Reuters' Charles Levinson has written a must-read investigative report on Wall Street's latest scheme to avoid critically important financial reforms: change a few words in their derivatives contracts and pretend that they are not guaranteeing their overseas affiliates. Wall Street's handful of biggest banks merely erase/delete the word "guarantee" from one or more of their foreign affiliates and then claim/pretend it is not guaranteed by the gigantic U.S.-based parent bank (backed by U.S. taxpayers) and, voila, their trades are not subject to U.S. regulations. And by the way, these activities really only involve Wall Street's four biggest banks - JPMorgan Chase, Citigroup, Goldman Sachs and Morgan Stanley - which control more than 90% of all the derivatives trading in the U.S.
This scheme (which we discuss in this fact sheet) is called "de-guaranteeing," but it is really just a form-over-substance loophole that allows the largest financial institutions in the U.S. to get "light touch" regulation overseas. Why? Because merely deleting the word "guarantee" does not mean that the foreign affiliates are not guaranteed or, as we at Better Markets call it, de facto guaranteed by the U.S. bank. Why? Because the U.S.-based bank directs its customers, clients and counterparties to its purportedly non-guaranteed affiliate overseas which always not coincidentally uses the same name as the U.S. bank.
Those customers, clients and counterparties understand they are doing business - albeit indirectly - with the U.S. bank and expect the U.S. bank to stand behind the foreign affiliate regardless of a deleted word. More importantly, the U.S. bank will have to stand behind the foreign affiliate (i.e., guarantee it) if it gets into trouble because the U.S. bank has directed its customers, clients, and counterparties to the foreign affiliate and will suffer serious - if not lethal - reputational damage in the markets if the U.S. bank failed to de facto guarantee its foreign affiliate in trouble.
This is a really serious issue, not a theoretical matter or theoretical risk to U.S. taxpayers. There are numerous examples of where Wall Street banks and other U.S. financial institutions have shipped their business overseas, but the risk and costs have come back to the U.S. taxpayer. And when the U.S. banks ship their derivatives trades overseas, they also ship U.S. jobs overseas and the revenue and taxes generated by those jobs. Thus, U.S. taxpayers pay in two big ways: first they lose jobs and revenue, then they have to bail out the bank when their overseas affiliates - explicitly guaranteed or not - blow up and drag down the U.S. parent company.
For example, this is exactly what Citigroup did in the middle of the 2008 financial crisis when it took $59 billion in assets back onto its balance sheet from non-guaranteed so-called "bankruptcy remote" SIVs that it had created and sponsored years before. Citi had absolutely no legal obligation to do it, but, to avoid asset fire sales and reputational damage, it nonetheless "had to" take the impaired assets back at 100 cents on the dollar. Citi had to then write down the values which reduced Citi's capital and contributed to the creditor run on the bank. The result? Citi had a liquidity crisis and was insolvent, ultimately requiring more than three bail outs to prevent its collapse into bankruptcy. Those government and U.S. taxpayer bailouts to Citi totaled almost $500 billion, more than any other single institution (and Citi remains the only too-big-to-fail U.S. bank that did not repay the taxpayer TARP funds it received).
Citi isn't the only example. There are lots of them. Remember AIG? It was a gigantic insurance company based in New York, but did its credit default swaps (CDS) gambling in "light touch" London in the years leading up to the financial crisis. But who was left on the hook to bail out AIG when its London CDS operations blew up and kick-started the financial crash? U.S. taxpayers and the U.S. government, which ended up having to provide $185 billion in a series of bailouts. Bear Stearns and Lehman Brothers are two other prominent examples of using overseas affiliates to avoid U.S. regulation.
Better Markets has been fighting Wall Street on this evasive, if not fraudulent, gambit for years. Much of our work, including the presentation we used in meetings with the Chairs, Commissioners and staff of the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC), can be found on our website here. As the Levinson investigative report points out, so far the CFTC and the SEC have failed to protect taxpayers as the law requires. Wall Street's four biggest and most dangerous banks have exploited the loophole and the regulators have not stopped them. U.S. taxpayers remain at grave risk from hundreds of trillions of mostly unregulated derivatives trading overseas by U.S. bank affiliates.
However Better Market has proposed a relative simple, market-based solution to this loophole called the "de facto guarantee test," which would enable regulators to determine which foreign affiliates are genuinely non-guaranteed and which ones are de facto guaranteed and pose an unacceptable risk to U.S. taxpayers that the law requires the CFTC and SEC to regulate. It is time for the CFTC and the SEC to adopt the de facto guarantee test and only allow genuinely non-guaranteed foreign affiliates to avoid U.S. laws and regulations.