Wednesday, June 23, 2010

Goldman Sachs, Morgan Stanley Least Affected By Swaps Proposal

By Phil Mattingly and Robert Schmidt
June 23 (Bloomberg) -- Three of the five U.S. banks that dominate swaps trading already perform most transactions outside their depository institutions and would face minimal disruption from a congressional proposal to reorder the derivatives business, financial statements and banking records show.

JPMorgan Chase & Co. and Citigroup Inc. would be hit hardest by the proposal, crafted by Arkansas Senator Blanche Lincoln, to wall off swaps desks from commercial banks. JPMorgan had 98 percent of its $142 billion in current value derivatives holdings inside its bank in the first quarter of this year while Citigroup had 89 percent of $112 billion, the records show.

Morgan Stanley and Goldman Sachs Group Inc., each of which entered the commercial banking business in 2008 in the midst of the financial crisis, would be less affected. Morgan Stanley kept just over 1 percent of its $86 billion in derivatives holdings in its bank in the first quarter, and Goldman Sachs Group’s held 32 percent of its $104 billion. Bank of America Corp., which absorbed broker-dealer Merrill Lynch in 2009, had 33 percent of its $115 billion in its bank.

Lincoln, a Democrat, contends the swaps-desk measure would reduce taxpayers’ exposure to risky banking activities. The banking industry has been lobbying against the idea for weeks, saying it would drive up costs and send business to foreign lenders. The trading numbers call into question the extent of the impact and whether the congressional action would favor one business model over another. While JPMorgan and Citigroup might have to spend billions to re-capitalize their trading desks, the three others might have much smaller costs.

‘Pick and Choose’

“Any time that Congress tries to pick and choose what parts of the genie to put back in the bottle, we’re going to be creating some pretty strange creatures,” said Bill Brown, a Duke University law professor and former global co-head of listed derivatives at Morgan Stanley.

JPMorgan has the vast majority of swaps trades in its bank, though the percentage may be inflated due to the double counting of a small amount of transactions in other parts of the its businesses, according to a person familiar with the company’s derivatives operations.

Spokespeople for Morgan Stanley, Citigroup, Bank of America and Goldman Sachs declined to comment for this story.

$615 Trillion

The swaps-desk provision is the most contentious of a larger set of rules aimed at reducing risk in the system by imposing for the first time a regulatory structure for the $615 trillion over-the-counter derivatives market. The changes would also require standardized derivatives trades to be cleared through a third party and traded on an exchange or so-called swap-execution facility and would regulate the foreign-exchange swaps market.

A committee of lawmakers reconciling the House and Senate versions of financial-regulatory reform is scheduled to take up derivatives language tomorrow. Lawmakers said they have left it for the end of the debate because of its complexity.

The swaps-desk measure introduced in April by Lincoln, who is chairman of the Senate Agriculture Committee, has cleared several hurdles in the legislative process while being criticized by the banking industry, the administration of President Barack Obama, the Federal Reserve and the Federal Deposit Insurance Corp. Last week, seven U.S. regional lenders, including U.S. Bancorp and SunTrust Banks Inc., came out against the measure.

Representative Barney Frank, the Massachusetts Democrat who is leading the House negotiations, said in May that he thought the Lincoln provision “goes too far.” He has changed his stance recently, telling reporters yesterday that “the essence” of the Lincoln proposal would be in the final legislation.

“Certainly they will be totally insulated from any insured deposits,” Frank said.


Last month Frank raised the idea that one way to achieve Lincoln’s goals without unintended consequences could be to expand the scope of another proposal in the bill -- the so- called Volcker rule, a ban on proprietary trading by banks. That notion has failed to gain traction in the talks, because the majority of the swaps trading by the banks is executed for other customers and might not be covered by a prohibition on banks’ trading for their own accounts.

Negotiations have been continuing on possible exemptions for banks to the Lincoln proposal for certain types of customer- driven derivatives products. Frank said yesterday Lincoln has pushed back against those, including an exemption for desks that serve as market-makers.

“Senator Lincoln wants that to go outside” the depository institution, Frank said. “And I think she’s going to win that one.”

Lucrative Business

Selling over-the-counter derivatives is among the most lucrative businesses for the largest financial companies. U.S. commercial banks held derivatives with a notional value of $212.8 trillion in the fourth quarter, according to the Office of the Comptroller of the Currency. JPMorgan, Citigroup, Bank of America, Goldman and Morgan Stanley hold 97 percent of that total.

The calculation of derivatives holdings for the five largest banks is based on a Bloomberg News analysis of the financial records of the bank holding companies and their subsidiaries, as well as records filed with federal banking regulators and posted publicly by the Federal Financial Institutions Examination Council.

Swaps and other derivatives are financial instruments based on the value of another security or benchmark. Some instruments, including contracts that insured mortgage-backed bonds, have been blamed for fueling a financial crisis that led to the worst recession since the Great Depression.

Fed Lending

Lincoln and her supporters argue that separating swaps trading from commercial banking would protect depositors and other small customers from potentially risky trading that could bring down a firm. They also say it would prevent bailouts by denying swaps traders the assistance that the government gives to banks, such as access to emergency lending from the Fed or deposit insurance from the FDIC.

“We view this as an essential component of making the system sound so that we can get back to where banks are lending to businesses that are growing and creating jobs,” said Heather Slavkin, a senior legal and policy adviser at the AFL-CIO. “When banks use their resources to gamble in the derivatives markets, they have less capital to invest in businesses that will create good jobs for working people and grow the middle class.”

Substantial Cost

Analysts from Citigroup last week wrote that longtime commercial banks would bear the brunt of the rule, noting that they would have to give up the benefit of funding their derivatives deals with funds from deposits. The June 16 report concluded that while it is “very difficult” to determine how much it would cost to capitalize a free-standing swaps desk, the price tag is likely to be “substantial.”

“It all comes down to the cost of funding and it’s always easier inside the bank where the credit rating is going to be higher, the source of funding is more stable and it’s cheaper,” said Brian Gardner, an analyst at investment firm Keefe Bruyette & Woods. “Can you do it in a broker-dealer? Yep. People have done it before and if they have to, they’ll do it again.”

Short-Term Disadvantage

While the swaps-desk rule, if adopted, would put JPMorgan and Citigroup at a short-term disadvantage with their competitors, the big dealers have been arguing on Capitol Hill that the bigger concern is that U.S. banks will be put at a competitive disadvantage with foreign counterparts. Large dealers such as Credit Suisse AG,Deutsche Bank AG and Barclays Plc, would be even less affected by the requirement, analysts said.

Neither the European Union nor Asian countries are looking at requiring banks to wall off their derivatives trading as part of their responses to the credit crisis.

“I’m getting a lot of calls, hearing from a lot from folks who do this for a living and they really think this is going to drive the business away from U.S. banks,” Representative Scott Garrett, a New Jersey Republican, said in an interview.

To contact the reporter on this story: Phil Mattingly in Washington at; Robert Schmidt in Washington at

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