Regulatory reports show 5 big banks face huge loss risk

McClatchy NewspapersMarch 9, 2009 

WASHINGTON — Five of America's largest banks, most of which have received $145 billion in taxpayer bailout dollars, still face potentially catastrophic losses from exotic investments if economic conditions substantially worsen, their latest financial reports show.

Citibank, Bank of America, HSBC Bank USA, Wells Fargo Bank and J.P. Morgan Chase reported that their "current" net loss risks from derivatives — insurance-like bets tied to a loan or other underlying asset — surged to $587 billion as of Dec. 31. Buried in end-of-the-year regulatory reports that McClatchy has reviewed, the figures reflect a jump of 49 percent in just 90 days.

The disclosures underscore the challenges that the banks face as they struggle to navigate through a deepening recession in which all types of loan defaults are soaring.

The banks' potentially huge losses, which could be contained if the economy quickly recovers, also shed new light on the hurdles that President Barack Obama's economic team must overcome to save institutions it deems too big to fail.

While the potential loss totals include risks reported by Wachovia Bank, which Wells Fargo agreed to acquire in October, they don't reflect another Pandora's Box: the impact of Bank of America's Jan. 1 acquisition of tottering investment bank Merrill Lynch, a major derivatives dealer.

Federal regulators portray the potential loss figures as worst-case. However, the risks of these off-balance sheet investments, once thought minimal, have risen sharply as the U.S. has fallen into the steepest economic downturn since World War II, and the big banks' share prices have plummeted to unimaginable lows.

With 12.5 million Americans unemployed and consumer spending in a freefall, fears are rising that a spate of corporate bankruptcies could deliver a new, crippling blow to major banks. Because of the trading in derivatives, corporate bankruptcies could cause a chain reaction that deprives the banks of hundreds of billions of dollars in insurance they bought on risky debt or forces them to shell out huge sums to cover debt they guaranteed.

The biggest concerns are the banks' holdings of contracts known as credit-default swaps, which can provide insurance against defaults on loans such as subprime mortgages or guarantee actual payments for borrowers who walk away from their debts.

The banks' credit-default swap holdings, with face values in the trillions of dollars, are "a ticking time bomb, and how bad it gets is going to depend on how bad the economy gets," said Christopher Whalen, a managing director of Institutional Risk Analytics, a company that grades banks on their degree of loss risk from complex investments.

J.P. Morgan is credited with launching the credit-default market and is one of the most sophisticated players. It remains highly profitable, even after acquiring the remains of failed investment banker dealer Bear Stearns, and says it has limited its exposure. The New York-based bank, however, also has received $25 billion in federal bailout money.

Gary Kopff, president of Everest Management and an expert witness in shareholder suits against banks, has scrutinized the big banks' financial reports. He noted that Citibank now lists 60 percent of its $301 billion in potential losses from its wheeling and dealing in derivatives in the highest-risk category, up from 40 percent in early 2007. Citibank is a unit of New York-based Citigroup. In Monday trading on the New York Stock Exchange, Citigroup shares closed at $1.05.

Berkshire Hathaway Chairman Warren Buffett, a revered financial guru and America's second wealthiest person after Microsoft Chairman Bill Gates, ominously warned that derivatives "are dangerous" in a February letter to his company's shareholders. In it, he confessed that he cost his company hundreds of millions of dollars when he bought a re-insurance company burdened with bad derivatives bets.

These instruments, he wrote, "have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks . . . When I read the pages of 'disclosure' in (annual reports) of companies that are entangled with these instruments, all I end up knowing is that I don't know what is going on in their portfolios. And then I reach for some aspirin."

Most of the banks declined to comment, but Bank of America spokeswoman Eloise Hale said: "We do not believe our derivative exposure is a threat to the bank's solvency."

While Bank of America advised shareholders that its risks from these instruments are no more $13.5 billion, Wachovia last year similarly said it could overcome major risks. In reporting a $707 million first-quarter loss, Wachovia acknowledged that it faced heavy subprime mortgage risks, but said it was "well positioned" with "strong capital and liquidity." Within months, losses mushroomed and Wachovia submitted to a takeover by Wells Fargo, which soon got $25 billion in federal bailout money.

Trading in credit-default contracts has sparked investor fears because they are bought and sold in a murky, private market that is largely out of the reach of federal regulators. No one, except those holding the instruments, knows who owes what to whom. Not even banks and insurers can accurately calculate their risks.

"I don't trust any numbers on them," said David Wyss, the chief economist for the New York credit-rating agency Standard & Poor's.

The risks of these below-the-radar insurance policies became abundantly clear last September with the collapse of investment banker Lehman Brothers and global insurer American International Group, both major swap dealers. Their insolvencies threatened to zero out the value of billions of dollars in contracts held by banks and others.

Until then, "we assumed everyone makes good on the contracts," said Vincent Reinhart, a former top economist for the Federal Reserve Board.

Lehman's and AIG's failures put in doubt their guarantees on hundred of billions of dollars in contracts and unleashed a global pullback from risk, leading to the current credit crunch.

The government has since committed $182 billion to rescue AIG and, indirectly, investors on the other end of the firm's swap contracts. AIG posted a fourth quarter 2008 loss last week of more than $61 billion, the worst quarterly performance in U.S. corporate history.

The five major banks, which account for more than 95 percent of U.S. banks' trading in this array of complex derivatives, declined to say how much of the AIG bailout money flowed to them to make good on these contracts.

Banking industry officials stress that most of the exotic trades are less risky — such as interest-rate swaps, in which a bank might have tried to limit potential losses by trading the variable rate interest of one loan for the fixed-rate interest of another.

In their annual reports to shareholders, the banks say that parties insuring credit-default swaps or other derivatives are required to post substantial cash collateral.

However, even after subtracting collateralized risks, the banks' collective exposure is "a big, big number" and a matter for concern, said a senior official in a banking regulatory agency, speaking on condition of anonymity because agency policy restricts public comments.

In their reports, the banks said that their net current risks and potential future losses from derivatives surpass $1.2 trillion. The potential near-term losses of $587 billion easily exceed the banks' combined $497 billion in so-called "risk-based capital," the assets they hold in reserve for disaster scenarios.

Four of the banks' reserves already have been augmented by taxpayer bailout money, topped by Citibank — $50 billion — and Bank of America — $45 billion, plus a $100 billion loan guarantee.

The banks' quarterly financial reports show that as of Dec. 31:

_ J.P. Morgan had potential current derivatives losses of $241.2 billion, outstripping its $144 billion in reserves, and future exposure of $299 billion.

_ Citibank had potential current losses of $140.3 billion, exceeding its $108 billion in reserves, and future losses of $161.2 billion.

_ Bank of America reported $80.4 billion in current exposure, below its $122.4 billion reserve, but $218 billion in total exposure.

_ HSBC Bank USA had current potential losses of $62 billion, more than triple its reserves, and potential total exposure of $95 billion. As a foreign-owned subsidiary, HSBC has neither applied for nor received U.S. government bailout money.

_ San Francisco-based Wells Fargo, which agreed to take over Charlotte-based Wachovia in October, reported current potential losses totaling nearly $64 billion, below the banks' combined reserves of $104 billion, but total future risks of about $109 billion.

Kopff, the bank shareholders' expert, said that several of the big banks' risks are so large that they are "dead men walking."

The banks' credit-default portfolios have gotten little scrutiny because they're off-the-books entries that are largely unregulated. However, government officials said in late February that federal examiners would review the top 19 banks' swap exposures in the coming weeks as part of "stress tests" to evaluate the institutions' ability to withstand further deterioration in the economy.

Representatives for Citibank, J.P. Morgan and Wells Fargo declined to comment.

Hale, the Bank of America spokeswoman, said that the bank uses swaps as insurance against its loan portfolio — they "gain value when the loans they are hedging lose value."

She said that Bank of America requires thousands of parties that are guarantors on these insurance-like contracts to post "the most secure collateral — cash and U.S. Treasuries, minimizing risk roughly 35 percent." The collateral is adjusted daily.

Bank of America's report of an $80.4 billion exposure doesn't count the collateral and "also assumes the default of each of the thousands of counterparty customers, which isn't likely," Hale said. Counterparties are the investors on the other side of the deal, often other banks or investment banks.

In response to questions from McClatchy, HSBC spokesman Neil Brazil said that the bank closely manages its derivatives contracts "to ensure that credit risks are assessed accurately, approved properly (and) monitored regularly."

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