After Mega Banks Supervised by the Fed Lose Over $10 Billion to a Highly Leveraged Hedge Fund, Fed Puts Lipstick on a Pig in its Financial Stability Report

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by Pam Martens and Russ Martens, Wall St On Parade:

Remember the phrase “putting lipstick on a pig.” It became popular after the dot.com bust when it was learned that the big Wall Street banks had glowingly recommended “hot” new issues of stocks to their customers while secretly calling them “crap” and “dogs” in internal emails.

Putting lipstick on a pig is what the Federal Reserve is attempting to do in the Financial Stability Report it released yesterday afternoon. Both the lipstick and the pig are captured in this paragraph on page 8 of the Fed’s report:

“Banks remain well capitalized, and leverage at broker-dealers is low. Measures of hedge fund leverage are somewhat above their historical averages, but the data available may not capture important risks from hedge funds or other leveraged funds.”

To unpack the scope of the Fed’s deception in this paragraph, one needs to first understand that as a result of the repeal of the Glass-Steagall Act in 1999, the largest federally-insured banks on Wall Street now own the largest broker-dealers (trading casinos). If the “data available” is not capturing the full scale of risks between the hedge funds and the mega banks and the broker dealers they own, then there is zero evidentiary support for the Fed to state that “Banks remain well capitalized.”

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Making certain that the mega banks remain well capitalized should be the number one priority of the Fed and its team of bank examiners, since the last time the Fed was caught with its blinders on resulted in $29 trillion in cumulative bailouts to resuscitate a pulse back into the financial system of the largest super power in the world.

In 2008, century-old Wall Street firms were blowing up faster than Roman Candles in a fireworks factory explosion: Bear Stearns, gone. Lehman Brothers, gone. Citigroup, insolvent and propped up by the Fed. Fannie Mae and Freddie Mac, put into government conservatorship – where they remain. AIG, propped up with government money in order to bail out its derivatives contracts with the mega banks. And on and on.

One would have thought the Fed’s abject failure as a regulator in the leadup to the financial crisis of 2008 would have resulted in Congress stripping it of any supervisory role going forward. Instead, Congress fell victim to Wall Street lobbying and actually increased the Fed’s oversight role of the mega bank holding companies in its 2010 Dodd-Frank financial “reform” legislation. Every American is far worse off as a result of that Congressional sellout.

What the Fed is attempting to sheepishly acknowledge in that oblique paragraph cited above is that 13 long years after the greatest financial crash since the Great Depression, it once again has no firm grip on the hidden dangers lurking at these mega Wall Street banks.

Congress learned just how inadequate the Fed’s much ballyhooed stress tests of these banks are when media reports emerged in late March that the Archegos Capital Management hedge fund had blown up as a result of obtaining as much as 90 percent margin loans on a handful of highly concentrated stock positions from Fed-supervised banks. Those banks have thus far reported more than $10 billion in losses from Archegos.

Archegos is just one of more than 3,000 family office-styled hedge funds operating in North America for which the Fed has no clarity. In Table 3 of the Fed’s most recent Financial Stability Report, it lists hedge fund assets in the U.S. financial system at $8 trillion. But since it has no idea of how much exposure banks have to family office hedge funds, that figure is likely to be wildly underestimated.

The mega banks have been able to dodge reporting the family office hedge fund margin loans to their regulators by structuring the loans as derivative swap agreements – private, over-the-counter (bespoke) contracts between two parties that regulators have little to no granular information about.

One federal regulator that does have some non-granular data about these derivative contracts is the Office of the Comptroller of the Currency (OCC) – a regulator for whom President Biden has yet to nominate a permanent head.

According to the OCC’s “Quarterly Report on Bank Trading and Derivatives Activities” for the quarter ending December 31, 2020, equity (stock) derivative contracts at federally-insured banks and savings associations have exploded from $737 billion (notional or face amount) since the Wall Street banks last blew themselves up in 2008 to $4.197 trillion notional as of December 31, 2020. That’s a heart-thumping increase of 469 percent in just 12 years.

The OCC report specifically notes that these equity derivative contracts are being held in the federally-insured banks – not at their broker-dealers.

The OCC report notes further that “The four banks with the most derivative activity hold 88.4 percent of all bank derivatives.” Those banks are: JPMorgan Chase, Bank of America, Citigroup’s Citibank, and Goldman Sachs – all supervised by the Fed. (The first three rank in the top four of the largest federally-insured banks in the U.S. Rounding out the top four is Wells Fargo.)

The official report on the 2008 financial crisis from the Financial Crisis Inquiry Commission determined that derivatives played a central role in the crash, noting that “over-the-counter derivatives contributed significantly to this crisis” through “uncontrolled leverage; lack of transparency, capital, and collateral requirements; speculation; interconnections among firms; and concentrations of risk in this market.”

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