The Interconnected Financial System in One Chart

Joining the other too-big-to-fail banks, Morgan Stanley (MS) has been moving its derivatives portfolio from its holding company to its banking subsidiary. We saw this last November, when Bank of America moved a huge chunk of derivatives from its Merrill Lynch subsidiary onto the balance sheet of its bank subsidiary. This OCC report on derivatives suggests that the total amount currently supported by the FDIC is approximately$1.11 trillion.

Reuters reports:

The [MS] bank increased its notional derivatives positions at its bank unit to $2.57 trillion at the end of March from $1.72 trillion at the end of December, OCC data show. The portfolio has increased from $1.21 trillion at the end of March 2011.

This move probably came in part as a response to the news from February 2012 that the credit rating agency Moodys was reviewing the ratings of banks, with a negative outlook. MS knew that it was likely to get a downgrade, and that could require it to give more safe assets (like Treasuries and cash) to its counterparties on derivatives. The increased collateral protects those counterparties against the possibility that MS couldn’t pay off its obligations. If something happens to MS, the counterparties can seize their collateral, even if MS files bankruptcy, thanks to the 2005 Bankruptcy Amendments.

That is what happened to AIG: it had a huge portfolio of credit default swaps, and when it got into financial trouble, its counterparties demanded more collateral than AIG could produce.

Posting prime collateral weakens the balance sheet of MS, because that collateral is not shown as an asset. That means it may need more capital, which hurts existing shareholders. A weak balance sheet makes MS a poor counterparty, hurting its ability to participate in the derivatives market. In normal times, it would lower the amount of lending MS could do, but that’s irrelevant today, since MS bank isn’t really a lending institution but a backstop for the investment banking business of MS, and anyway, the Fed is dumping money on any bank that asks.

MS says it would have to post additional collateral of as much as $9.6 billion in the event of a downgrade, which has now happened. That’s real money. Of course, the MS bank has all those luscious FDIC-insured deposits to post, sticking the FDIC with its risks. Or, it can run over to the Federal Reserve discount window and get some of that lovely cash for free. I have to say that if I had money in the MS Bank, I’d take it out. Oh wait, I might have money there if my broker is Morgan Stanley (think MF Global).

US banks insist that they are fully protected because they only have strong counterparties, not those weakling banks in Europe, but powerful institutions backed by the Fed or strong US corporations or hedge funds or sovereign wealth funds. But the International Monetary Fund doesn’t see it with those rose-colored spectacles. In April it published its Global Financial Stability Report (.pdf), in which it asserts that US banks are exposed to European bank problems through their derivative businesses.

(click to enlarge)

The explanation is complicated. In short, there are downward spiraling feedback loops. Interested readers should look at the material beginning on .pdf page 52. Click on the chart and you will see a graphical representation of the feedback loops. This isn’t idle speculation according to the IMF.

The potential of negative feedback loops to affect U.S. banks is real, as illustrated by events in the second half of 2011. As concerns about the solvency and liquidity of European banks mounted, the spotlight turned to U.S. broker-dealers. Market participants erred on the side of caution by reducing or hedging their exposures to U.S. broker-dealers. As a result, the price of default protection for U.S. broker-dealers widened faster than that of European banks in September 2011, demonstrating how interconnectedness could rapidly evolve into systemic risk (Figure 2.4.2).

Jamie Dimon and his counterparts at other derivatives monsters have never admitted the risks of the derivatives market even in the wake of the fail whale trade that cost the bank’s shareholders billions in market valuation losses, or the collapse and bailout of AIG and its counterparties, or in the aftermath of the Lehman debacle. They figure we’ll never understand the intricate links that the IMF charts out, and we won’t blame them when the house of cards collapses.

Now we see why. The financial sector doesn’t have anything at stake. They have the Fed and the FDIC to guarantee their gambles. They get the gains, and all the losses will be to other people’s bank deposits, other people’s pensions, and other people’s 401Ks; not to mention taxpayer bailouts of the banks and the FDIC, and the Fed money printing machine. It’s disgusting.