Commentaries

Derivatives moolah

The nation’s top commercial banks are poised to generate record revenue from trading derivatives this year. And that’s as good a reason as any why no one should expect the nation’s bank to go along peacefully with a plan to regulate the trading of these sophisticated instruments.

In the first half of the year, the 25 biggest commercial banks took in $15 billion from trading derivatives, with JPMorgan Chase and Goldman Sachs being two of the biggest beneficiaries. And as things stand now, the nation’s banks will easily surpass the record $18.8 billion in derivatives trading revenue taken in during 2006.

In short, there’s a lot of money to be made from trading derivatives. So don’t expect banks to easily accept new rules that will put a crimp in this important source of income.

Oh, and just where did Goldman get most of its derivatives trading revenue from? Trading credit default swaps and other credit derivatives. The OCC reports that Goldman, in the second quarter, raked-in $1.48 billion from trading CDS-like transactions.

That ain’t chump change.

A Dimon in waiting?

It’s a natural impulse of journalists to herald a top-level corporate management shake-up as setting the stage for a new heir apparent to a strong-willed chief executive. And not surprisingly, that’s how some in the financial media are reacting to news of today’s changing of the guard of JPMorgan Chase’s investment banking division.

But it’s way to premature to draw any conclusions from the announcement that Jes Staley will become sole CEO of the investment bank, following the departure of Bill Winters and the elevation of Steve Black to a new post within the investment bank.

Winters and Black had been co-CEOs of the investment bank. Black is being bumped-up executive chairman of the investment bank and will work with Staley as he becomes sole CEO sometime next year.

But this doesn’t necessarily mean Staley, 53, becomes the man to succeed Jamie Dimon as the big kahuna at the head of the entire banking enterprise.

For starters, Dimon, who is the same age as Staley, isn’t leaving JPMorgan anytime soon. Unless Dimon makes a career move into politics–there has been speculation about him wanting to be Treasury secretary–he’s pretty well-entrenched at JPMorgan.

Also, the assumption that Staley is the heir apparent stems from the old-line thinking that the investment bank will continue to set the pace at JPMorgan. But maybe it will be the commercial banking group may that will someday rise in dominance at JPMorgan, especially if investment banks are finally required to set aside higher levels of capital in the future.

And finally it doesn’t appear Black, 57, is out of the picture either.

Cazenove lives it large in ECM

Thomson Reuters data on equity capital markets activity over the first 9 months of the year throws up some pretty exciting data if you are a Cazenove shareholder.

Top of the European league table by a country mile sits JP Morgan with $33.5 billion of deals. And that figure incorporates the ECM deals done by JPM’s UK subsidiary (50 percent plus a share) JP Morgan Cazenove. On its own JPM Caz was responsible for $24.2 billion of deals, making it top of the table by some distance. Its nearest rival was Morgan Stanley with $15.5 billion of deals.

This figure has particular resonance because of the possibility that JPM might buy out the Cazenove stake in JPM Caz.

$24.2 billion is a touch under 15 billion pounds. Underwriting fees are about 3.25 percent of value these days. Apply this to the figure and you get to about 480 million pounds. JPM Caz doesn’t get to keep all of this: it has to pay JPM for access to its balance sheet and share fees with other institutions when it sub-underwrites. There are also accountants and lawyers to pay.

A good rule of thumb might be that JPM Caz gets to keep about half the underwriting fees. That suggests that JPM Caz might have earned 240 million pounds from equity underwriting in the first nine months of the year. This figures compares with the 217 million pounds it earned from all corporate finance activities (including M&A fees) in the whole of 2008.

Were the ECM business to keep clanking along at the same rate in the fourth quarter, JPM Caz could be on track to make 320 million in revenues from just this source – not much less than the 350 million pounds the whole firm earned last year. It’s not clear exactly how much of the total revenue ECM accounts for – but somewhere around half might be a good stab.

Giving props to Wall Street’s risks

Wall Street would like you to believe that when investment banks take on risk they are largely doing it for the benefit of investors — maybe even you and me.

Bankers say much of the capital that their firms put at risk each day is to complete trades for big corporations, mutual funds, pension funds, hedge funds and university endowments. And contrary to the conventional wisdom, proprietary trading — bets made for a bank’s own behalf — is really just a small part of their business.

Lately, Wall Street’s captains of capitalism have been aggressive in pushing the “we take big risks for our customers, not for ourselves” line of argument.

That’s especially so in the wake of the public furor over the outsized trading gains at the big banks like Goldman Sachs Group, JPMorgan Chase and Barclays and even Citigroup, so soon after the collapse of Lehman Brothers.

The notion that risk is being taken for customers as opposed to for the firm’s own benefit is somehow supposed to make it seem more palatable and somehow less risky.

Still, for many, the image persists that investment banks spend a lot of time and resources gambling on stocks, bonds, commodities or currencies to generate fat profits and big bonuses. And there’s good reason for that image: Wall Street firms don’t break out the dollars they take in from client trades versus those generated by prop trading.

Yet from the perspective of Wall Street bankers, it’s perfectly logical to see much of their risk taking simply as part of trades for their customers.

A death panel for Citi

It’s way too soon for the federal government to contemplate reducing its considerable equity stake in Citigroup.

If anything, now’s the time for the feds to finally get tough with the troubled giant and establish a firm deadline for forcing Citi to shrink itself.

What better way to mark the anniversary of Lehman Brothers’ chaotic collapse and the birth of bailout nation than with a presidential directive giving Citi one year to reduce its $1.8 trillion balance sheet by half?

Harsh? Yes, but that’s the point. To restore the principle of moral hazard, the managers of giant banks need to know that there must be some consequences for their reckless actions.

Any “too big to fail” bank that gets bailed out shouldn’t be able to simply walk away to live another day as if nothing has happened.

Now don’t get me wrong. The bailout of the banking system was necessary to prevent a global financial meltdown. Propping up Citi with a $45 billion cash infusion and a federal guarantee on $300 billion in toxic assets prevented an out-of-control collapse of the mammoth bank that would have made Lehman’s bankruptcy look like a case in small-claims court.

But Wall Street historian Charles Geisst says Citi “hasn’t paid much of a price” for its many misdeeds — including SIVs, CDOs and subprime mortgages, not to mention reckless credit card and auto loans. And I suspect a lot of the populist anger over the bailout stems from the view that the banks have gotten away with murder.

What derivatives, porn have in common

The key to the Obama administration’s plan to bring order to the murky world of derivatives ultimately rests on the definition of what is a standard run-of-the mill derivative.

That’s because Team Obama wants the vast majority of derivatives — financial instruments that derive their value from an underlying stock, bond or other asset — to get traded on regulated and well-capitalized exchanges and clearing houses.

So there’s an incentive for regulators to force banks to classify as many derivatives as possible as plain vanilla transactions. But in the nearly two months since the financial regulatory overhaul was proposed, no one has come up with a workable definition for distinguishing a standard derivative from a customized one — essentially an untradeable, one-off transaction. 

Treasury Secretary Timothy Geithner has promised that the administration will propose a broad definition of a standard derivative that will be difficult for banks to “evade” by putting so many bells and whistles on a transaction that it becomes a non-standard derivative. 

But so far he’s offered nothing. 

I hope Geithner does better at coming up with a definition for a standard derivative than former U.S. Supreme Court Justice Potter Stewart did in 1964 for deciding whether a movie or book was pornographic. Back then, Stewart famously said about pornography: “I know it when I see it.” 

The Stewart approach, however, didn’t work well for sorting out the constitutionality of various state obscenity laws. And it certainly won’t work with derivatives, where even the bankers who create these exotic financial instruments often can’t come to an agreement on what separates a plain vanilla derivative from a more unique transaction.

Geithner: Look forward in anger

So Timothy Geithner went ballistic and started throwing around some obscenities during a meeting at the Treasury over the slow pace of financial regulatory reform.

Well, good for him. It’s about time someone in the Obama administration got a little red in the face over the financial crisis.

But here’s the thing: the Treasury Secretary’s temper tantrum was misdirected and he ended up taking his anger out on the wrong parties. The people Geithner really needs to be delivering a few choice words to are the nation’s bankers — especially the ones who were bailed out by U.S. taxpayers and now act as if last fall never happened.

What’s really needed now is for Geithner to get in the face of big bank honchos like JPMorgan Chase’s Jamie Dimon and Bank of America’s Ken Lewis and tell them to start moving on mortgage modifications, in order to keep people in their homes and stop the wave of foreclosures.

Now I’ve got no problem with Geithner losing his cool with Mary Schapiro in the room, as The Wall Street Journal and Reuters reported he did. (Federal Reserve Chairman Ben Bernanke and Federal Deposit Insurance Corp Chairman Sheila Bair also attended the meeting.)

The verdict is still out on whether Schapiro has the stomach to shake the lethargy out of the Securities and Exchange Commission, given her uneven track record at the Financial Industry Regulatory Authority and its predecessor regulator, NASD.

Bernanke, despite bearing a lot of the blame for getting us into the crisis, has performed rather admirably since the collapse of Lehman Brothers. It’s fair to say that the steps taken by Bernanke to pump liquidity into the financial system have done more to stabilize the economy than anything the Obama administration has done.

Jamie vs. Lloyd

Depending on your point of view, Jamie Dimon is the saint of Wall Street and Lloyd Blankfein is Wall Street’s biggest villain. Or vice-a-versa. Or maybe they’re both villains.

I suppose some might even argue that Dimon, the top honcho at JPMorgan Chase and Blankfein, the top gun at Goldman Sachs, are both saints. But the people in the pro-sainthood camp are keeping their thoughts to themselves these days.

But if charitable giving is one way to measure a person’s generosity and human spirit, Blankfein comes in slightly ahead of Dimon. Based on the most recent tax records for their respective charitable foundations, Blankfein distributed $643,850 to various groups in 2007 to Dimon’s charitable gift giving of $440,383.

Blankfein spread his money around between 38 charitable groups, many of them Jewish organizations. Dimon contributed to 16 different groups, of which a third are based in Chicago. Dimon, of course, lived in Chicago when he headed up Bank One, which eventually merged with JPMorgan.

Dimon’s single biggest donation was a $265,401 grant to Duke University, where one of his daughters goes to school. In 2005, he was a featured speaker at conference at Duke’s business school.

Other charities Dimon contributed to include: the Chicago Public Education Fund, the New York Historical Society and Access Living–a Chicago-based group that works with the disabled.

As for Blankfein, his single biggest contribution was a $100,005 grant to Prep for Prep, a New York-based that helps high-achieving minority students prepare for life at boarding schools. He also gave $100,000 each to New York Cornell Medical Center and the United Jewish Appeal Federation.

Who will be CIT’s Buffett?

The behind-the-scene negotiations surrounding CIT Group’s threatened bankruptcy filing is bringing to mind the 2001 collapse of Finova, another sizeable mid-market lender.

 On the eve of Finova’s bankruptcy filing in March 2001, Warren Buffett seemingly came to the rescue with a $6 billion loan package to help keep the financial firm running in bankruptcy and payoff creditors. The financial package, which Buffett put together with Leucadia National Corporation, came from a new company called Berkadia.

The offer from Buffett set-off an usual bidding war for the right to provide rescue money to the bankupt company. Rival bids soon emerged from GE Capital and Goldman Sachs.

Ultimately, the Buffett and Leucadia partnership prevailed. Finova, which did a lot of factoring for mid-sized companies like CIT, emerged from bankruptcy and the loan was paid off several years ago.

Finova shareholders, of course, lost out in the bankruptcy. But the firm’s creditors were treated rather well and the firm was able to continue running some of its lending business.

Right now, Reuters and others are reporting that Goldman Sachs and JPMorgan Chase are talking about providing some short-term financing of up to $3 billion to CIT. But CNBC is also reporting that the banks may be talking about providing CIT with bankruptcy financing to continue operating.

If I had to place a bet, it’s looking like a Finova all over again.

Tax Wall Street trades

Reports of the death of the investment bank have been greatly exaggerated, as Mark Twain might have put it.

Now all the chatter is about how little things have changed on Wall Street, with trading revenues and fees from underwriting stock deals padding the bottom lines of both banks. Back in September, The New York Times ran a lengthy article headlined “Wall Street, R.I.P.: The End of an Era.”

But this week the paper of record is writing about the return of the gilded pay package at Goldman.

Of course, things are different on Wall Street. Two big investment banking competitors are gone, leaving more opportunities for the remaining players. Banks like Goldman and Morgan Stanley owe a large debt of gratitude — and maybe their very existence — to the federal government.

In particular, Goldman, Morgan Stanley and JPMorgan collectively sold more than $80 billion in government-guaranteed debt. The government-backed bond sales enabled the banks to raise desperately needed capital at a time when investor confidence was at an all-time low.

It’s amazing what a big bank can do when it’s all but got the full faith and credit of the U.S. government behind it.

The big trading gains at Goldman and JPMorgan also should put to rest the notion that banks can’t generate hefty trading revenues, if forced to operate with lower levels of leverage. The gross leverage ratio — a measure of a bank’s debt to assets — dropped to 14.2 at Goldman, nearly half of what it was at the start of the financial crisis.