Part 2: Little Known & Dangerous Provision of the Bankruptcy Code

Posted on Aug 28, 2013 By Don Lawson

Don LawsonIn Part 1 of “A little known and potentially dangerous provision of the Bankruptcy Code”, I explained derivatives and qualified derivative counter parties and the special treatment they are afforded under the United States Bankruptcy Code.  In Part 2, I hope to explain how changes in the laws regulating banks and financial institutions is working in concert with the special treatment of qualified derivative counter parties to create the setting for a financial catastrophe far greater than what we witnessed in 2008.   Now, on to Part 2.

Glass Steagall and The Graham-Leach Act of 1999

In 1999, the US Congress passed the Graham-Leach Act of 1999.  Among the many provisions of Graham-Leach, perhaps the most significant was the repealing of the Glass-Steagall Act of 1933.  The Glass-Steagall Act, passed during the Great Depression, prohibited banks, investment companies and insurance companies from combining any portion of their businesses.  Glass-Steagall sought to correct what was believed to have triggered the Great Depression: a lack of regulation of and between banks, investment companies and insurance companies.  Under Glass-Steagall, banks were prohibited from owning investment companies or insurance companies and vice versa.  The purpose of this was to remove the direct inherent risk of the stock market from banking.  Prior to Glass-Steagall, banks could use customer deposits to invest in the stock market.  When the Stock Market crashed in 1929, most bank customers lost everything as their deposits had been used by the bank to invest in the Stock Market.  Graham-Leach removed these provisions.  Once again, banks were allowed to put customer deposits at risk through their investments banks.  And this is where derivatives and derivative counterparties come into play.

Derivatives and Derivative Counter Parties

Fast forward to today.  At present, all four of the banks mentioned in Part 1 (JP Morgan, Bank of America, Cit and Goldman Sachs) are FDIC insured and are heavily invested in derivatives.  Thanks to the Graham-Leach Act of 1999, all of these banks have the right to move their respective derivative exposure inside their federally insured bank, which they all did after the 2008 financial crisis.  If any one of these banks were to have even a slight problem financially, the consequences could be devastating due to the amount of derivatives each bank has and the way in which derivatives are treated in bankruptcy.  In a typical bankruptcy of a federally insured financial institution, the FDIC takes the bank into receivership and protects the assets and liabilities of the bank.  However, if the bankrupt financial institution has derivative counterparties (as all four of the above institutions do), the FDIC will still take the bank into receivership but the derivative counterparties are not stayed from canceling their derivative contracts and collecting any under lying collateral, including all of the bank’s deposits.  No other creditor has this power.  However, the Bankruptcy Code is very clear that qualified derivative holders have the right to take any and all collateral securing their derivative, regardless of the consequences.

In the above scenario, the FDIC would be left to fund all insured deposits as all deposits would be taken by the derivative counterparties.  As of 3/31/2013, JPMorgan Chase had total “core” deposits of approximately $877.9 Billion.  Core deposits are demand deposits (checking accounts), savings accounts, money market accounts and certificates of deposits maturing in less than one year.  If even 1% of JPM’s derivative exposure were to collapse, that could completely wipe out its entire deposit base.  And this is not even a bankruptcy scenario; this is simply a quiver in the financial markets.  For example, if interest rates were to increase (remember the majority of these derivatives are Interest Rate swaps) and JPM were to be perceived by the Market to be in a position of not being able to meet its financial obligations, the derivative counterparties could swoop in and seize the underlying collateral for those derivatives.  And don’t worry about preferential transfers if JPM were to ultimately go bankrupt,  because derivative counterparties are also exempt from the “claw back” provisions of the Bankruptcy Code (meaning assets seized from a debtor within 90 days of the bankruptcy become property of the bankruptcy estate and the bankruptcy court has the authority to claw-back those assets taken from the debtor).  And it is just this type of scenario that could cause what is seemingly a “Too Big To Fail” bank to fail.  In fact, the failure of Lehman Brothers and much publicized bailout of AIG can be directly and in-directly traced to the special treatment of derivative counter parties in bankruptcy.  With Lehman Brothers, qualified derivative counter parties rushed to close out the derivatives just prior to Lehman Brothers’ Chapter 11 bankruptcy filing.  The counter parties knew they were exempt from the claw back provisions of the bankruptcy code and seized the under lying collateral securing the derivatives as quickly as possible before all of the collateral was gone[1].  Similarly, AIG’s derivative creditors knew that their demands for more and more collateral to secure their positions could not be questioned in bankruptcy and AIG knew that Bankruptcy would actually worsen its already poor financial condition as all underlying collateral would be seized.  Thus, instead of filing for bankruptcy, the federal government stepped in and bailed out AIG to the tune of $182 billion[2],[3].  Interestingly, AIG recently sued the Federal Government that bailed them out stating that the terms of the bailout were too onerous and the Government did not fairly compensate the Shareholders of AIG for taking an 80% ownership interest in AIG in exchange for providing $182 billion in bailout funds.  AIG is suing the Government for $25 billion.

I know this seems far-fetched.  But ask yourself: Did it seem far-fetched five years ago that Lehman Brothers (a global financial services firm founded in 1858), Countrywide Mortgage (the largest mortgage company in the US), Wachovia Bank (the fourth largest bank in the US) and Washington Mutual (the largest Savings and Loan in the US) would go bankrupt?  Did it seem far-fetched five years ago that Fannie Mae, Freddie Mac, AIG, General Motors and Chrysler Motors would file bankruptcy or be taken into government receivership?  Did it seem far-fetched that just five years ago our government would provide a virtually no questions asked $750 Billion bailout, mainly to the same four banks that now hold roughly 94% of all derivatives in the US?   I am not saying this will happen, but the potential for this is very real.  In fact, the above scenario has already played out for JPMorgan Chase on a smaller scale.  In 2012, the now famous “Whale Trade” cost JPMorgan at least $6.2 Billion[4].  And what was the cause of this loss?  Derivatives!  In fact, it is now being reported that traders inside of JPMorgan actually bet against the bank using derivatives to counter the very positions the bank itself was taking[5].  The traders were actually hoping the bank would lose money, thus making themselves money in the process.  This type of activity is very alarming and adds even more risk to an already risky endeavor.  Further, ex- Goldman Sachs trader, Fabrice Tourre, was found liable on July 31, 2013 for six counts of fraud.  The case involved a toxic mortgage deal known as Abacus, which Goldman created in 2007 at the request of hedge-fund manager John Paulson, so that he (Paulson)could bet against it, part of his strategy for making $15 billion on the crisis. The jury found that Tourre had misled investors about the nature of the deal, tricking them into thinking it had not been built for failure from the start. Tourre now faces the possibility of heavy financial penalties and a lifetime ban from the securities industry[6].   The above are just two examples of how the risk for these types of transactions is immeasurably increased.

Given their increased exposure to risk, the unknown and hidden “behind the scenes” internal frauds and the limited power of the Federal Reserve and the US Government to step in and bail out the banks again, the aforementioned banks could not possibly deal with another financial crisis like the one that swept through the US and the World in 2008.  All four of these institutions are larger in size and riskier than they were in 2008.  And prior to 2008, the derivative risk that each bank had was held outside of the federally insured portion of their bank.

Bankruptcy of Cyprus Popular Bank

 

So, what would happen today if we experienced another financial crisis similar to 2008?  We need only to look at Cyprus.  Earlier this year, Cyprus Popular Bank (the second largest bank in Cyprus) went bankrupt and uninsured depositors had their bank deposits levied by the Cypriot Government.   Cyprus Popular Bank (CPB) suffered a crisis of confidence similar to the scenario described above; their exposure to risky investments and derivatives led the Market to believe that CPB could not meet its obligations.  A bank run ensued and the Cypriot Government forced the bank to close.  The Cypriot Government was ordered to levy the deposits in order to receive a bailout from the European Union and the International Monetary Fund. The Cypriot Government took the deposits in order to pay creditors.  The depositors that lost their money were given stock in the Bank of Cyprus as compensation for their loss.  In the US, we have the Federal Depositors Insurance Corporation (FDIC) that insures deposit accounts for individuals for up $250,000.00.  The rationale being that if a financial institution goes bankrupt, insured depositors would not lose their money as long as they have less than $250,000 in the bank.  However, if a large “Too Big To Fail” bank went bankrupt, ALL deposits would be seized by their derivative counterparties, leaving the FDIC to step in and replace “insured” deposits.  The problem is, as of March 31, 2013, the FDIC only has a $35.7 Billion Reserve Fund[7].  If JPMorgan Chase were to fail, the FDIC’s current fund balance represents only 4% of JPMorgan’s total Core deposits base.  Thus, the FDIC would have no choice but to borrow from the US Treasury or let ALL depositors, both uninsured and INSURED lose 96% of their deposits.  This, I am afraid will be the new bailout.  Remember, prior to 2008, the largest banks had not moved their riskiest investments (derivatives) into their deposit bank.  Today, all four of the largest banks have their derivative portfolio housed inside their deposit bank.  And because of the specific and unprecedented treatment afforded derivative counterparties in bankruptcy, the risk to the financial system and the nation itself is immeasurably greater.  Ironically, the rationale for the special treatment of derivative counterparties in Bankruptcy is to avoid a financial crisis.  In reality, it may very well be the cause of the next one.