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!”
This link to the oil price plunge does help explain the sense of urgency in tacking this provision onto a 1,600-page bill that few in Congress probably bothered to read. All they needed to know was to vote yes. And for the undecideds, Obama and Dimon came to the rescue.
Once again, a large year-end bill packed with poison had plenty of no votes on both sides, enabling imposters like Steve Israel to claim his “conscience” couldn’t let him vote yes.
On a larger scale, this Oscar performance by Washington and Wall Street helps to paint a preview of how the continuing oil price plunge is causing havoc, with all the rats now scrambling to protect their tails.
If you want to R E A L L Y understand the derivative add-on to the avoiding-the-government-shutdown bill just passed by the House – read (and pay particular attention to the utilization of Citibank’s PROPOSED wording to be included in the bill !!!!) :
Apparently you will need to scroll down to see the URL/link that was included. Here is it again just in case:
I’d also add to this and its something important to understand. For over a century the oil industry was a money printing industry, they in fact for the most part never had to go to the banks, they financed themselves. Remember the oil companies basically invented the credit card, and they didn’t use the banks, they created their own credit.
Now consider the last leg of the oil industry, the “shale revolution” which has been up to the top of their derricks in debt from day one and it is little clear who or how much profit was made in the last several years at $100 barrel.
But the more important thing to consider again is how the industry that was the life’s blood of 20th century industrial society, indeed much of modernity itself, went into debt in the last five years to a level it hadn’t in the previous 150. Says everything about the American and global economy 2014.
So the reason for the urgency is the core issue not the action itself. Urgency usually means unexpected outcome – not planned – needs to be addressed.
what if the AIG game was played again?
That is in 06 to 08′ – Paulson / Magnetar and many others created CDO’s with garbage and many knew the game – “before everyone else” – took out Naked CDS contracts with AIG as the stuffie.
why wouldn’t Saudi Arabia with ARAMCO with 10 million a day in production and know the demand at the margin and most importantly the policy response as to price and production and targets – before everyone else – take out the equivalent hedges with the banks for say 50% of one years production or $200 Billion.
They have the credit and production to take the risk and make the banks the stuffie this time?
what would a politician do with those beating down the door for his vote and the bid/ ask?
Huh? There was a huge regional bank crisis when oil prices collapsed in the early 1980s. It was driven by letters of credit deals that secure debt. A bank called Penn Square upstreamed those loans to Continental Illinois and SeaFirst in Seattle. All were financed by debt and wells being drilled which were not economical. When the music stopped the debt came crumbling down taking down Continental and SeaFirst (two of the ten largest banks in the US) as well as many others. Pretty much every bank in Texas and Oklahoma went bust.
You beat me to it! I was working in the oil fields in the Permian Basin in Texas in the early 80’s and remember Penn Square bank and the fallout from it’s collapse quite well. It caused *a lot* of layoffs (myself included) – it has been on my mind a lot recently.
Recall that before that collapse occurred in the early 1980’s a friend who was a financial officer at a major oil company at the time told me that it was important to remember that oil is a commodity.
Have wondered whether one of those banks mentioned wasn’t the template for subsequent increasingly sophisticated control frauds.
OK, I’m confused about something. Sorry if I’ve missed it, but is this mostly about using taxpayer guaranteed funds, or getting zero-interest funds? Yes the banks could make these bets through subsidiaries/affiliates, and let’s face it, they’ll get bailed out no matter what. But how much would their gambling money cost them through these subsidiaries, and how much will it cost them now? Does anyone have a figure for how much of a percentage they save on their funds, if anything? Or does this affect limits on the total amount that they can borrow at zero interest?
The cost of financing derivatives positions is higher because counterparties recognize the credit risk is greater. I don’t have an estimate of exact costs. But this is clearly a “make more dough” issue than a “oh we need this to stay in these businesses” issue.
OK, I get that – if counterparties see that funds are guaranteed that can give the banks a cost advantage. But what about the up-front cost of the funds that they use to gamble with? Does that go down, or does the amount of available ZIRP funds go up? Could their non-guaranteed affiliates borrow unlimited cash at zero interest?
Good, if less financially focused, write-up here…
Take away the junk financing, the per barrel price everything was sold on, and the new wells to keep it going, and the “Shale Revolution” suddenly looks a lot like a new “Derivative Risk Revolution”.
As we used to say in the movie business, “Rule #1 – always do it with someone else’s money”
One thing I’m not so sure about in the Kunstler piece is his claim that when the current bust craps out, “the result of that is no more junk financing for a long, long time”. Seems to me the search for yield never ends, and if there is no way to end ZIRP, then ZIRP will continue to drive investors to irrational (insane?) risk regardless of what happened to the previous bunch – or to them the last time!
I’m not really disagreeing with you here, but I am curious: why the crazed need for people with tons of money to make more money on that money? Inflation is generally low, and the things that have gone up the most in recent years (gasoline, heating oil, food at the supermarket) are hardly concerns of people with millions in the bank. Why the obsessive need to take idiotic risks when you are already well-off? I understand if you are a pensioner with a fixed asset base and need the earnings to live on, but that’s not the vast majority of the money chipped in by what I like to call “the investor class” (capitalist or rentier) that drives these markets. If I had $10 million I would hardly risk losing 80% of it on the off chance that I might double it.
Sharks gotta keep swimming….
Good point! First answer: people with lots of money tend to be those people who are obsessed with getting more money. Second answer: ‘insane risks’? When you are likely to get bailed out? Third answer: this is not abut their physical standard of living, so much as it is about status and, even more so, power. A multi- billionaire may not live any better than someone with ten million in the bank (a bigger penthouse is nice but there is only so much space that a person can physically enjoy) – but the former can be effectively above the law, the latter is vulnerable and in many ways has no more power than a regular working class stiff.
Excellent comment, James Levy. As I recall, greed/avarice is labeled one of the seven deadly sins. Only question I have is for whom it is deadly: An individual or an entire society?
It’s hard to disagree.
But there is only so much “Who could have possibly known it would turn out like this?” you can use on the institutional investor (to whom the banks are selling a lot of this rubbish). People tend to get litigious after the second or third fleecing, not that it helps much. Kind of reminds me of the housing market bubble, which I hear is back too. BUT, now that gas is super cheap, and were totally recovered and stuff, I do not know why people are so worried. You should see the sweet-ass pick-up truck and jet ski I bought with my HELOC.
Following this trail, no telling what will be exposed. After 2008, demand for oil subsided, and the price went up. It is not difficult to infer that monetary stimulus and ZIRP let those with access to the free money bid up assets, including oil. As with any supported price increase, after a lag time production increased and the price supports became increasingly expensive over time until a crash occurred. If one supposes the price of oil should never have exceeded $85 in the time frame, then investigating how it went higher and why would be fruitful. It cost a lot of people a lot of money and delayed economic recovery. Did a banking cartel effectively corner the market? How could that have happened? What margin calls and exposures occur as the price falls? Who will make money from the falling price? Along with other collapsing commodities and instruments, I think it’s fair to say there are now some in the .01 percent whose assets have come to little burros, and more light will be shed on this unhappiness in the next few weeks. In a way, it reminds me of the Corzine affair. But that would have been nothing, if the FDIC had covered his depositors’ accounts. Lesson learned. Fancy if the swap push-out came to pass, and it exposed something untoward in the big bank stress tests. That would lend a sense of urgency for a legislative remedy. But it is just a tempest in a teapot, right?
Citibank has within a few months changed their minds/lied about how much money is needed to break even in fracking The bank said in its year-end report that at least 15pc of US shale producers are losing money at current prices, and more than half will be under water if US crude falls below $55. The high-cost producers in the Permian basin will be the first to “feel the pain” and may soon have to cut back on production.
BP shows strain of Opec price war with $1bn of cuts 10 Dec 2014
Petrol to drop to £1 a litre, says Goldman Sachs 09 Dec 2014
Dollar surge endangers global debt edifice, warns BIS 07 Dec 2014
The claims pit Bank of America against its arch-rival Citigroup, which insists that the US shale industry is far more resilent than widely supposed, with marginal costs for existing rigs nearer $40, and much of its output hedged on the futures markets.
Citibank as of Dec 10 2014 is claiming that Bank of America is wrong Citibank is instead claiming that the US Shale Industry ( Fracking for Oil) can make money at around $40 a barrel.
Just this Sept. 23 Ed Morse, Citigroup Inc.’s head of global commodities research in New York, said by phone . Oil from shale formations costs $50 to $100 a barrel to produce.
If your going to lie try not to change your facts so quickly Citibank
Oct 8, 2014
Shale oil is expensive to extract by historical standards and only viable at high-enough prices, Ed Morse, Citigroup Inc.’s head of global commodities research in New York, said by phone Sept. 23. Oil from shale formations costs $50 to $100 a barrel to produce, compared with $10 to $25 a barrel for conventional supplies from the Middle East and North Africa, the Paris-based International Energy Agency estimates.
“There is probably something to the notion that if prices fell suddenly to $60 a barrel, the production growth would turn negative,” he said.
Crude prices might not fall enough to shut in production. About 70 percent of U.S. reserves would remain economic with global prices at $75 a barrel, according to Wood Mackenzie, an industry consultant based in Edinburgh.
http://www.bloomberg.com/news/2014-10-07/shale-boom-tested-as-sub-90-oil-threatens-u-s-drillers.html to read more http://my.firedoglake.com/blog/2014/12/14/did-citibank-bets-on-fracking-go-bad-is-that-why-they-pushed-congress-to-bail-out-derivatives/#respond I hope you can use this information Yves and get it to the people
… $300 trillion in derivatives on American taxpayers’ shoulders.
The bankers don’t have the money to pay so they think that the people have the money to pay
The people dont even have enough money to pay for the premiums on $300 trillion in derivatives.
Some American travelers put a Canadian flag on their backpack
and they think that nobody can recognize them as Americans
Yep. The best part is the bankers initially made money selling the junk bonds, and then the CDS. I can hear the CDS pitch now – “It’s insurance on people using gas… do you think people will stop using gas?” Now, they are going to make money shorting the same stuff, knowing it is starting to smell pretty bad in all those shale-oil boom towns. I do not watch TV much, but lately I actually saw a late-night infomercial about investing in the shale-oil boom (maybe the is common, but I was dumbstruck). Yeah, so anyway I put all my retirement money in, the yields are great, and I hear we’re going to be an oil exporter soon!
Wonder who is holding the big stinky bag with all those CDS’s in it?
There’s also a more prosaic factor at play to explain the urgency.
The regulators started to make noises in the summer that they were getting impatient with the banks foot dragging on implementation signalling they weren’t inclined to grant another extension after 6/15.
That attitude, couple with the failure to pass the repeal in the Senate kicked off a recruiting spree beginning in late august to build push-out implementation teams.
I was bombarded with call beginning in August thru thanksgiving. I know CIti was anticipating at least a 70-130 person team. I know a handfull of people who were recruited, but not hired, during the last few months. We all thought it was a little odd that the banks weren’t actually hiring, but put it down to the usual snail pace of the hiring phase.
Given the size of the teams and the shallowness of the available talent pool this was going to result in a large 4Q hit, hence reduced bonus payouts this year.
I’m sure that was a significant factor in the urgency analysis.
The Cromnibus move was, among other things, a perfect hedge against regulatory costs this year and prospectively.
You see the same thing going on in the recruiting (but not hiring ) for Volcker implementation teams.
MichaelC, Seems to me like just another iteration of “Extend & Pretend”, only in this instance WRT appearing to comply with the law until they can get the law repealed.
Is the CDS on oily junk bonds cleared through a central counterparty or are they largely customized?
If oil drops through a technical price of $40/barrel and causes the FIRE sector to implode, will Jamie Dimon proclaim: “Don’t look over here. Look over there! The USA State Department has evidence that Vlad the Bad Putin shot down oil prices with a ballistic missile.” After which, the Republican controlled US congress will impeach President Putin on the grounds of treason.
Expanding on damien’s comment (above). If the oil price drop is a KSA power play it would seem logical to use the markets to strengthen their position as they may need to keep the price low for a considerable time.
IMO, the swiftness of the price drop is the key indicator that it is not due to market conditions alone.
As most here already know, KSA is a low-cost producer and the ‘swing producer’ because they are the largest/have the most excess capacity. Thus they have varying amount of price-setting capability. In the weak economic climate that we now have, they can prop up the price or bring it down dramatically (as they seem to be doing). A much lower price stimulates the economy and will lead to increased demand, at which point KSA will again determine when, and how swiftly the price will rise.
The price drop hurts oil-producing rivals – some of which have morphed into geopolitical rivals (Russia, Iran, Qatar). KSA has a reason to inflict ‘pain’ on each of these rivals: supporting US (against Russia/Venezuela); influencing Iran’s decision on a nuclear peace deal (economic stress => political stress) ; forcing Qatar and other Gulf/OPEC countries to acknowledge/accept KSA leadership (both economic and political).
A financial windfall could help KSA to maintain pressure (for as long as it takes) to achieve the results it, and its allies, desire. (Note: Industrial economies gain a financial advantage also via the lower price for oil).
Even if KSA has not reaped trading profits during the plunge in prices, the banks are smart enough, and sly enough, to argue that what they thought was market risk was really geopolitical risk and should be therefore be covered by the government. Of course they would use such an argument to push through legislation that is as broad and advantageous to them as possible.
Aside: If this is a KSA power play, does it help explain why the US can’t come up with a plan against ISIS (5 months after ISIS’s dramatic capture of Mosul)? Perhaps planning is stalled until the Qatar-Saudi rivalry has been worked out and/or there is some determination on whether a deal will be possible with Iran?
Note: Qatari support for MB and other groups has angered KSA. And it seems that Qatar and Turkey (maybe others?) may see ISIS as useful (against Syria and Kurds, respectively) while KSA views ISIS as a potential, if not immediate real threat.
PS thanks to Andrew Watts for info and perspective (at NC, a few days back) that helped in this analysis.
H O P
As I recall, the KSA told our President that the price of oil was going too high four or five years ago. It was in the news. When they saw investors piling in, and knowing how to precipitate a price crash from experience, perhaps they were behooved to quietly purchase derivatives that paid off if the price of oil were to fall. Perhaps the lower price now isn’t a cost to them at all, if they hedged in this manner. Many thought the price of oil would never go below $100 again, and many invested as if it would keep going higher, and thus would have been on the other side of such trades.
One of the reasons I wrote this is that you see few attempt to bring people up to speed by connecting dots (sometimes a few dots but not many). One of these attempts is this:How Qatar Seized Control of the Syrian Revolution. You can piece together a lot of story from online sources.
It’s not rocket science. More importantly, it’s not ‘CHAOS!’ – a term which some commentators have picked up. There are multiple parties seek the best outcome for themselves and to anyone that does have some understanding it can easily LOOK like the interplay is chaotic.
But it is important to question everything because we are lied to and misled constantly (Gruber!). I am always asking myself how the MSM narrative differs from reality. It can be very very difficult to get to reality because most people don’t have access to the necessary info and/or don’t even know what are the right questions to ask (As skeptical as I am, it never seems to be enough).
Here is an alternative explanation for the price drop (ht Gordon in today’s links) that makes sense, in part because it places the US-Russian conflict as the primary position. On the whole, it has the ring of truth, in part because much of the opposition to US and US allies comes from Russia/Russian support for the other side.
Such is the gist of Bill Black’s explanation a few days ago.
” 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).”
– CLOs hold CDS positions?
That confused me as well. CLOs are supposed to hold only loans or bonds, wasn’t aware CDS were part of the mix. Maybe he meant to write CDO.
Whether it is a CDO or CLO or CMO, then CDS can be a part of a synthetic variation in one or more of the tranches. That banks are holding junk bond CLO’s which they cannot sell that are synthetic variations with CDS in one or more of the tranches, it would not be a great surprise. The banks packaged it that way for profit and bonuses, but if they cannot unload it on the Muppets, then the taxpayer and/or the centralized clearing party(ies) may be on the hook.
Not unpacked adequately. I should have explained.
The CLOs used to package and sell takeover loans are (obviously) from actual loans.
You can also make CLOs out of CDS (synthetic CLOs).
So they manufacture synthectic bonds from CDSs and assign them tranches in CLOs.
This exposes the vulnerability of the economics profession in its assumption that all outcomes can be measured probabilistically and the use of such models by financial institutions for estimating risk. The energy-oriented debt issued was assessed for risk, which is how the interest rate and quality of the bonds is determined. And yet no energy expert, financier or economist foresaw oil at $60 per barrel. It could not be modeled, Taleb and his black swans be damned, because the future is inherently uncertain. Jist as happened in 2007-2008 the financial industry is blindsided by a risk they didn’t even realize existed thanks to their chief economists and quants telling everyone the risks had all been identified, probably along a normal Gaussian distribution.
Keynes got it right.
It is said again and again “And yet no energy expert, financier or economist foresaw oil at $60 per barrel. It could not be modeled. ” However , within relatively recent memory – the 1970’s , the 1980’s – the global economy has experienced strong, long-lived upward and downward price swings. The literature on the boom and bust nature of the ‘commodity cycle’ is so large as to be unreadable, and as recently as last year I read on an oil investment web site that ‘the cure for high oil prices is high oil prices’.
I personally experienced this in 1882 when the oil drilling equipment manufacturer I worked for went from too-many-orders-to-process to zero orders within one month.
With rising speculation and credit commodities boomed from the mid-1990’s, and one after another – copper, timber , softs – have crashed. Energy is the last commodity domino to contract.
Anyone who has more depth to their knowledge of commodity prices please correct me.
There is no way to determine the timing or cause of such events. A year ago when swaps were issued, did anyone model that Sauid Arabia would willingly take losses or that OPEC would effectively cease to exist? Couldn’t be done, but the economics profession assumes that future outcomes can be known. And now everyone is in a riskier position than they ought be.
To late in the day to pick up this question now, but perhaps soon we could have insights on how the Koch Bros fit into this story?