Conventional wisdom among banking experts is that Wall Street’s successful fight last week to get a pet provision into the must-pass budget bill (or in political junkies’ shorthand, Cromnibus) as more a demonstration of power and a test for gutting Dodd Frank than a fight that mattered to them. But the provision they got in, which was to undo a portion of Dodd Frank that barred them from having taxpayer-backstopped deposits fund derivative positions, may prove to be more important than it seemed as the collateral damage from the 40% fall in oil prices hits investors and intermediaries.
Mind you, all the howling by Big Finance over this measure can’t be seen as an indicator of its importance. Yes, they have been trying to get this passed for two years. In fact, as Akshat Tewary of Occupy the SEC points out:
The provision that just got passed by the House (Section 630 of the Cromnibus) is identical to another bill already passed by the House last year – HR 992 (Swaps Regulatory Improvement Act). So the House has basically passed the same bill twice. Last year the Senate wouldn’t approve it and the banks were not happy…so the Republicans thought they would hide it in the budget bill so the Senate was forced to approve it this time.
Industry participants view any incursion on their right to make profit (as in pay themselves big bonuses) as a casus belli. That leads to regular histrionics about minor restrictions, like the TARP’s pathetically weak limits on executive bonuses.
Exerts on regulation said that the Dodd Frank provision at issue, known as derivatives push-out, was simply about the big US financial firms keeping their profit margins via continued access to cheap funding. Banks weren’t barred from engaging in this type of business but they’d have to do it in different legal entities. As American Banker explained:
What they won was the repeal of a Dodd-Frank Act provision that requires them to push out a portion of their derivatives business into subsidiaries. Big banks fought against its inclusion in the 2010 financial reform law and have been steadily fighting to repeal it ever since…
Many analysts agreed that repealing the swaps provision, which was Section 716 of Dodd-Frank, is likely to only help banks on the margins, since they are allowed to continue engaging in the activity through affiliates. But by fighting so hard, some saw signs of darker motivations.
“Wall Street’s determined lobbying on Section 716 provides compelling evidence that Wall Street’s business model depends on the ability of large financial conglomerates to keep exploiting the cheap funding provided by their ‘too big to fail’ subsidies,” said Arthur Wilmarth, a professor of law at George Washington University. “Shame on Congress if it allows megabanks to continue to pursue the same business strategy that brought us the financial crisis.”
This interpretation may be too benign. As structured credit expert Tom Adams said via e-mail:
Why are the proponents pushing so hard, with respect to the Dodd-Frank provision on derivatives pushed out of insured banks, to get this done now? Why not just wait until Republicans have control of the House and Senate? Why is Jamie Dimon calling on members now, rather than just waiting? The timing is weird.
Perhaps there are political reasons that give various parties cover they want and that’s all there is to it.
On the other hand, I’ve been closely watching the blow up in the oil and energy markets and I wonder if there may be a link to the Cromnibus fight.
Much of the recent energy boom has been financed with junk debt and a good portion of that junk debt ended up in collateralized loan obligations. CLOs are also big users of credit default swaps, which was an important target of the Dodd Frank push-out. In addition, over the past 6 months banks were unable to unload a portion of the junk debt originated and so it remained on bank balance sheets. That debt is now substantially underwater. To hedge, banks are using CDS. Hedge funds are actively shorting these junk debt financed energy companies using CDS (it’s unclear where the long side of those CDS have ended up – probably bank balance sheets and CLOs).
Finally, junk financed energy companies have been trying to offset the falling price of oil by hedging via energy derivatives. As it turns out, energy derivatives are also part of the DF push-out battle.
Conditions in the junk and energy markets are pretty dire right now as a result of the collapse in oil, as you know. I suspect there are some very anxious bank executives looking at their balance sheets right now.
Since the derivatives push-out rule of Dodd Frank was scheduled to go into affect in 2015, the potential change in managing their exposure may be causing a lot of volatility for banks now – they need to hedge in large numbers at the best rates possible. Is it possible that bank concerns (especially Citi and JP Morgan) about the potential energy-related losses are why Dodd Frank has to be changed now?
Yves here. To unpack this for generalists, CLOs or collateralized loan obligations, are used to sell highly leveraged loans, which are typically created when private equity firms take companies private. In the last big takeover boom of 2006-2007, which was again led by private equity buyouts, banks were left with tons of unsold CLO inventory on their balance sheets. The games banks played to underreport losses (such as doing itty bitty trades with each other or friendly hedge funds to justify their valuations) and the magnitude of the damage didn’t get the attention they warranted because all eyes were on the bigger subprime/CDO implosion.
This CLO decay could eventually be to be more serious than the losses after the 2006-7 buyout boom. This time, the lending was less diversified by industry. Although it hard to get good data, by all account shale gas companies have been heavy junk bond issuers, and energy-related investments have also been disproportionately represented in recent acquisitions. The high representation of energy bonds in junk issuance means they are also the largest single industry exposure in junk bond ETFs, which were wobbly even before oil started taking its one-way wild ride. Here is one stab at estimating the concentration . From ETF.com:
Energy companies have traditionally been big users of the debt markets, and while of course huge diversified companies don’t often end up in the junk bond funds, plenty of smaller, more speculative companies do….
So how does this impact junk bond ETFs? The iShares iBoxx $ High Yield Corporate Bond ETF, for instance, has roughly a 15 percent exposure to energy. Our Analyst Pick SPDR Barclays High Yield Bond ETF has more than 17 percent in energy. And since both ETFs follow indexes that eventually try and mirror the market for available debt, their exposure to energy is likely to increase, as this year was the largest in a long time for energy junk-bond issuance. Some analysts have it as high as 19 percent of all new paper that’s hit the street in 2014.
Note that the ETF concern isn’t necessarily related to derivatives exposures except to the extent that ETFs use derivatives to manage liquidity (and that creates the notorious basis risk, that the derivatives trades are at prices that don’t mesh tidily with cash market trades). Bond market ETF risk is already an official worry; the SEC’s chairman Mary Jo White flagged it as a concern for the corporate bond ETFs.
Now how do all these energy-related trouble spots relate to the Dodd Frank pushout rule? Even though there are presumably large hedging-related losses on energy prices themselves, a lot of that was likely done via exchange-traded futures and hence would not hit the banks. Moreover, there is a large cohort of industrial buyers of energy like airlines who routinely hedge their purchases who are the losers on some of these trades. That mean those costs don’t hit the financial system, and they represent an opportunity loss rather than an actual outlay. M oreover, some experts contend that any energy hedging by banks would have been exempted from the push out but one wonders about the status of customized OTC derivatives written for customers.
The fact that these issues loom large in understanding the potential economic costs to banks, and hence taxpayers, and the underlying information about exposures was so opaque as to keep it from being included in the debate is troubling in and of itself. As George Bailey of Occupy the SEC put it, “Liz’s hair isn’t on fire enough!”