Bankers Address Crisis Prevention, Morgan Reports $2B Trading Loss

Published May 11, 2012

Just a few hours after Federal Reserve Chairman Ben Bernanke addressed the Fed’s 48th Annual Conference on Bank Structure and Competition in Chicago, JP Morgan Chase announced it had suffered $2 billion in trading losses in one of its credit portfolios in the past six weeks.

The news served to underscore Bernanke’s caution that financial institutions remain troubled by consumer and commercial real estate loans, with other pockets of problems.

Bernanke probably was not expecting to later in the day learn of a pocket big enough to hold $2 billion of trading losses over six weeks at one company.

Crisis Aversion

The May 9-11 conference brought together the Fed chairman with bankers and regulators who used the venue to discuss the steps they have taken to ensure that financial institutions don’t go through another financial crisis like the one that hit in 2008.

Bernanke said bank capital levels, liquidity and profitability are improving despite the real estate loan issues and smaller “pockets” of problems.

One such problem was unveiled with the news of JPMorgan Chase’s $2 billion trading losses. The portfolio proved to be “riskier, more volatile and less effective as an economic hedge” than the bank initially believed, according to a regulatory filing.

Bernanke had taken an encouraging tone in his talk.

‘Substantial Improvements’

“Financial-market indicators reflect the substantial improvements in banks’ financial conditions since the crisis as well as the sizable challenges remaining,” Bernanke said. “Bank credit default swap (CDS) premiums are now well below their crisis peaks, and bank stock prices have retraced some of their earlier losses and have outperformed the broader market this year, boosted somewhat by the release of the [industry stress tests] results in March and first-quarter earnings that largely beat analysts’ expectations. However, CDS premiums remain elevated for some of the larger, more globally connected firms.”

Bank stress tests are more forward-looking than previous bank exams, said Lisa Ryu, assistant director of the Fed’s regulation and supervision division, later in the conference. Earlier bank exams tended to look to past conditions, so they were poor indicators of future performance. The new test, which most of the nation’s largest financial institutions recently passed, includes testing for a severe global recession and other severe potential problems.

Yet Ryu cautioned the new stress test “shouldn’t be considered a panacea” for identifying all potential failures of the nation’s largest banks – or other “systemically important financial institutions.”

Broad Takeover Authority

The Federal Deposit Insurance Corporation now has the authority to take over not only failing banks and thrifts but also investment banks, insurance companies, or others deemed as “systemically important.”

Such authority, which was granted in the Dodd-Frank Act, would have enabled the government to take over investment firms Bear Stearns and Lehman Brothers and insurance firm American International Group before they failed in 2008.

So said acting FDIC Chairman and conference speaker Martin J. Gruenberg.

To help save AIG from collapse in 2008, the Federal Reserve created an $85 billion credit facility in exchange for receiving a 79.9 percent stake in the company. More than $100 billion more of additional credit lines and government purchases of AIG assets followed. Bear Stearns received an emergency federal to stay afloat and soon thereafter was sold to JP Morgan Chase. Lehman Brothers went out of business.

The U.S. Treasury recently sold $5.75 billion of its stock in AIG, leaving the federal government owning 1.06 billion shares of AIG, or $29 billion of the company.

Saving Subsidiaries

Gruenberg said he believes the FDIC can help avoid or at least reduce the impact of AIG-like problems not only by stress testing, but also by taking over financial entities when they fail so that some of the profitable subsidiaries – if there are any – can continue to operate “business as usual.” This would help mitigate potential losses, he said.

Large financial services firms all have numerous subsidiaries that may operate quite independently from one another. So the FDIC’s plan for any takeovers involves placing the parent company into receivership and passing its assets — principally investments in its subsidiaries  — to a newly created bridge holding company, which would eventually be sold to private investors.

According to Gruenberg, “this will allow subsidiaries that are equity solvent and contribute to the franchise value of the firm to remain open and avoid the disruption that would likely accompany their closings. Because these subsidiaries will remain open and operating as going-concern counterparties, we expect that qualified financial contracts will continue to function normally as the termination, netting and liquidation will be minimal.

“We believe that this resolution strategy will preserve the franchise value of the firm and mitigate systemic consequences. This responds to the goal of financial stability.”

Equity, Debt Claims in Receivership

Equity claims of the firm’s shareholders and the claims of the subordinated and unsecured debt holders would be left behind in the receivership. In exchange the receivership would have the equity in the bridge holding company as an asset.

Initially, the FDIC, as receiver, would own the bridge company and appoint a temporary board of directors and CEO from the private sector. They would run the company under the FDIC’s oversight during the first step of the process.

“The next stage in the resolution is to transfer ownership and control of the surviving franchise to private hands,” Gruenberg said. “But before this happens, we must ensure that the bridge has a strong capital base and address whatever liquidity concerns remain.”