Mo Money Mo Problems?

It’s like the more money we come across
The more problems we see

Chances are, Notorious B.I.G. wouldn’t be welcomed with open arms by the House Financial Services Committee. Of course, Notorious B.I.G. is dead, but I think it’s safe to say that Barney Frank and colleagues don’t know who the guy was, let alone whether somebody bust a cap in his ass. To be fair, the members of the House Financial Services Committee can’t be bothered with a dead rapper because they need to be concerned with an even more infamous moribund entity: Notorious A.I.G.

To stave off financial Armageddon in 2008, the government lent a total of $182.5 billion to a company that had transformed itself from a staid insurer into an irresponsible speculator. Now, I don’t want to go into the specifics of the bailout or why AIG needed the cash to stay alive, but to those who desperately seek answers, fear not – some time in the near future I will give a more detailed treatment of what exactly AIG Financial Products was doing with all those derivatives and how the government stepped in (in the meantime, if you really can't wait, see this article hot off the presses from Bloomberg, which delivers a less than heartening account of intrigue surrounding AIG's bailout).

In this post, I call attention to AIG because $182.5 billion is a lot of taxpayer money, and while a government transfer may have been necessary (though the actual largess was perhaps too large; again, see this bad boy) to prevent the fall of capitalism, Barney Frank isn’t interested in letting Washington make a similar gesture anytime soon. For once, I can proudly say that I wholeheartedly agree. After all, the government shouldn’t be in the business of risking 2% of GDP on behalf of a private company. And to those who think otherwise, I say move to China or India.

In an attempt to prevent another AIG-style taxpayer-led bailout, the White House and Barney Frank are apparently working on a proposal that would shift the burden of a rescue from Uncle Sam to Uncle Lloyd (Blankfein) and the rest of Wall Street. I don’t think that Blankfein and his cohorts would disagree with the need for such a shift. The real question (and source of conflict) will be how the administration plans to pull it off.

Since the full details of the scheme haven’t emerged, it would be premature of me to deliver an all-out attack on the government’s proposed course of action. Still, I will say that I fear the administration may end up unfairly penalizing certain firms for the benefit of others. The WSJ article implies that in the event of a rescue, the government will levy fees on all institutions with more than $10 billion in assets. While big institutions should pay to save the financial framework they rely on, it’s important that the punishment fits the crime.

More specifically, if, as was the case with AIG, some type of derivatives exposure is the cause of a financial firm’s collapse, the government should levy the largest fees on the banks that trade the most derivatives, not the banks that have the most assets. The distinction is an important one because in the United States, the relationship between total assets and the total notional amount of derivatives is somewhat tenuous. In other words, the biggest derivatives players aren’t necessarily the biggest banks. For example, according to the Q2 report of the Office of the Comptroller of the Currency (OCC), Wells Fargo is the nation’s fourth largest bank by assets (with about $1.3 trillion), but the total notional amount of its derivatives holdings is only about 10% of that of Goldman Sachs, which possesses 25% less in assets.

In fact, in the United States, derivatives exposure is almost entirely concentrated among just five firms (listed from most to least exposed): JP Morgan, Bank of America, Goldman Sachs, Morgan Stanley, and Citigroup. Together, these five institutions account for more than 95% of all derivatives contracts but under 60% of all assets among the top 25 derivatives holding companies in the country.

Yes, as hard as it may be for some on Wall Street to fathom, the banking system in general extends well beyond the likes of Goldman and Morgan (JP or Stanley). But, in terms of derivatives exposure, it really doesn’t. So, if another AIG came along and threatened to destroy our financial fabric with an ill-advised portfolio of credit derivatives, it would be insane to levy a higher bailout fee on Wells Fargo (which holds about $220 billion in credit derivatives) than on Goldman (which possesses over $6 trillion).

Surely, derivatives will not be the only cause of financial problems down the line, and in some senses, with its mammoth mortgage portfolio, Wells Fargo is riskier than Goldman. I am just calling attention to derivatives disparities to highlight the folly of applying an inflexible asset test to shift the bailout burden from taxpayers to financial firms. I am not saying the government will do this. Indeed, I hope they don’t since when it comes to Wall Street, Notorious B.I.G. may be wrong. It’s not clear that mo money does mean mo problems.