As the 2012 political debates turn inevitably uglier and important national issues become ever more politicized, it's important to ressurect the fact that the national interest does not recede merely becasue trill makes it less visible. -- Dennis Santiago, July 12, 2012.
Originally published October 27, 2011 in the Huffington Post:
One of the sad things about the state of the U.S. economic engine as it sits with the gearbox in neutral is that we seem unable to break so many bad habits. For decades, we have exported jobs by outsourcing first manufacturing and then services gaining cheap goods by ultimately paying for them with the most precious trade good of all: quality of life.
We became addicted to a disposable economy based on strategic corporate principles like "a 100-percent replacement of the installed base every 10 years" and "just-in-time supply chains seeking the lowest mathematical cost of execution." The engineering design principles for product development and maintenance have changed from the old hallmark of American-made durability to "buy it, use it, trash it," particularly in consumer goods where designed-in-obsolescence has been elevated to a business strategy.
The old joke about contracts being awarded to the lowest bidder has become our nightmare as it idles companies, their workers, the commercial real estate they sit on, the durable goods they invest in to manufacture things, and the secondary economic accelerators like housing, education and the rest of the infrastructure that defines the vision of the American way of life.
When I talk to bankers about this and ask them why they aren't lending to domestic commercial and industrial borrowers, they tell me they'd love to but there's no demand to borrow. The bottom line is that U.S. businesses have so little faith in where the economy is headed right now that they don't want to take the risk of new debt. And why should they if all that will happen is that their good efforts will get outsourced and come back as a cheap replica for half the price that lasts a third as long. You math folk can work out how the lifetime value of the customer is boosted by that trick. So the banks sit on excess deposits to lending ratios on their books, waiting for the day business owners believe it's time to put the engine back in gear again. In the meantime, "Third World America."
This is a mess we made for ourselves, to be sure. It was fueled by academic theories that valued the unfettered circulation of money far more than the preservation of culture and lifestyle. And so sits one of the world's most important economies suffering from having mined out the hole of the disposable society to the point that it doesn't make a lot of sense to people anymore. We spent our piggy banks on garbage, and it's bothering every one of us. And not just in the United States. Every other economy on the planet knows full well that since 1945, the world has needed a healthy and viable U.S. economy around which to organize and calibrate their socio-economic strategies. We unhinge for an extended period of time, and it will have enormous complications for the human race.
But here's the thing. What was done can be undone. And personally, I think that the damage isn't that great. My bet is that repatriating 5 percent of the U.S. manufacturing and services sectors will more than put the U.S. economy back on track, and that will have positive implications worldwide.
But how can it be done? What American ingenuity can make this happen? Here are a couple of ideas to ponder that will hopefully spark imagination and innovation.
It's time to shift gears away from the false god of disposability. We should consider demanding changes in our engineering design and product-support strategy expectations. What I mean by this is to retrain our industries and designers to emphasize aspects of products that focus on making products more durable and maintainable. Or to put it another way, American-made quality again. The jargon that goes along with this are things like "fault tolerance," "doubled mean times between failure," "designed for maintainability" and other techno-babble. But what it ultimately does is change the balance on the products we use so that instead of buying and trashing three of them every seven years, more of them will be bought once and maintained for five years. This restarts what used to be a healthy and viable repair-shop industry in this country that got blown away in the last couple of decades.
It's also a very green-conscious strategy, by the way. The highest carbon emission cost for a manufactured good is the initial production event, so deliberately redesigning a fraction of our consumer products inventory to two carbon hits per decade, down from three to five per decade, is worth taking a look at.
And there's nothing that says cost and quality of production won't continue to improve even within such design guideline changes. There's a whole new generation of technologies that, if applied creatively, can leverage one American worker to have the output equal to that of several overseas workers, possible even enough to equalize our folk to teams of other folk on a per capita GDP comparison basis. That sentence means it will make economic sense for companies to choose to manufacture in the United States again. Can you say improved aggregate quality of life?
Speaking of disruptive technologies that could change the foundations of many service industries away from outsourcing, I point out the parting gift of Steve Jobs. His girlfriend SIRI may just be the solution we've all been waiting for instead of talking to some overseas call center that can't really help you, anyway. And she's sassy. The implications are tremendous. I'd say tidal. The question to me is: will we be able to reap it properly?
I'll close with a loud and clear challenge to academia. One of the things the U.S economy desperately needs is for U.S. schools that teach engineering, business and public policy to begin to devote more research to this line of thinking. A little disrupting the status quo from time to time is a good thing. Earn your keep. Push the edge in new directions. Never mind occupying Wall Street; we need solutions for Main Street.
Thursday, July 12, 2012
In this issue of The Institutional Risk Analyst, IRA CEO Dennis Santiago talks about the implications of the revelations about a rogue hedge fund operation at JPMorgan Chase.
It was a bit of a shock to me and many of our readers when the current trouble in JPMorgan’s derivatives desk erupted. Not because the vulnerability to this type of problem in the desks of these big banks was not there – IRA’s stress testing methodology has tracked off-balance sheet exposure as part of our CAMELS analysis regime for years -- but because I had not expected that this particular bank would be the one where this risk would first realize in the market place. In retrospect, that aspect of the letter S in the term CAMELS which stands for “sensitivity to market risk” is in fact uniformly distributed among the participants in derivatives market making and the susceptibility to a future beta event remains for any of them.
The question at this point is not whether the rest of the banks have this risk. The going forward questions are more appropriately, how should banks manage their susceptibility and vulnerability to this class of risk? How should insurers and markets price the risk-reward nature of such exposures? And in what direction should regulators aim the going forward definition of safe and sound practices?
IRA has commented a number of times in the past that we believe that risk and stress testing needs to be done in the context of benchmarking as opposed to the myopia of internally focused analysis. In this case, the need is even more acute given the fact that the banks (a) have trillions upon trillions of notional balances exposed and (b) bank counterparties view these derivatives exposures as material investments. So let us look at a catalog of banks so exposed. As is the case whenever it’s an IRA analysis, we winnow from a census of all the active banks and look at the individual FDIC Certificate holders. In this particular illustration of systemic vulnerability, the unit institutions with assets over $10 billion – the Dodd-Frank stress testing and reporting threshold – that have derivatives operations that reported a fair value estimates of the traded portion of their exposures in the 1st Quarter of 2012 reporting cycle.
Table 1 – Over $10B Asset FDIC Certificate Holders, 1Q2012
|NAME||DERIVATIVES, FOR TRADE (Notional) $K||DERIVATIVES, NOT FOR TRADE (Notional) $K||TOTAL DERIVATIVES (Notional) $K|
|JPMORGAN CHASE BANK NA||63,650,436,000||6,735,675,000||70,386,111,000|
|CITIBANK NATIONAL ASSN||48,584,581,000||3,127,381,000||51,711,962,000|
|BANK OF AMERICA NA||40,110,943,370||6,229,087,191||46,340,030,561|
|GOLDMAN SACHS BANK USA||42,270,359,000||483,791,000||42,754,150,000|
|HSBC BANK USA NATIONAL ASSN||3,777,639,035||624,804,016||4,402,443,051|
|WELLS FARGO BANK NA||3,085,841,000||603,658,000||3,689,499,000|
|MORGAN STANLEY BANK NA||2,543,674,000||23,167,000||2,566,841,000|
|BANK OF NEW YORK MELLON||1,324,329,000||48,569,000||1,372,898,000|
|STATE STREET BANK&TRUST CO||912,454,345||6,075,991||918,530,336|
|PNC BANK NATIONAL ASSN||144,085,198||245,974,999||390,060,197|
|NORTHERN TRUST CO||236,579,751||6,063,973||242,643,724|
|U S BANK NATIONAL ASSN||69,801,437||42,854,555||112,655,992|
|KEYBANK NATIONAL ASSN||67,703,029||16,040,052||83,743,081|
|FIFTH THIRD BANK||46,571,169||22,149,571||68,720,740|
|BRANCH BANKING&TRUST CO||23,132,303||45,959,894||69,092,197|
|UNION BANK NATIONAL ASSN||40,620,251||10,150,020||50,770,271|
|RBS CITIZENS NATIONAL ASSN||29,700,353||7,884,815||37,585,168|
|BOKF NATIONAL ASSN||26,262,687||91,000||26,353,687|
|CAPITAL ONE NATIONAL ASSN||16,312,132||12,524,821||28,836,953|
|BMO HARRIS BANK NA||22,921,436||4,375,739||27,297,175|
|HUNTINGTON NATIONAL BANK||16,632,280||9,623,040||26,255,320|
|DEUTSCHE BANK TR CO AMERICAS||22,350,000||0||22,350,000|
|FIRST TENNESSEE BANK NA||12,575,654||7,009,789||19,585,443|
|MANUFACTURERS&TRADERS TR CO||15,476,745||1,987,079||17,463,824|
|BANK OF THE WEST||9,671,287||5,306,737||14,978,024|
|FLAGSTAR BANK FSB||12,541,133||68,954||12,610,087|
|WEBSTER BANK NATIONAL ASSN||7,557,676||812,904||8,370,580|
|CITIZENS BANK OF PA||5,909,044||1,659,980||7,569,024|
|ASSOCIATED BANK NA||3,393,915||1,140,487||4,534,402|
|FIRST NIAGARA BANK NA||2,414,551||1,942,247||4,356,798|
|ONEWEST BANK FSB||21,000||4,188,151||4,209,151|
|ZIONS FIRST NATIONAL BANK||2,533,297||1,007,383||3,540,680|
|FIRSTMERIT BANK NA||2,498,353||248,033||2,746,386|
|FROST NATIONAL BANK||1,315,800||90,968||1,406,768|
|RABOBANK NATIONAL ASSN||1,289,000||141,000||1,430,000|
|SILICON VALLEY BANK||1,086,802||281,065||1,367,867|
|FIRST NB OF PENNSYLVANIA||1,398,124||16,282||1,414,406|
|MORGAN STANLEY PRIVATE BK NA||580,857||436,198||1,017,055|
|FIRST REPUBLIC BANK||602,163||364,780||966,943|
|AMEGY BANK NATIONAL ASSN||575,434||129,561||704,995|
|BANK OF HAWAII||538,673||147,407||686,080|
|ING BANK FSB||4,226||445,031||449,257|
|STATE FARM BANK FSB||215,171||0||215,171|
As can be seen, within this group, there are four large players followed by five medium sized players and then a collection of lesser – but still exposed – participants. All told, fifty three banks in this highly focused peering. Biggest of them in terms of the size of the notional derivatives book is JPMorgan Chase Bank N.A.
What is far more important to understand though is the context of the risk undertaken by JPMorgan versus this peer group. Was it extraordinary? Does analysis of it help us understand where the line of what is systemically unsafe might lie? For that we first turn to leverage. For this we look at the ratio of these institutions’ traded derivatives to the fair value envelope of these instruments as reported in their CALL reports. The resulting number is an indicator of “the amount of scrambling that is likely to have to happen in the event of a glitch in the Matrix”. The larger the total notional balance size combined with the leveraging factor help quantify the potential nightmare of each billion of realized loss. It’s the kind of thing that makes a Tums and Xanax a food group for Chief Risk Officers; maybe for corporate treasurers too.
Table 2 – Derivative Desk Operating Leverage Multiplier Estimates, 1Q2012
|NAME||FAIR VALUE ENVELOPE OF TRADED BOOK, Reported $K||DERIVATIVE DESK OPERATING LEVERAGE MULTIPLIER, Computed||IMPLIED FAIR VALUE OF NOT FOR TRADE PORTION, Computed $K|
|JPMORGAN CHASE BANK NA||153,680,000||458.0||14,706,574|
|CITIBANK NATIONAL ASSN||111,839,000||462.4||6,763,680|
|BANK OF AMERICA NA||45,531,246||1,017.8||6,120,369|
|GOLDMAN SACHS BANK USA||32,116,000||1,331.2||363,413|
|HSBC BANK USA NATIONAL ASSN||15,133,688||290.9||2,147,805|
|WELLS FARGO BANK NA||44,542,000||82.8||7,287,747|
|MORGAN STANLEY BANK NA||169,000||15,188.4||1,525|
|BANK OF NEW YORK MELLON||9,186,000||149.5||324,973|
|STATE STREET BANK&TRUST CO||7,400,437||124.1||48,953|
|PNC BANK NATIONAL ASSN||1,958,763||199.1||1,235,211|
|NORTHERN TRUST CO||1,253,612||193.6||31,329|
|U S BANK NATIONAL ASSN||1,558,409||72.3||592,822|
|KEYBANK NATIONAL ASSN||1,466,130||57.1||280,821|
|FIFTH THIRD BANK||2,026,473||33.9||653,158|
|BRANCH BANKING&TRUST CO||1,403,773||49.2||933,785|
|UNION BANK NATIONAL ASSN||1,944,329||26.1||388,711|
|RBS CITIZENS NATIONAL ASSN||1,829,382||20.5||383,777|
|BOKF NATIONAL ASSN||355,222||74.2||1,227|
|CAPITAL ONE NATIONAL ASSN||716,553||40.2||311,222|
|BMO HARRIS BANK NA||952,920||28.6||152,753|
|HUNTINGTON NATIONAL BANK||518,196||50.7||189,928|
|DEUTSCHE BANK TR CO AMERICAS||1,755,000||12.7||0|
|FIRST TENNESSEE BANK NA||263,981||74.2||94,481|
|MANUFACTURERS&TRADERS TR CO||825,001||21.2||93,871|
|BANK OF THE WEST||804,388||18.6||284,996|
|FLAGSTAR BANK FSB||83,122||151.7||455|
|WEBSTER BANK NATIONAL ASSN||85,179||98.3||8,272|
|CITIZENS BANK OF PA||388,152||19.5||85,127|
|ASSOCIATED BANK NA||144,105||31.5||36,245|
|FIRST NIAGARA BANK NA||117,873||37.0||52,547|
|ONEWEST BANK FSB||203||20,734.7||202|
|ZIONS FIRST NATIONAL BANK||152,286||23.3||43,328|
|FIRSTMERIT BANK NA||116,959||23.5||10,563|
|FROST NATIONAL BANK||150,759||9.3||9,749|
|RABOBANK NATIONAL ASSN||70,000||20.4||6,902|
|SILICON VALLEY BANK||21,521||63.6||4,422|
|FIRST NB OF PENNSYLVANIA||97,906||14.4||1,127|
|MORGAN STANLEY PRIVATE BK NA||139||7,316.9||60|
|FIRST REPUBLIC BANK||27,201||35.5||10,262|
|AMEGY BANK NATIONAL ASSN||30,214||23.3||5,553|
|BANK OF HAWAII||66,923||10.3||14,379|
|ING BANK FSB||22||20,420.8||22|
|STATE FARM BANK FSB||15||14,344.7||0|
Notice that there are a variety of strategies with regards to derivatives that begin to be exposed by this relatively simple calculation. There are institutions that clearly pursue very conservative approaches to these instruments and others that make use of them more aggressively. That’s not an unexpected result for anyone that has taken the time to understand that the pathways to operating a financial institution are not at all homogeneous, never have been.
Among the big four houses, there seem to be two schools of thought on this ratio, JPMorgan and Citibank electing to run their desks at one ratio and Bank America and Goldman Sachs operating at another one. It implies that a future beta event of similar magnitude as what beset JP Morgan would impact Citi similarly and the other two would have to scramble twice as hard. These are consequence management planning factors and are in fact most useful for costing how much to put into things like compliance oversight and risk taking authorization in the now so as to mitigate consequences if and when.
As one goes down the food chain the differences in strategy become broader straddling the middle ground of the big four with a few institutions electing higher leverage while most seek a more conservative path. Notable among these are the computed ratios of Well Fargo NA and Morgan Stanley NA which exhibit computational differences in the fair value estimates reported to the FDIC. Morgan Stanley basically says the balance sheet value is next to nothing. They may or may not be right but from a benchmarking standpoint, it is a real artifact in the numbers. A number of other smaller institutions also have this reporting approach.
Wells Fargo NA is notable because it pursues the most conservative leveraging approach even as the bank competes head on against its commercial banking competitors. In relative terms, the Wells Fargo desk would have to make a positioning error maybe five times the magnitude of what happened to JPMorgan to realize the same amount of turmoil. Interestingly, it indicates to someone like me to caution that Wells Fargo be the one most on guard against future complacency. Their competitors have incentives to be more hyper-diligent going forward and in the competitive space of derivative zero sum games, that means something.
Finally let’s look at how much of the real balance sheet is affected by these derivatives. Using the assumption that the traded leverage ratio is a fair indication of leverage in the remainder of the derivatives book, we can perform a CALL report based apples-to-apples estimate of the book value of these instruments. The caveat is that this analytical assumption may or may not be true but confirming this would have to involve performing a proprietary review to increase the fidelity of the calibration. Still, the question of just how much a derivatives desk impacts the overall portfolio of a bank is an important piece of information to have.
Table 3 – Portfolio Analysis of Estimated De-Leveraged Derivatives Value vs. Total Assets
|NAME||TOTAL ASSETS, $K||ESTIMATED BALANCE SHEET VALUE OF DE-LEVERED DERIVATIVES, $K||PERCENT OF TOTAL ASSETS, %|
|JPMORGAN CHASE BANK NA||1,842,735,000||168,386,574||9.1|
|CITIBANK NATIONAL ASSN||1,312,764,000||118,602,680||9.0|
|BANK OF AMERICA NA||1,448,261,695||51,651,615||3.6|
|GOLDMAN SACHS BANK USA||101,927,000||32,479,413||31.9|
|HSBC BANK USA NATIONAL ASSN||206,808,958||17,281,493||8.4|
|WELLS FARGO BANK NA||1,181,817,000||51,829,747||4.4|
|MORGAN STANLEY BANK NA||67,651,000||170,525||0.3|
|BANK OF NEW YORK MELLON||229,715,000||9,510,973||4.1|
|STATE STREET BANK&TRUST CO||183,994,204||7,449,390||4.0|
|PNC BANK NATIONAL ASSN||287,766,197||3,193,974||1.1|
|NORTHERN TRUST CO||91,340,913||1,284,941||1.4|
|U S BANK NATIONAL ASSN||330,227,426||2,151,231||0.7|
|KEYBANK NATIONAL ASSN||84,838,858||1,746,951||2.1|
|FIFTH THIRD BANK||114,402,170||2,679,631||2.3|
|BRANCH BANKING&TRUST CO||169,026,116||2,337,558||1.4|
|UNION BANK NATIONAL ASSN||91,575,684||2,333,040||2.5|
|RBS CITIZENS NATIONAL ASSN||106,242,373||2,213,159||2.1|
|BOKF NATIONAL ASSN||25,733,983||356,449||1.4|
|CAPITAL ONE NATIONAL ASSN||133,000,029||1,027,775||0.8|
|BMO HARRIS BANK NA||94,826,410||1,105,673||1.2|
|HUNTINGTON NATIONAL BANK||55,584,664||708,124||1.3|
|DEUTSCHE BANK TR CO AMERICAS||39,839,000||1,755,000||4.4|
|FIRST TENNESSEE BANK NA||25,439,984||358,462||1.4|
|MANUFACTURERS&TRADERS TR CO||78,221,757||918,872||1.2|
|BANK OF THE WEST||62,342,865||1,089,384||1.7|
|FLAGSTAR BANK FSB||14,030,798||83,577||0.6|
|WEBSTER BANK NATIONAL ASSN||19,109,508||93,451||0.5|
|CITIZENS BANK OF PA||33,062,054||473,279||1.4|
|ASSOCIATED BANK NA||21,617,331||180,350||0.8|
|FIRST NIAGARA BANK NA||35,463,055||170,420||0.5|
|ONEWEST BANK FSB||25,009,840||405||0.0|
|ZIONS FIRST NATIONAL BANK||17,179,085||195,614||1.1|
|FIRSTMERIT BANK NA||14,646,838||127,522||0.9|
|FROST NATIONAL BANK||20,472,031||160,508||0.8|
|RABOBANK NATIONAL ASSN||11,646,000||76,902||0.7|
|SILICON VALLEY BANK||19,608,406||25,943||0.1|
|FIRST NB OF PENNSYLVANIA||11,525,969||99,033||0.9|
|MORGAN STANLEY PRIVATE BK NA||12,069,555||199||0.0|
|FIRST REPUBLIC BANK||29,718,987||37,463||0.1|
|AMEGY BANK NATIONAL ASSN||12,005,462||35,767||0.3|
|BANK OF HAWAII||13,760,753||81,302||0.6|
|ING BANK FSB||95,828,916||44||0.0|
|STATE FARM BANK FSB||14,455,112||15||0.0|
What reveals is a story of concentration risk. Of the fifty-three banks of this peer group, only four have derivatives as a proportion of their total assets exceeding five percent. One of them is JPMorgan Chase NA. Of the remaining three, Citibank NA is similarly sized. Goldman Sachs is its own unique investment banking model. HSBC Bank USA NA is a significantly smaller entity. Notable is that both Bank of America NA and Wells Fargo NA are the asset giants among a group that allocates between two to five percent of the portfolio to these instruments; the remaining banks live in the noise indicating hedging as opposed to investment or market making purposes for this asset class. A possible exception might be those banks that reported near zero fair values.
So in context let’s look again at JPMorgan Chase. It’s definitely the biggest operation dwarfing every other. While the business was run on the higher end of the leverage spectrum, it was not the highest model in operation. In terms of tangible exposure to the balance sheet, it is or was the segment leader. The combination of the three factors is the signature of high susceptibility to event risk and high vulnerability to significant stress in the event that risk manifests. In the end it was a mistake to have ever believed that mass and reputaion were that much protection against this type of risk. It’s a painful lesson to be sure and one that other banks should heed based purely an objective assessment of their own numbers in the context of these types of inconvenient truth benchmarks.
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