Risky trading comes roaring back

The exotic financial products that nearly crippled the economy in 2008 are roaring back at the nation’s biggest banks, according to data released Friday that reform advocates worry come just as regulations to rein in risky trading are being weakened in Washington.

Demand for derivatives — contracts whose value is derived from stocks, bonds, loans and currencies — is growing as investors and corporations try to lock in low interest rates. But critics worry that there are too few rules to protect taxpayers from a market dominated by a handful of banks.

On Friday, the Office of the Comptroller of the Currency reported that banks pulled in $7.5 billion in revenue from trading derivatives in the first three months of 2013, a 7 percent increase from the corresponding period a year ago, and a 72 percent jump from the fourth quarter of 2012. The face value of the derivatives held by banks rose 4 percent over the prior year to $231.6 trillion, according to the report.

“The improvement in the U.S. economy and low interest rates led to significant capital-raising activity in the bond markets,” said Kurt Wilhelm, director of the OCC’s Financial Markets Group. “That led to strong client demand for risk-management products as investors increased their hedging and positioning against potential changes in monetary policy.”

In the run-up to the financial crisis, Wall Street firms used complex forms of derivatives to place risky, and ultimately fatal, bets on the mortgage market. Insurance giant American International Group, for instance, teetered on the brink of bankruptcy in 2008 because of its exposure to complex derivatives known as credit-default swaps.

AIG’s near collapse and the fall of Lehman Brothers led to provisions in the Dodd-Frank financial law to reduce risks for derivative trading and improve transparency. But the financial services industry has fought to narrow the scope of the regulations and delay implementation.

And some say the effort has been successful.

A week ago, the comptroller granted banks two more years to move derivative trades into separate units that are walled off from the rest of the bank. The “swaps push-out” rule bars those affiliates from accessing the Federal Reserve’s emergency-lending facilities or relying on federal deposit insurance. Critics view the delay as another blow to reform.

“Regulators have to get serious about implementing this law,” said Marcus Stanley, policy director of Americans for Financial Reform. “The derivatives market is dominated by insured banks,” which means taxpayers would be on the hook if they ran into trouble, he said.

Meanwhile, the Commodity Futures Trading Commission agreed last month to lower the number of banks from five to two that asset managers have to contact when seeking a price for a derivatives contract. The rule was intended to increase competition among the banks that issue contracts.

Four banks — JPMorgan Chase, Citigroup, Bank of America and Goldman Sachs — account for 93 percent of all the derivatives activity. Thirty-eight banks began trading derivatives in the first three months of the year, bringing the total to 1,390, according to the OCC report.

“The growth of derivatives by insured banks should worry everyone,” said Dennis Kelleher, a former Senate aide who now runs Better Markets, an advocacy group. “The problem with insured banks having massive derivatives activity is no one knows until they blow up.”

Regulators are attempting to shine more light on the opaque market by establishing new trading platforms that will require all contract prices be made public after the deal is inked. That rule will come into effect in 2015.

Wilhelm at the OCC said the current level of bank derivatives activity is no reason for concern. “We are concerned when market participants who don’t understand how to use derivatives use them . . . not when effective risk managers use derivatives,” he said.

The regulator is encouraged by the decline in counterparty credit exposure, or contracts where a bank would lose value if the counterparty to the deal defaulted. Credit exposure from derivatives fell 7 percent to $358 billion in the first quarter as rates ticked up, causing lower fair values of interest rate contracts, Wilhelm said.

Danielle Douglas covers the banking industry for The Washington Post.
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