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Exotic deals threaten big banks

WASHINGTON — America's five largest banks, which already have received $145 billion in taxpayer bailout dollars, still face potentially catastrophic losses from exotic investments if economic conditions substantially worsen, their latest financial reports show.

Citibank, Bank of America, HSBC Bank USA, Wells Fargo Bank and J.P. Morgan Chase reported that their "current" net loss risks from derivatives — insurance-like bets tied to a loan or other underlying asset — surged to $587 billion as of Dec. 31. Buried in end-of-the-year regulatory reports that McClatchy has reviewed, the figures reflect a jump of 49 percent in just 90 days.

The disclosures underscore the challenges that the banks face as they struggle to navigate through a deepening recession in which all types of loan defaults are soaring.

The banks' potentially huge losses, which could be contained if the economy quickly recovers, also shed new light on the hurdles that President Barack Obama's economic team must overcome to save institutions it deems too big to fail.

While the potential loss totals include risks reported by Wachovia Bank, which Wells Fargo agreed to acquire in October, they don't reflect another Pandora's Box: the impact of Bank of America's Jan. 1 acquisition of tottering investment bank Merrill Lynch, a major derivatives dealer.

Federal regulators portray the potential loss figures as worst-case. However, the risks of these off-balance sheet investments, once thought minimal, have risen sharply as the United States has fallen into the steepest economic downturn since World War II, and the big banks' share prices have plummeted to unimaginable lows.

With 12.5 million Americans unemployed and consumer spending in a freefall, fears are rising that a spate of corporate bankruptcies could deliver a new, crippling blow to major banks. Because of the trading in derivatives, corporate bankruptcies could cause a chain reaction that deprives the banks of hundreds of billions of dollars in insurance they bought on risky debt or forces them to shell out huge sums to cover debt they guaranteed.

The biggest concerns are the banks' holdings of contracts known as credit-default swaps, which can provide insurance against defaults on loans such as subprime mortgages or guarantee actual payments for borrowers who walk away from their debts.

The banks' credit-default swap holdings, with face values in the trillions of dollars, are "a ticking time bomb, and how bad it gets is going to depend on how bad the economy gets," said Christopher Whalen, a managing director of Institutional Risk Analytics, a company that grades banks on their degree of loss risk from complex investments.

Gary Kopff, president of Everest Management and an expert witness in shareholder suits against banks, has scrutinized the big banks' financial reports. He noted that Citibank now lists 60 percent of its $301 billion in potential losses from its wheeling and dealing in derivatives in the highest-risk category, up from 40 percent in early 2007. Citibank is a unit of New York-based Citigroup. In Monday trading on the New York Stock Exchange, Citigroup shares closed at $1.05.

Berkshire Hathaway Chairman Warren Buffett, a revered financial guru and America's second-wealthiest person after Microsoft Chairman Bill Gates, ominously warned that derivatives "are dangerous" in a February letter to his company's shareholders. In it, he confessed that he cost his company hundreds of millions of dollars when he bought a re-insurance company burdened with bad derivatives bets.

These instruments, he wrote, "have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks. ... When I read the pages of 'disclosure' in (annual reports) of companies that are entangled with these instruments, all I end up knowing is that I don't know what is going on in their portfolios. And then I reach for some aspirin."

Most of the banks declined to comment, but Bank of America spokeswoman Eloise Hale said: "We do not believe our derivative exposure is a threat to the bank's solvency."

Trading in credit-default contracts has sparked investor fears because they are bought and sold in a murky, private market that is largely out of the reach of federal regulators. No one, except those holding the instruments, knows who owes what to whom. Not even banks and insurers can accurately calculate their risks.

"I don't trust any numbers on them," said David Wyss, the chief economist for the New York credit-rating agency Standard & Poor's.

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