By Christine Harper, Matthew Leising and Shannon Harrington
Aug. 31 (Bloomberg) -- Wall Street is suiting up for a battle to protect one of its richest fiefdoms, the $592 trillion over-the-counter derivatives market that is facing the biggest overhaul since its creation 30 years ago.
Five U.S. commercial banks, including JPMorgan Chase & Co., Goldman Sachs Group Inc. and Bank of America Corp., are on track to earn more than $35 billion this year trading unregulated derivatives contracts. At stake is how much of that business they and other dealers will be able to keep.
“Business models of the larger dealers have such a paucity of opportunities for profit that they have to defend the last great frontier for double-digit, even triple-digit returns,” said Christopher Whalen, managing director of Torrance, California-based Institutional Risk Analytics, which analyzes banks for investors.
The Washington fight, conducted mostly behind closed doors, has been overshadowed by the noisy debate over health care. That’s fine with investment bankers, who for years quietly wielded their financial and lobbying clout on Capitol Hill to kill efforts to regulate derivatives. This time could be different. The reason: widespread public and Congressional anger over the role derivatives such as credit-default swaps played in the worst financial crisis since the Great Depression.
“Public sentiment isn’t very much in their favor,” said Richard Lindsey, a former director of market regulation at the U.S. Securities and Exchange Commission who worked at Bear Stearns Cos. from 1999 to 2006, referring to Wall Street firms. “In some places, they’re not going to have anybody who wants to listen to them.”
Bad Omen
In a bad omen for the industry, the Obama administration kept the details and timing of its plan to regulate the derivatives markets under wraps before making it public earlier this month.
Robert Pickel, head of the International Swaps and Derivatives Association, and Scott DeFife, chief lobbyist for the Securities Industry and Financial Markets Association, were meeting with Deputy Treasury Secretary Neal Wolin on Aug. 11, when Wolin mentioned that the proposals would be sent to Congress in 60 minutes, according to a person familiar with the meeting. The sudden notice was not what they were used to.
“The administration is desirous of maintaining control and the initiative on this,” said Craig Pirrong, a finance professor at the University of Houston who has testified before Congress about derivatives trading. “They wanted to make sure they could get their vision out there pure and uninfluenced by the industry.”
Big Five
The Obama proposal made public that day is an effort to gain oversight and control of the market for derivatives traded over the counter. The so-called OTC market consists of privately negotiated contracts that enable companies or investors to hedge against or bet on swings in the value of bonds, interest rates, currencies, commodities or stocks. Unlike exchanges, the business is unregulated and prices aren’t public.
The five biggest derivatives dealers in the U.S. -- JPMorgan, Goldman Sachs, Bank of America, Morgan Stanley and Citigroup Inc. -- held 95 percent of the $291 trillion in notional derivatives value of the country’s 25 largest bank holding companies at the end of the first quarter, according to a report by the Office of the Comptroller of the Currency. More than 90 percent of those derivatives were traded over the counter, the OCC data show.
Trading Revenue
In the first six months of 2009, those five banks made $35 billion from trading in both derivatives, including interest- rate and credit-default swaps, and cash instruments such as Treasuries and corporate bonds, according to company reports collected by the Federal Reserve.
About half of JPMorgan’s $31.2 billion in trading revenue from 2006 to 2008 probably came from derivatives, based on a breakdown the firm provided in a presentation in February and revenue figures in regulatory filings those years, according to Alexander Yavorsky, a senior analyst at Moody’s Investors Service in New York.
The proportion of trading revenue that comes from derivatives is similar at other top firms, according to people familiar with the banks’ income sources.
Spokespeople for all five companies declined to comment.
The Obama plan would require that the most common, or standardized, OTC derivatives be processed through clearinghouses, whose members would make good on trades in the event any of them default.
Bid-Ask Spread
The $182.5 billion federal rescue of American International Group Inc. underlined the problem of so-called counterparty risk, or the danger that one of the parties to a contract won’t be able to meet its obligations. For years New York-based AIG had run a lucrative business collecting fees by selling banks and other investors credit-default swaps, a form of insurance that would pay out if their pools of mortgage securities defaulted. When the housing market collapsed, AIG found itself unable to meet its promises and the government stepped in with taxpayer money to honor the contracts.
Wall Street expected that the administration would try to mandate clearinghouses. It didn’t anticipate the proposals would go further by requiring standardized trades be listed on exchanges or regulated platforms that entail reporting of trades, according to people familiar with how the legislation developed and who asked not to be named.
That could cost Wall Street a lot of money.
Under the current system, the banks profit from the so- called bid-ask spread, which is the gap between what they charge customers and what they pay to hedge their trades.
Interest-Rate Swaps
When a company or investor wants to enter into a swap, the bank checks internal pricing sources to determine the cost of making the opposite trade with another bank, which would enable it to eliminate any exposure on the trade. Armed with that information, it then offers a higher swap price to the client, allowing the bank to pocket a profit. The prices are measured in basis points, each of which is 0.01 percentage point.
Banks earn one to three basis points on average, each year, by creating an interest-rate swap for a customer, according to a former Deutsche Bank AG trader who asked not to be identified. For example, a bank that charges three basis points for a 10- year swap with the notional value of $100 million will earn about 23 basis points, or $230,000, over the lifetime of the trade when accounting for the present value of money, the former trader said. Banks do thousands of such deals a year.
“Part of the pull and tug is that the banks are trying to prevent more and more of the product from being commoditized in the sense of being exchange-traded,” said Charles Peabody, an analyst at Portales Partners LLC in New York, which provides institutional equity research. “Like anything that starts to get commoditized -- we’ve seen that with Trace on the bond side -- it’s obviously going to pressure margins.”
Margin Squeeze
Trace, shorthand for the Trade Reporting and Compliance Engine, was created in 2002 to post prices on all registered corporate bonds 15 minutes after trades occur. The public disclosure meant bond dealers no longer had better price data than clients, and profit margins in the business shrank by more than 50 percent, according to a Bloomberg News review of trades and a study published by the Rochester, New York-based Journal of Financial Economics.
Sanford C. Bernstein & Co. analyst Brad Hintz estimates that Wall Street revenue from trading fixed-income, commodities and currency swaps in the over-the-counter market may be reduced by 15 percent just by a move to clearinghouses. Forcing trades onto exchanges would cut revenue further.
Reducing Secrecy
Obama’s plan deals another blow to banks. It aims to discourage them and their customers from using non-standard, or customized, derivatives that can’t be processed by a clearinghouse or traded on an exchange by requiring that parties to such trades hold more capital to protect themselves against losses. The plan would also require they put up more money, known as margin, to insure they make good on the trades. Both changes would impose added costs on banks and some customers.
Regulators would get to see all of the trades in the market and the positions held by each of the participants, while the public would get data on trading volumes and open positions for the market as a whole, helping to reduce secrecy. The plan also seeks to limit sales of derivatives to individuals and small municipalities to make sure unsophisticated investors don’t get talked into contracts they don’t understand.
While the proposed Obama legislation goes further than some banks expected, it was derived from a broader plan released in June that the industry had already helped influence, said Lauren Teigland-Hunt, managing partner of Teigland-Hunt LLP, a New York law firm that represents hedge funds and institutional investors in the derivatives market.
‘Starting Point’
“They did their homework, they didn’t want to roll out something stupid,” Teigland-Hunt said of the administration. “Once they did that, they said, ‘We’re going to do this legislation. We’re not going to have it written for us.’”
The new, more detailed proposals are “a starting point,” she said. “The industry will have an opportunity to weigh in here, and will weigh in here.”
The Obama proposals don’t go as far as some people have urged. Hedge fund billionaire George Soros and Berkshire Hathaway Inc. Vice Chairman Charles Munger are among investors who have called for limits on the use of credit-default swaps. Soros wrote in a March 24 Wall Street Journal column that regulators should ban so-called naked swaps, in which the buyer isn’t protecting an existing investment.
Two days later Treasury Secretary Timothy Geithner dismissed such an idea before the House Financial Services Committee, telling members that “my own sense is that banning naked swaps is not necessary and wouldn’t help fundamentally.”
‘Overrated and Overpriced’
Janet Tavakoli, founder and president of Tavakoli Structured Finance Inc. in Chicago, said in an interview that derivatives have allowed banks to camouflage risk.
“There has been massive widespread abuse of over-the- counter derivatives, which have contributed to transactions that people knew or should have known were overrated and overpriced at the time they came to market,” said Tavakoli, who traded, structured and sold derivatives over more than two decades in the financial industry.
Wall Street is accustomed to getting its way with derivatives legislation. The last major congressional action, in 2000, was designed to exempt over-the-counter derivatives from government oversight.
Commodity Futures Act
Lawyers for Wall Street’s largest banks initiated and shepherded the 2000 Commodity Futures Modernization Act through Congress because they were concerned the business was in jeopardy from reforms proposed by Brooksley Born, then chairman of the Commodity Futures Trading Commission, according to two lawyers involved in the process who asked not to be identified.
The market has swelled more than sixfold since then, according to industry data.
“The Street does make money on this, so it tends to be pretty important to them,” said Lindsey, the former Bear Stearns executive who now works as an adviser to hedge funds and institutional investors at New York-based Callcott Group LLC.
Analysts can only estimate how much revenue the big banks make from over-the-counter derivatives because the banks provide little disclosure in their quarterly 10-Q and 10-K filings, said Portales Partners’ Peabody.
“I’ve been in the business for 30 years, and I read these 10-Qs and 10-Ks, and I still walk away not understanding how they’re conducting their business, how profitable it is,” Peabody said.
Wall Street Campaign
In recent months, Wall Street firms have embarked on a lobbying campaign to influence the media and legislators.
Goldman Sachs held an off-the-record seminar for reporters in April to explain how credit-default swaps work. Deutsche Bank has offered to put clients in touch with media to discuss concerns about increased capital and margin requirements.
JPMorgan has mobilized some corporate clients, advising them that the proposed changes could hurt their ability to hedge against losses, according to a person familiar with the matter.
The banks “are saying everyone thinks we’re biased, so you have to go out there and talk about it,” said Paul Zubulake, a senior analyst at Boston-based research and consulting firm Aite Group LLC.
While banks say the need for customized contracts stems from customer demand, it’s often the case that Wall Street pushes the products on their clients, said Lindsey, the former Bear Stearns executive.
“Some customers want bespoke derivatives, but often these products are sold, not bought,” he said.
Derivatives 101
On Aug. 24, while lawmakers were on recess, the U.S. Chamber of Commerce organized a briefing for congressional staffers aimed at explaining how companies use derivatives to manage risk. The session, called “Derivatives 101,” featured speakers from Cargill Inc. and Devon Energy Corp., so-called end-users that don’t represent banks, said Jason Matthews, who leads the group’s lobbying efforts on financial-services issues.
The organization called the briefing because “some proposals would make it very difficult for many companies, including manufacturers, energy companies and commercial real estate owners and developers to use over-the-counter derivatives to manage the risks of their day-to-day business,” Matthews said in his e-mail invitation to the staffers.
Wall Street firms and trade associations have held a series of meetings with staff members of the House Financial Services Committee to discuss derivatives trading, said Cory Strupp, who ran government relations for JPMorgan before joining SIFMA, the securities-industry group, last year.
Defining ‘Standardized’
“There’s been a big learning curve, and members and staff have gone a long way along that curve,” said Strupp, a key lobbyist on derivatives. Strupp was on the team at JPMorgan a decade ago when the industry persuaded Congress to repeal the depression-era Glass-Steagall law that separated deposit-taking companies from investment banks.
While the Obama proposals will have “a lot of influence,” they won’t necessarily serve as a “base text” for legislation, Strupp said.
Wall Street firms stand to benefit from staving off efforts for reform. One senior executive at a top-five derivatives firm, who declined to comment publicly, said that while he expects Congress will adopt some form of legislation, he thinks it will be a long time coming and that the degree of reform is in doubt.
One key issue is how the government and regulators define the word “standardized,” which will determine what contracts need to be handled by clearinghouses and can be traded on exchanges.
“The legislation would say that all standardized contracts need to be cleared, which begs the question what is standardized?” said Geoffrey Goldman, a partner who focuses on derivatives and structured products at law firm Shearman & Sterling in New York. “The bill doesn’t answer that question.”
Schapiro, Gensler
That question, which will determine how much change there is in the way the contracts are traded, may fall to regulators, including SEC chairman Mary Schapiro and Gary Gensler, chairman of the Commodity Futures Trading Commission, Goldman said.
In interviews last week, both Schapiro and Gensler said there was a need to make the OTC derivatives market more transparent and less risky by moving more trading onto exchanges and clearinghouses.
“I feel passionately that we must bring the over-the- counter derivatives marketplace under regulation,” said Gensler, a former Goldman Sachs banker who opposed giving the CFTC oversight of over-the-counter derivatives when he worked at the Treasury Department from 1997 to 2001. “Looking back, there’s no doubt that I think all of us should have done more to protect the American public knowing what we know now.”
ICE, CME
Another debate is over which clearing platforms or exchanges should be used. JPMorgan, Goldman Sachs, Bank of America, Citigroup, Morgan Stanley and other banks will begin sharing profits next year from the credit-default swap clearinghouse ICE US Trust LLC.
While the banks have an interest in supporting that initiative, they’re expected to lobby to remove any requirements that the contracts be executed on exchanges because that would cut them out of making a profit on the trades, according to lawyers working for the banks.
“The broker-dealers are happy to clear as much as they can because they do have a vested interest in the clearing companies that they’re clearing these products through,” said Aite Group’s Zubulake.
Chicago-based CME Group Inc., the world’s largest futures exchange, would be a logical place to clear interest-rate swaps because it already clears Eurodollar futures, which are often used as a hedge for rate swaps, Zubulake said. He doubts that will happen though.
“They don’t want to clear an interest-rate swap through the CME because they don’t own the CME,” Zubulake said.
Delaying Reform
Paul Gulberg, a colleague of Peabody’s at Portales Partners, said the most likely outcome is legislation requiring that trades be reported and, in some cases, cleared. He said it’s “not very likely” the law will force derivatives onto an exchange or an electronic facility.
Health-care reform may make it unlikely any derivatives legislation will be enacted in the near future, Peabody said.
For Wall Street, the longer it takes to get legislation passed the better. As stock market values and the economy improve, anger at banks is likely to subside.
“If we don’t pass it by early 2010, we get into the congressional election period where this is just too controversial an issue,” Peabody said. “You’ve got too many different financial interests with opposing views that Congress just isn’t going to go out on a limb and pass it and put their re-election in jeopardy. We don’t think we’re going to see legislation until 2011.”
To contact the reporters on this story: Christine Harper in New York at charper@bloomberg.net; Matthew Leising in New York at mleising@bloomberg.net; Shannon D. Harrington in New York at sharrington6@bloomberg.net.
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