Dick Bove Lambastes Living Will

Bank analyst Dick Bove took to CNBC Tuesday to lambaste the “living will” and in doing so tasked regulators for requiring the largest financial institutions, including banks and derivatives exchanges, to detail how they would unwind their operations in the case of a bankruptcy. But in doing so did Bove reveal a critical flaw in big bank financial analysis on the issue?

Fighting powerful “resistance” to living wills with the goal to protect assets, consider risk management

Focusing on risk management and the macabre details of a “sudden” big bank bankruptcy are often unsettling to those longing for nothing but positive economic news. But in the world of derivatives risk management, avoiding macabre outcomes often come from analysis of what some consider the unpleasant. This is the realm into which Bove weighed in.

A sudden bankruptcy is most likely to occur during an unregulated derivatives default event and many regulators and monetary institutions, in the face of powerful bank “resistance” on the topic, have fought tooth and nail on the issue. The International Monetary Fund, for example, delivered a blunt message on June in support of living wills. The IMF and United Nations have been key players recently in fighting for risk management protocols regarding unregulated derivatives. Living wills and the ability of regulators to properly unwind a bank during “stressful” circumstances similar to what occurred in 2008 have become a critical concern inside regulatory and monetary circles as well as the Obama Administration.

Bove, however, isn’t in this camp. The respected vice president of equity research at Rafferty Capital was sharply questioning the logic behind regulators requiring large banks to focus on bankruptcy rather than more productive, profitable endeavors. He called the concept of worst case risk management in living wills “very negative” and said it causes management to take the eye off the growth ball.

“If you go to the management of any company and say, ‘I want you to concentrate on what you are going to do when you go bankrupt’ as opposed to ‘I want you to concentrate on what you should do to assist the growth of your company, help your shareholders, your employees to build the economy,’ you are going to get a very different result,” he said, saying that focusing on bankruptcy “that’s not the right way to run an industry.” To this CNBC’s Kelly Evans said “taking out the financial system and requiring a taxpayer bailout is also no way to run financial companies.”

“Why isn’t it?” Bove responded.

Think about that question for a minute. Why isn’t wiping out the financial system and requiring tax payer bailouts considered a good thing?

Evans is both diplomatic and knowledgeable. Without mentioning the restricted term “bank unregulated derivatives” on CNBC air, Evans, known to be part of a group of journalists that has a degree of inside access to those pulling strings, used a coded message when she discussed “wiping out the financial system.” Yes, this topic is being actively discussed behind the scenes and a battle is taking place between those who want to protect the world economy and that small but powerful group that is resistant. Evans was recently in Colorado covering an event that featured Larry Summers where, sources speculate, such topics were on the mind and lips of several in attendance.

The key issue consistently overlooked in the living will debate

The point that wasn’t addressed in Bove comments on living wills is perhaps most often overlooked or obfuscated. There is a two word answer to the question Bove was asking on CNBC.  “Why do banks need to have living wills?”

The answer is “unregulated derivatives,” a term that was never verbalized in the discussion.

A “living will” requires that banks clearly outline how they operate in the case of a bankruptcy. The most likely cause of a big bank bankruptcy comes from the triggering of unregulated derivatives. Regulators have worried that if a significant amount of these “insurance policies” default it could financially swamp not only the bank’s balance sheet, but overwhelm FDIC insurance and, with potential exposure well into the trillions, put the U.S. government itself at risk.

There is significant risk in derivatives risk that the large banks and their multitude of concerned employees, hardworking, valuable contributors to society, could be at risk in a derivatives default.  In part, this is what regulators are working so hard behind the scenes to protect as well as the public.

Risk in homes vs U.S. homes vs Greek government debt: Next bank bailout will involve different assets

In his comments Bove advocated for future bank bailouts, noting that the government turned a profit on its last bailout efforts. However, sophisticated quantitative modeling and fundamental analysis of the risky bank derivatives positions notes that, unlike the last bailout, which was based on the U.S. housing market, the next derivatives bailout is going to be likely based on sovereign debt, such as that in Greece.

This was never mentioned in his analysis and it makes the bailout risk modeling after a default much different. In fact, relative to U.S. housing, Greek government debt and the like, which is likely a core asset in a second big bank bailout, is a much riskier payback proposition than holding a solid U.S. housing asset.

There is a difference between unregulated derivatives risk and Google’s derivatives risk

The questions on Bove’s mind, however, were not centered on unregulated derivatives, as the word was never mentioned in the interview. What has Bove all fired up was the fact regulators dare ask large banks to plan out a bankruptcy while leaving other companies, such as Google Inc (NASDAQ:GOOG) (NASDAQ:GOOGL), alone.

The answer is clear, of course, if Bove cares to look at the issue clearly. Google does not carry the potential risk that a $70 trillion in estimated derivatives exposure does as just one bank does. If Google fails, consumer bank checking and savings accounts, along with the FDIC bailout fund, are not at risk.

In email statements to ValueWalk, Bove accurately notes that Google likely is engaged in utilizing derivatives to hedge currency risk. This comparison, however, isn’t complete with recognizing that the bank’s $50 to $70 trillion derivatives is quite different from Google’s derivatives hedging, assumed to be under $1 billion per year and are hedged against their revenues. Further, if Google fails, the U.S. government won’t be forced to enter a bailout that could easily be in the trillions. Even if a small percentage of the big bank derivatives default, much of which is exposed to interest rates and debt, the potential bailout level could very easily eclipse even the U.S. government’s practical ability to bailout the big banks.

Where do banks hold derivatives risk on their public balance sheets?

In the CNBC interview where he dismissed the need for a big bank living will, and in statements to ValueWalk, Bove noted interesting and valid points regarding how derivatives are handled on the bank balance sheet. While there has never been known formal documentation distributed, Bove, considered a banking insider, said the losses from derivatives appear in the loan losses section of the balance sheet.

Separate analysis indicates placing derivatives under “loan loss” might not entirely accurately categorize risk exposure to that exists to currencies, business failure and other issues not related to interest rates. Further, categorizing a derivatives transaction as a “loan,” implying someone is obligated to pay back a financial debt, rather than a trading activity, might seem odd. But credit to Bove for reorganizing where on the balance sheet such revenue was being placed. Although, to date, this number has never been broken out and derivatives defaults are relatively rare. In regards to where the income is placed on the income statement, that takes place in Net Interest Income, Bove said.

Defending Dick Bove: not even the former CFO of Citi understood where the derivatives risk was being reported

In Bove’s defense, those operating unregulated derivatives inside the large banks have done excellent work at obfuscating the biggest risk on their balance sheet. When former Citi Chief Financial Officer Sallie Krawcheck was recently asked at a Morningstar, Inc. (NASDAQ:MORN) press event where the derivatives revenue and risk was placed on the balance sheet, she acknowledge she did not know how derivatives were accounted for. “Banks are complex organizations,” was her response.  And she’s not alone. Her appearance followed a respected JPMorgan Chase & Co. (NYSE:JPM) executive who confirmed in a press briefing that the bank was unaware of its derivatives risk.

Bove is more knowledgeable than most, having a long history of being the loudest big bank cheerleader amid a growing concern regarding protecting the banks and markets during potential financial crisis.

What is the issue and why do banks and the economy need to be protected?

When the end of 2014 was in the books, the Bank of International Settlements pegged its upward estimate of worldwide over the counter, off-exchange traded derivatives represent near $692 trillion. More materially for U.S. banks, their primary regulator, the Office of the Comptroller of the Currency, a division of the U.S. Treasury Department, documents U.S. bank unregulated derivative exposure at $203 trillion – held almost exclusively by the four largest banks.

Even if just one percent of the derivatives insurance defaulted at the same time, the $2 trillion loss would easily exhaust the FDIC insurance pool and wipe out the market cap of the four major banks, bringing their value to zero. (JPMorgan, the largest U.S. bank, has a market cap near $243 billion, for instance.) However, confidential modeling on the topic has as one of its assumptive pegs that nearly ¾ of all exposure to the derivatives is based on interest rates in one way or another.

Major insurance firms, all who have much more diverse exposure and use generally much less leverage, have typically lower risk profiles than that of an unregulated derivative. Thus, the likelihood is that in an economic environment where sovereign debt and interest rates heats up – observers knowledgeable of the situation point to Greece as the start of interest rate and sovereign debt issues, not the end – speculate that a derivatives default, once the ball is rolling, could easily reach ten percent, or over $20 trillion in losses.

It is unclear exactly at what point the derivatives losses become too much for the U.S. government to backstop to save the four largest banks. Experts privately note that once the defaults start coming the damage will likely continue to grow over time.  What is clear is that even just a small default rate of 1 percent can wipe the four largest banks investment value to zero. This isn’t hyperbole. Derivatives revenue is said to be the highest factor among the big bank divisional profit statements, with some estimates pointing to 0.8 percent of the notional derivatives value being gross revenue to the bank, or close to $560 billion in the case of JPMorgan’s nearly $70 trillion derivatives exposure. Since none of this information is public, it is important to note this is a derivatives estimate and calculation formulas could vary. Derivatives expert Janet Tavakoli has said that the bank derivatives risk is significantly underpriced, implying reduced revenue expectations and pointing to the fact the big bank school of derivatives pricing is slightly different from the Chicago School.

Regulators are working to protect the economy, the markets and big bank jobs

This, of course, is the concern. In significantly underpricing the risk, raising the leverage beyond recommended levels and violating key principles of derivatives risk management, such as transparency, the derivatives that underlie the economic system should be an issue to which regulators are attentive. Protecting the economy, investors and jobs at the big banks can be considered patriotic duty, particularly when it comes in the face of strong and powerful resistance from the 1 percent inside the banks that don’t like to cooperate to keep the world economy secure.

Saying regulators shouldn’t conduct logical risk management exercises in an effort to save the U.S. economy and plan for a logical and known risk is, itself, a significant risk management failure.

A living will helps regulators keep the big banks intact. It protects the great legacy of the likes of JPMorgan from what is the suicide belt of unregulated derivatives. Failure to analyze this, the banks largest risk factor, is more than odd.

Watch Bove’s CNBC interview here.