with $52 billion in gross derivative assets, energy companies with $31 billion and industrial concerns with $18 billion.

The disparities are striking. So, too, is the concentration of the instruments among the biggest banks. Mr. Zion notes that J.P. Morgan Chase, Bank of America, Citigroup, Goldman Sachs Group and Morgan Stanley account for about 95% of the derivatives total, in line with data from the Office of the Comptroller of the Currency.

This shows just how intertwined and interdependent the biggest U.S. firms remain. In a report published back in June 2008, Mr. Zion wrote: “With the financial sector having so much more exposure to derivatives than all of the other sectors combined, it makes you wonder: Who is on the other side of all those derivative contracts? If it’s not primarily with corporate America, could it be with hedge funds, individuals, pension plans, governments etc.? Or are the companies in the financial sector simply entering into derivative transactions amongst themselves.”

The latter explanation may well be the case given banks’ need to hedge their own massive loan and securities portfolios.