Probably won't need this guy

A recent post by Ellen Brown at Web of Debt claims that US bank depositors could lose some of their money if the bank failed, citing this paperfrom the FDIC and The Bank of England. She quotes from the paper, bracketed material is her addition:

An efficient path for returning the sound operations of the G-SIFI to the private sector would be provided by exchanging or converting a sufficient amount of the unsecured debt from the original creditors of the failed company [meaning the depositors] into equity [or stock]. In the U.S., the new equity would become capital in one or more newly formed operating entities. …

Brown doesn’t mention the National Bank Depositor Preference Act, 12 USC § 1812 (d)(11). That law says that in a bank receivership, the depositors get first call on any assets. It seems almost impossible that a bank could lose enough money to cause losses to depositors. But I have other questions about the paper.

The Rosy Assumptions of the FDIC/BOE Paper

The paper is a joint exercise between the FDIC and the Bank of England. It is designed to help with the difficulties presented by international financial entities that are too big to fail. The parties agree that the strategy for dealing with a failed TBTF should “assign losses to shareholders and unsecured creditors”, p. 2, and there is where the problem arises. When you deposit money in a bank, the money belongs to the bank, and you become an unsecured creditor. You have the right to get the money back from the bank, but if it doesn’t have enough to go around, you are just one of many creditors. In the US, we ameliorate that problem through the FDIC, which insures your deposit up to $250K, and the distribution priorities.

Prior to Dodd-Frank, the FDIC only had the ability to take over a failed bank. According to the FDIC/BOE paper, under Dodd-Frank, the FDIC would take over just the parent company of the TBTF bank, leaving the subsidiaries in full operation. The assets of the parent would include the stock it holds in its subsidiaries. Those would be transferred to a bridge financial holding company and hopefully the subsidiaries would continue their operations under new management. The shareholders of the parent and probably the unsecured creditors of the parent would be wiped out.

The FDIC would evaluate the subs to make sure they are adequately capitalized, then transfer them into private hands. The FDIC/BOE paper says “By leaving behind substantial unsecured liabilities and stockholder equity in the receivership, assets transferred to the bridge holding company will significantly exceed its liabilities, resulting in a well-capitalized holding company.” P.6. Well, maybe.

Shouldn’t We Think About Derivatives?

The FDIC/BOE paper doesn’t use the word “derivatives”, and it’s not wise to worry only about the problems we’ve seen in the past. However, derivatives retain the ability to blow a hole in the balance sheet of a TBTF bank, as we saw in the London Whale trades. As an example, let’s look at JPMorgan’s balance sheet from most recent 10-K. Total deposits are nearly $1.2 trillion, and other debt totals about $950 billion of which some may be secured. Total net worth of the consolidated enterprise is $204 billion. The balance sheet includes an entry for trading liabilities, which includes anticipated losses on derivatives (10-K, p. 214). The figure was about $132 billion, of which about $71 billion is “derivatives payable”. P. 221. We get another estimate of exposure to derivatives from the OCC call reports on derivatives. According to the most recent figures , JPMorgan bank subs had a total credit exposure to risk based capital ratio of 228%. This is a crucial number:

… Total Credit Exposure … is equal to the sum of Net Current Credit Exposure and Potential Future Exposure. The first is the net amount owed to the bank if all contracts were suddenly liquidated. The second is an attempt to estimate the potential future losses, using a formula developed by regulators. This number is compared to the Total Risk-Based Capital, which is the sum of Tier One Capital and Tier Two Capital. This calculation effectively excludes Tier Three Capital, the assets for which there is no liquid market and no clear method of calculating value.

If we accept the OCC guess as the losses in a meltdown, it looks like total capital would be wiped out, and the enterprise would be insolvent*. Most of JPMorgan’s derivatives are in its bank subsidiaries**. We don’t have separate financials for the bank subs, but it’s a good guess that they would be insolvent too. That is because derivatives are given special protections by Dodd-Frank. Counterparties to JPMorgan’s losing trades have a legal right to demand collateral to cover their prospective losses right up to the date of the receivership, and beyond, if the bank subsidiaries themselves aren’t put into receivership as FDIC/BOE paper assumes. That money is gone, and won’t be available to cover deposits, because Dodd-Frank includes provisions just like the Bankruptcy Code does to protect the counterparties. See 12 USC § 5390(c)(8). The collateral is always the most liquid kind, cash or treasuries. The result of these provisions is to deplete the liquid assets of the banking subsidiaries. You may recall that Lehman Brothers is suing JPMorgan alleging that it made $8.6 billion in unjustified collateral calls in the last four days before Lehman collapsed.

In this ugly scenario, the capital of the bank subsidiary could be wiped out, and it would make the bank effectively insolvent. Someone would have to make up that loss, and we are back where we started: the FDIC/BOE paper says that would include unsecured creditors. Depositors are unsecured creditors. The FDIC would have to take the bank subsidiaries into a straight bank receivership and get rid of liabilities that way. In a bank receivership, the depositors get first preference for payment. 12 USC § 1812(d)(11).

In the case of JPMorgan, there are hundreds of billions of dollars of unsecured creditors other than depositors. It is inconceivable that depositors will have to take a loss. But, in the ugly scenario, exactly how does the FDIC think the bank subsidiary has a strong capital position? What about its miserable liquidity situation? Isn’t that relevant? How would a buyer evaluate the rest of the assets?

And here’s another question. If the bank subsidiary goes into a receivership, the counterparties to its derivatives contracts can expect that the derivative contracts would be terminated, leaving them as unsecured creditors behind the depositors. What would the effect be on their financial condition? Wouldn’t the TBTF bank be pecked at by vulture derivatives counterparties, just like Lehman Brothers? Why are these derivatives in the bank subsidiaries anyway? Our bank regulators can’t even manage to get the regulations under the Volcker Rule done. How can we expect them to cope with this kind of mess? Why don’t we just break them up?

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*The financial statements say Tier 1 and Tier 2 capital total about $194 billion. Most of the derivatives are in the bank subsidiaries. The OCC’s calculations indicate exposure of 228% of Tier 1 and Tier 2 capital, which is about $442 billion. The financial statements include $132 billion in exposure for trading liabilities of which I think about $71 billion relates to derivatives. Total net worth is $204 billion. If the OCC got the derivatives right and nothing else changed, the entire enterprise would be insolvent by more than $100 billion in book values, perhaps in the range of $160 billion if I’m right about reserves for derivatives losses, and assuming that the positive trades remain intact. We don’t know what the bank and brokerage subsidiaries actually look like so we are reduced to guessing about the losses. I’d say it’s pretty likely bank subs are insolvent taken together. A complete list of subsidiaries is here.

**Compare Table 1 with Table 2 here.

Photo by Tony Gonzalez via Flickr