Stunning collection. Thanks for the Schlafley mention. She and her sister (Cardinal Mindzenty Foundation) are one of the reasons I've always followed you.
The Role of the Financial Institutions In Enron’s Collapse
Banks In All The Wrong Places
Over the course of these last two years others as well as myself have been sounding the alarm over the condition of the nation's credit system. It doesn’t matter which kind of debt we are talking about — mortgage debt, installment debt, credit card debt, corporate debt, municipal debt, or federal debt — we have become a nation of debtors. Taking on debt has its limitations. At some point you reach a limit where that debt is no longer sustainable. What we are now seeing is the unraveling of that debt at the corporate level from Enron, Global Crossing, Kmart and to WorldCom. The stock market decline has ushered in the first phase of a deflating credit bubble. Companies can no longer tap the credit markets to pay their bills. Bond defaults are up, delinquencies are rising, and many companies have been forced out of the commercial paper markets. So they now have to tap the long-term debt markets and pay higher rates of interest as credit spreads have widened. This means that their interest costs are going up. To help mitigate rising costs of borrowing long-term, many companies are using the swap markets, exchanging their long-term debt for short-term debt to help lower interest rate costs.
The problem is that interest rate swaps makes up the bulk of the derivative market. These swaps pose another risk if interest rates begin to rise later on this year. The rise in interest rates will be triggered by the dollar's decline. So in addition to the credit risks, we also have derivative risk. This poses an additional risk for many companies such as GE and others that have swapped out much of their debt in order to lower their costs of borrowing. It also raises counterparty risk for banks if many of these companies can’t honor their swap arrangements, having to pay the difference if rates begin to rise. So in addition to credit risks, we also have interest rate risks lurking in the form of these swap arrangements. Banks are the largest writers of these instruments.
Danger in Derivatives
The media attention has been on the companies that have defaulted on their loans or have filed for bankruptcy protection. To a lesser extent, the attention has been on the banks. A credit bubble has two sides to the equation: the borrower (Enron, Global Crossing, Kmart WorldCom) and the lender (J.P. Morgan Chase, Citigroup, Bank America). Banks have not only been the lender and underwriters on much of this debt, they have also been the writer of derivatives that go hand-in-hand with the expansion of credit. In fact, bank derivative growth has been growing at double-digit rates over the last decade. During the first quarter of this year the notional value of derivatives in bank portfolios increased by $946 billion. Interest rate contracts increased by $972 billion to $39.3 trillion. So in addition to the debt debacle, you also have the danger of another derivative debacle such as we had with LTCM back in 1998. Many of the top banks such as J.P. Morgan Chase, Citigroup, and Bank America are also the nation's largest writers of derivatives. These three banks have derivative portfolios totaling close to $40 trillion in notional value or roughly 87 percent of the derivative portfolio of the nation's top 354 banks. This is a high concentration in just a few players in what is a very risky business.
On top of making bad loans, the banks also have exposure as the largest underwriters in the derivative business. J.P. Morgan Chase is leveraged over 700-1 when you look at the bank's exposure to derivatives. The net equity of JPM has to back those derivatives. If you look at J.P. Morgan Chase’s derivative book, the bank looks and acts more like a hedge fund then it does a pillar of stability of the financial establishment. The credit problems are only one side of the problem. No one knows what the bank's derivative risks are other than that they have $23.4 trillion in derivatives against equity of around $40 billion.
This isn’t the only problem the bank has at the moment. J.P. Morgan Chase and Citigroup made $5 billion in cash loans using complex transactions that were disguised as energy trades. This made the loans hidden from Enron’s balance sheet. Investigators found out that J.P. Morgan and Citigroup were Enron’s main source of prepay funding. The Senate Governmental Affairs subcommittee is now looking into the extent to what these banks knew and the role they may have played in aiding Enron’s accounting deceptions. J.P. Morgan promoted prepay loans to customers in the 90’s because of their “balance sheet friendly” nature. In addition to the Senate, the Manhattan’ district attorney’s office is looking into the role J.P. Morgan Chase played in making offshore loans to companies in an effort to keep the debt off the balance sheet. Insurance companies, which issued surety bonds as guarantees that Enron would repay its offshore loans, are now suing the banks because they claim the banks kept knowledge of the company’s perilous financial condition from them.
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