Wall Street Erases the Line Between Its Jocks and Nerds – WSJ

Wall Street Erases the Line Between Its Jocks and Nerds
— Read on www.wsj.com/articles/wall-street-erases-the-line-between-its-jocks-and-nerds-1534564810

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PwC faces 3 major trials that threaten its business

Philip Merrill’s notes:

1) Do Auditors need to be seasoned professionals in the businesses they audit?

2) Or, CPA’s that have to take the customers word for accuracy in financial statement representation including notes.

By Francine McKenna

Published: Aug 15, 2016 12:32 p.m. ET

The Big Four global audit firms go to court all the time but are rarely put on trial.

PricewaterhouseCoopers LLP, the U.S. member of the global professional-services giant, is currently facing not one, not two, but three significant trials for allegedly negligent audits. An unfavorable verdict in the trial currently playing out in a Florida state court could inflict a significant monetary wound. That, combined with a possible unfavorable judgment in another trial scheduled for federal court in Alabama in February of 2017, and a third in a Manhattan federal court within the next year, may be fatal.

The case against PwC brought by the Taylor Bean and Whitaker bankruptcy trustee is quite unusual, said Tom Rohback, an attorney with Axinn Veltrop & Harkrider. That’s because it is one of the few cases from the credit crisis seeking to hold auditors responsible for crisis-era losses to actually go to trial.

“Beyond the $5.5 billion sought, the case is unusual because the plaintiff is the trustee of the entity that committed the fraud and is suing not its own audit firm but the audit firm of the institution it defrauded,” he said. “

Settlements preferred

In the U.S. the Big Four audit firms have, in recent history, almost always settled because of the fear that one catastrophic jury verdict could shut them down for good. In addition, trials show the public just how often auditors fail to detect fraud. Settlements prevent the public from hearing that in open court and typically put partners’ pretrial testimony under confidential court seal forever.

‘The trial has the potential to influence public perception of auditors, as well as strategies used by the plaintiff lawyers that try cases against them, regardless of the eventual verdict.’

Tom Rohback, Axinn Veltrop and Harkrider

The bankruptcy trustee for Taylor Bean & Whitaker Mortgage Corp., once the 12th-largest U.S. mortgage lender, sued PwC for $5.5 billion in damages in 2012 after the bank went bankrupt in August 2009. Federal regulators, not the bank’s auditor, Deloitte, uncovered a $3 billion fraud involving fake mortgage assets. The bankruptcy trustee for Taylor, however, alleges that PwC was negligent in not spotting the fraud from its perch as auditor of Colonial Bank, which bought the allegedly fake mortgages that Taylor Bean had originated and that made Taylor Bean’s losses worse.

Beth Tanis, the lead attorney for PwC from the firm King & Spalding, issued a statement at the beginning of the trial: “PricewaterhouseCoopers did not audit or perform any other services for Taylor Bean. With regard to the services performed for Colonial Bancgroup, one of the targets of Taylor Bean’s fraud, PricewaterhouseCoopers did its job,” said Tanis. “As the professional audit standards make clear, even a properly designed and executed audit may not detect fraud, especially in instances when there is collusion, fabrication of documents, and the override of controls, as there was at Colonial Bank. We are confident that a jury will understand the applicable rules and standards in this case and decide accordingly.”

A spokeswoman for PwC declined to provide further comment.

Six Taylor Bean executives went to jail for their roles in the fraud. The bank’s former chairman, Lee Farkas, was sentenced to 30 years in prison. Taylor Bean auditor Deloitte settled with the trustee for an undisclosed amount in 2013.

The bankruptcy route

Colonial Bank, a Montgomery, Ala., institution with $25 billion in assets, also filed for bankruptcy in 2009. The Colonial Bank bankruptcy trustee and the Federal Deposit Insurance Corp. brought a lawsuit in 2012 against PwC for negligence as the auditor of Colonial Bank, claiming $1 billion in damages. That case is scheduled to go to trial in February.

The FDIC’s suit was its first against an auditor for a financial-crisis-era bank fraud or failure. Crowe Horwath LLP, Colonial’s outsourced internal audit firm, is also named in the Colonial suit. (Remember Arthur Andersen internal and external auditor for Enron?)

Tanis, in her opening statement at the trial on Aug. 9, said that no one at Taylor Bean relied on PwC’s audit of Colonial Bank, even though Colonial was Taylor Bean’s biggest mortgage buyer.

“There will be no document showing you that these directors or anybody else at Taylor Bean ever received these Pricewaterhouse audit reports, actually read these Pricewaterhouse audit reports and relied on them,” she said.

Largest Banking Regulatory Fines (2008 – 2015)

Bank

Date

Fine Amount

Description

Bank of America

August 2014

$16,650,000,000

Settlement to resolve allegations of misselling mortgage-backed securities. The … Show More

Bank of America

February 2012

$11,820

Part of the National Mortgage Settlement; $8.6bn paid as relief to borrowers, $3 … Show More

Bank of America

January 2013

$11,600

Settlement resolving repurchase requests of faulty mortgage sales. Bank agreed t … Show More

Bank of America

March 2014

$9,330

Settled charges of misleading investors over mortgage backed securities.

Citigroup

July 2014

$7,000,000,000

Settled charges of misleading investors over mortgage backed securities. $4bn pa … Show More

JPMorgan Chase

November 2013

$13,000,000,000

Part of $13bn settlement; $4bn paid as relief to consumers, $2bn paid as civil penalty

Wells Fargo

February 2012

$5,350

Part of the National Mortgage Settlement; $4.3bn paid as relief to borrowers, $1 … Show More

JPMorgan Chase

February 2012

$5,290

Part of the National Mortgage Settlement; $4.2bn paid as relief to borrowers and … Show More

JPMorgan Chase

October 2013

$4,000

Part of $13bn settlement; settles federal and state claims by FHFA.

JPMorgan Chase

October 2013

$4,000

Settlement over securities laws violations in connection with mortgage-backed se … Show More

Bank

Date

Fine Amount

Description

Data collected from the Financial Times on May 20, 2015.

See more details ›

Taylor Bean’s employees, customers and creditors, who all lost something when the firm went bankrupt, were relying on Colonial Bank to operate as an honest business partner that was accurately reflecting its financial obligations to Taylor Bean, a point emphasized by Steve Thomas, the attorney for the Taylor Bean trustee, in his opening statement on Tuesday.

Thomas told the jury that PricewaterhouseCooper’s failure mattered, because many people were counting on it to do its job. “PwC was lending credibility to Colonial’s financial statements. PwC’s failure mattered because Taylor Bean and Whitaker, and others, relied on PwC to do its job,” he said.

‘PwC was lending credibility to Colonial’s financial statements. PwC’s failure mattered because Taylor Bean and Whitaker, and others, relied on PwC to do its job.’

Steve Thomas, attorney for Taylor Bean trustee

PwC and the other Big Four accounting firms all had major clients that failed, were bailed out or were effectively nationalized during the crisis. None of those cases went to trial. Ernst & Young LLP paid $99 million to investors and $10 million to the New York attorney general’s office for its role as auditor of Lehman Brothers Holdings Inc. KPMG settled its exposures early, and within a week of each other in 2010 settled for an undisclosed amount for its audit of New Century, another big mortgage originator, and paid $24 million for its audits of Countrywide Bank, which was distressed when it was sold to Bank of America BAC, +0.74% .

Deloitte settled its exposure as auditor of Bear Stearns for $19.9 million. Bear Stearns was bought for a relative pittance by J.P. Morgan JPM, +0.61%  during the crisis. Deloitte was also the auditor of Washington Mutual and contributed $18.5 million to a settlement with investors for its negligent audits. Deloitte went on to earn hundreds of millions of dollars reviewing J.P. Morgan’s exposure to foreclosure fraud claims for Bear Stearns and Washington Mutual mortgages it inherited as part of those purchases.

The litigation hit

Those settlements pale in comparison to the total of $6.5 billion that Taylor Bean and Colonial Bank trustees are looking for from PwC. On Aug. 5 U.S. District Judge Victor Marrero in Manhattan rejected PwC’s request to dismiss MF Global’s lawsuit alleging professional malpractice that contributed to the October 2011 bankruptcy of the brokerage firm once run by former New Jersey Gov. Jon Corzine. That suit is seeking $1 billion in damages, bringing the total potential claims PwC is facing over a very short period to $7.5 billion.

Jim Peterson, a former in-house attorney for Arthur Andersen and the author of the book “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms,” has periodically asked the question on his blog: “How big is the ‘worst case’ litigation hit that would disintegrate one of the surviving Big Four?”

Back in September 2006, a report by the consulting firm London Economics to the EU markets commissioner modeled the collapse of a Big Four partnership in the U.K. That model quantified the level, according to Peterson, “of personal sacrifice, beyond which the owner-partners would lose confidence, withdraw their loyalty and their capital, and vote with their feet.”

Peterson’s analysis concluded that critical numbers of partners would defect and put a firm into a death spiral, if they faced a partner-income-distribution reduction of 15% to 20% that extended over three or four years. Peterson extended the figures to the global level to calculate breakup figures for the Big Four. That brought the number down from an optimistic maximum of about $7 billion to about $3 billion.

However, global numbers assume that a Big Four network under deadly financial threat could hold it together and count on the support of its member firms and partners around the world. But that’s not what happened to Arthur Andersen after the bankruptcy of client Enron and an indictment for obstruction of justice in 2001. Instead, Andersen’s non-U.S. member firms flew the coop in 2002, and the firm itself was forced to fold.

Based on the experience of Arthur Andersen, it is unlikely, Peterson told MarketWatch, that PwC’s non-U.S. member firms would pitch in to pay a U.S.-based catastrophic court judgment or a series of them. Peterson’s most recent update of his tipping-point calculation, completed in early 2015, assumes the U.S. firm is left to pay its own way out, as was Andersen’s U.S. firm. The worst-case tipping points for the U.S. practices shrinks from the $3 billion global number down to $900 million for the most financially vulnerable of the four firms.

These numbers matter, according to Peterson, because the loss of another Big Four firm would throw the entire system into chaos.“There is no contingency plan or readiness among the three survivors to stay in an even more risky business or take on the failed firm’s risky clients or outstanding litigation claims,” he said.

The Petrobras angle

The three lawsuits against PwC that are on trial or going to trial in the next year all name only the U.S. firm as a defendant. Another large case names PwC’s Brazil member firm for its allegedly negligent audits and failure to detect a multibillion-dollar bribery and corruption fraud at the state-sponsored oil company Petrobras.

Those plaintiffs, which include the Bill Gates Foundation, could decide to name PwC U.S. as a defendant or eventually require the U.S. firm to ante up to pay a verdict that would otherwise knock out the Brazilian firm, a key cog in its service network for multinational clients.

MarketWatch asked Rohback why PwC would choose to go to trial given the stakes. “Oh, they probably didn’t choose to try the case. They just haven’t hit on a settlement number they can stomach yet,” he said.

PwC has few options at this point, Rohback said. “There’s still time to settle, and they could win it. If they lose, they can ask the judge for a stay in enforcing any judgment until an appeal can be heard.”

Florida law prohibits judgments that would bankrupt a defendant. PwC would probably be reluctant to go to court and open its books to prove it was too poor to pay a judgment. However, in a previous case against an audit firm in Florida tried by Taylor Bean trustee attorney Thomas, the court allowed audit-firm partners to be paid “profits” each year before considering claims of any parties damaged by the firm’s frauds or gross negligence.

Audit firms have no duty to reserve for or disclose serious legal contingencies, since they are partnerships. Thomas had to file a motion to force discovery because he suspected that while the case was under appeal “assets have been or are being dissipated or diverted while such a stay is in place.”

Francine McKenna

Francine McKenna is a MarketWatch reporter based in Washington.

Email Francine at fmckenna@marketwatch.com

Deutsche Bank, Barclays Seen Losing Millions Amid Swiss Rout

Bloomberg Jan 16, 2015

Deutsche Bank AG and Barclays Plc (BARC ▼ -1.58% 224.35), two of the world’s largest currency dealers, were among the first banks to suffer losses after the Swiss central bank’s surprise decision to abandon a cap on the franc, people with knowledge of the matter said.

Deutsche Bank lost $150 million on Thursday amid an unexpected surge in the Swiss franc, said one of the people, who asked not to be identified because the figure hasn’t been made public. Barclays’s losses were less than $100 million, another person said. The losses are still being calculated, and may spread to other asset classes, including equities, one of the people said.

The Swiss National Bank’s decision to scrap the three-year-old ceiling sent the franc up as much as 41 percent versus the euro, while climbing more than 15 percent against all of the more than 150 currencies tracked by Bloomberg. Two brokers, Global Brokers NZ Ltd. and Alpari (UK) Ltd., said they were forced to shut down amid continuing market turmoil.

Barclays’s losses won’t have a material impact on results and the London-based bank is able to fulfill all spot Swiss currency trades made, said the person.

Oil Crash Exposes New Risks for U.S. Shale Drillers

Photographer: Andrew Burton/Getty Images

U.S. shale oil production.

Tumbling oil prices have exposed a weakness in the insurance that some U.S. shale drillers bought to protect themselves against a crash.

At least six companies, including Pioneer Natural Resources Co. (PXD) and Noble Energy Inc. (NBL), used a strategy known as a three-way collar that doesn’t guarantee a minimum price if crude falls below a certain level, according to company filings. While three-ways can be cheaper than other hedges, they can leave drillers exposed to steep declines.

“Producers are inherently bullish,” said Mike Corley, the founder of Mercatus Energy Advisors, a Houston-based firm that advises companies on hedging strategies. “It’s just the nature of the business. You’re not going to go drill holes in the ground if you think prices are going down.”

Oil Prices

The three-way hedges risk exacerbating a cash squeeze for companies trying to cope with the biggest plunge in oil prices this decade. West Texas Intermediate crude, the U.S. benchmark, dropped about 50 percent since June amid a worldwide glut. The Organization of Petroleum Exporting Countries decided Nov. 27 to hold production steady as the 12-member group competes for market share against U.S. shale drillers that have pushed domestic output to the highest since at least 1983.

WTI for January delivery rose $2.41, or 4.5 percent, to settle at $56.52 a barrel today on the New York Mercantile Exchange.

Debt Price

Shares of oil companies are also dropping, with a 49 percent decline in the 76-member Bloomberg Intelligence North America E&P Valuation Peers index from this year’s peak in June. The drilling had been driven by high oil prices and low-cost financing. Companies spent $1.30 for every dollar earned selling oil and gas in the third quarter, according to data compiled by Bloomberg on 56 of the U.S.-listed companies in the E&P index.

Financing costs are now rising as prices sink. The average borrowing cost for energy companies in the U.S. high-yield debt market has almost doubled to 10.43 percent from an all-time low of 5.68 percent in June, Bank of America Merrill Lynch data show.

Locking in a minimum price for crude reassures investors that companies will have the cash to keep expanding and lenders that debt can be repaid. While several companies such as Anadarko Petroleum Corp. (APC), Bonanza Creek (BCEI) Energy Inc., Callon Petroleum Co., Carrizo Oil & Gas Inc. and Parsley Energy Inc., use three-way collars, Pioneer uses more than its competitors, company records show.

‘Best Hedges’

Scott Sheffield, Pioneer’s chairman and chief executive officer, said during a Nov. 5 earnings call that his company has “probably the best hedges in place among the industry.” Having pumped 89,000 barrels a day in the third quarter, Pioneer is one of the biggest oil producers in U.S. shale.

Pioneer used three-ways to cover 85 percent of its projected 2015 output, the company’sDecember investor presentation shows. The strategy capped the upside price at $99.36 a barrel and guaranteed a minimum, or floor, of $87.98. By themselves, those positions would ensure almost $34 a barrel more than yesterday’s price.

However, Pioneer added a third element by selling a put option, sometimes called a subfloor, at $73.54. That gives the buyer the right to sell oil at that price by a specific date.

Below that threshold, Pioneer is no longer entitled to the floor of $87.98, only the difference between the floor and the subfloor, or $14.44 on top of the market price. So at yesterday’s price of $54.11, Pioneer would realize $68.55 a barrel.

‘Better Upside’

David Leaverton, a spokesman for Irving, Texas-based Pioneer, declined to comment on the company’s hedging strategy. The company said in its December investor presentation that “three-way collars protect downside while providing better upside exposure than traditional collars or swaps.”

The company hedged 95,767 barrels a day next year using the three-ways. If yesterday’s prices persist through the first quarter, Pioneer would realize $1.86 million less every day than it would have using the collar with the floor of $87.98. That would add up to more than $167 million in the first quarter, equal to about 14 percent of Pioneer’s third-quarter revenue.

Exposure Cost

The strategy ensures that the bulk of Pioneer’s production will earn more than yesterday’s market price. The three-ways will also prove valuable if oil rises above the subfloor.

“What they have is much better than nothing,” said Tim Revzan, an analyst with Sterne Agee Group Inc. in New York. “But they left some money on the table that they could have locked in at a better price.”

Noble Energy used three-ways to hedge 33,000 barrels a day, according to third-quarter SEC filings. Assuming yesterday’s prices persist, Houston-based Noble will bring in $50 million less in the first quarter than it would have by locking in the floor prices.

Bonanza Creek, based in Denver, Colorado, set up three-ways with a floor of $84.32 and a subfloor of $68.08, SEC records show. If prices stay where they are, the company will realize $8.1 million less in the first quarter than it would have by just using the floor.

Ryan Zorn, Bonanza Creek’s senior vice president of finance, said that the comparison doesn’t take into account the advantages of the strategy. The proceeds from selling the $68.08 puts helped pay for the protection at $84.32, without which Bonanza Creek would likely have purchased cheaper options with a lower floor.

’Much Better’

“The other comparison is if we’d done nothing,” Zorn said. “I view it as being much better than being unhedged.”

Representatives for Anadarko, Noble, Carrizo and Parsley didn’t return e-mails and phone calls seeking comment.

“Because we’ve had high energy prices for so long, it could have given them a false sense of confidence,” said Ray Carbone, president of Paramount Options Inc. in New York. “They picked a price they thought it wouldn’t go below. It has turned out to be very expensive.”

Callon (CPE)’s first-quarter three-ways cover 158,000 barrels with a floor of $90 and a subfloor of $75, company filings show. Callon, based in Natchez, Mississippi, will get $3.3 million less that it would have realized by using the $90 floor, assuming prices stay where they are.

“Certainly, if we’d had the foresight to know prices were going to crater, you’d want to be in the swap instead of the three-way,” said Eric Williams, a spokesman for Callon. “Swaps make more sense if you knew prices were going to go down the way they did, but a few months ago everyone was bullish.”

To contact the reporter on this story: Asjylyn Loder in New York at aloder@bloomberg.net

To contact the editors responsible for this story: Dan Stets at dstets@bloomberg.net Richard Stubbe

Will Wildcatter’s ‘Naked’ Gamble on Oil Prices Pay Off? Continental Resources CEO Hamm Sells Hedges, Betting on Quick Rebound in Crude

By ERIN AILWORTH, GREGORY ZUCKERMAN and DANIEL GILBERT WSJ
Dec. 9, 2014 12:35 p.m. ET

Harold Hamm ’s willingness to make risky bets helped him build Continental Resources Inc. into the one of the biggest oil producers in North Dakota’s Bakken Shale and a symbol of the U.S. energy boom. But his latest gamble—a quick rebound in crude prices—is rubbing some investors and analysts the wrong way.

Mr. Hamm, who founded Continental and owns 68% of its shares, announced in early November that the company had cashed in almost all of its financial hedges that guaranteed it could sell millions of barrels of oil for about $100 apiece. The company said it had realized $433 million in cash from selling the hedges, some of which ran through 2016.

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“We feel like we’re at the bottom rung here on prices and we’ll see them recover pretty drastically, pretty quick,” Mr. Hamm said on a Nov. 5 call with analysts. He said the Organization of the Petroleum Exporting Countries was pushing down oil prices to slow America’s expanding energy output.

Now, removing the hedges, known in the industry as “going naked,” looks misguided even to some of the company’s fans, after the recent tumble for oil prices. The benchmark price for U.S. oil has continued to slide, falling from $81 in late October to $63.82 on Tuesday.

If Continental had kept the contracts that insured it against lower crude prices, it could have reaped $52 million more for its oil in November, according to a Wall Street Journal review of company disclosures. And it might have received $75 million more this month, assuming current conditions continue.

The Journal’s calculation of about $127 million in forgone revenue is similar to projections by several Wall Street analysts, and those projections would continue to rise in the coming months if oil prices remain below $96 a barrel.

ENLARGE
The company said it disagreed with the Journal’s figures but wouldn’t provide its own, except to say that after figuring in revenue it received for selling its hedges, it expects the “net negative effect” to be $25 million to $30 million in November and December. It sold nearly $1.2 billion of oil and gas in the third quarter and reported net income of $533 million.

“It was a bad move with terrible timing,” said Gregg Jacobson, a portfolio manager at Caymus Capital Partners LP, a $200 million Houston hedge fund manager that had about 4.5% of its portfolio in Continental shares as of the end of the third quarter. Though he thinks the hedging sale will prompt some investors to view the company as unusually risky, Mr. Jacobson said he remains a supporter because of its executives’ skill in finding and drilling for oil.

“In the long run, the stock will respond to how they perform in the field,” he said.

While shares of many U.S. energy producers have had double-digit percentage declines since oil prices began falling in late June, Continental’s stock has been hammered. Its shares, which closed up 7.2% at $36.18 on Tuesday, have fallen by more than half since the end of August, and more than 25% since Mr. Hamm disclosed on Nov. 5 that the company had sold the hedges.

Mr. Hamm said in an interview that he still believes his bet could pay off but that it might take as many as two years to tell. “You can’t condemn that as a bad decision,” he said. “You haven’t seen it play out.”

Companies like Continental can react quickly to market changes, he said, which gives them an advantage over OPEC’s members. The cartel is discounting “the resiliency of U.S. producers,” he said, adding that investors “need to look at Continental long-term.”

A wildcatter—he has called himself an “explorationist”—Mr. Hamm started the company that would become Continental in 1967 and first struck oil in 1971 in Oklahoma. More than two decades ago, he began focusing on exploring the then-little-known Williston Basin, which stretches from South Dakota to the Canadian province of Saskatchewan. Over time, his company became a leader in the Bakken formation in North Dakota, which has become one of the biggest oil fields in the U.S.

Continental produced nearly 35 million barrels of oil last year, almost four times what it was producing five years earlier. That growth has helped push U.S. oil output to more than 9 million barrels of crude a day, up from 5 million in 2008.

Though Continental has become a leader of the U.S. energy boom, it is unusual. Institutional and activist investors have curbed some of the risk-taking of wildcatters at other energy outfits, and few companies of Continental’s size remain controlled by their founders.

Continental said it had 5.2 million barrels insured in November and December at an average price of about $100.

When oil prices are falling, hedges—contracts that many energy companies buy to protect against declining prices by guaranteeing a minimum price for the oil and gas they produce—become much more valuable. Continental notes that several of its competitors aren’t hedged, including Apache Corp. , which has no hedges on the books in 2015. Apache said it does have some production insured through the end of this year.

Mr. Hamm isn’t the first energy executive to abandon hedges. Under the leadership of former CEO Aubrey McClendon , Chesapeake Energy Corp. dropped its natural-gas hedges in 2011, leaving it exposed to a dismal gas market and dealing with a cash crunch the following year.

‘It was a bad move with terrible timing… In the long run, the stock will respond to how they perform in the field’
—Gregg Jacobson, a portfolio manager at Caymus Capital Partners
Continental isn’t likely to face a liquidity crisis—its debt is smaller than many of its competitors at about 1.7 times its cash flow, according to S&P Capital IQ. And the company has $1.75 billion in unused credit, recent financial filings show.

“They’ve built such a good balance sheet, they have the luxury of making this gamble,” said Jason Wangler, an analyst for Wunderlich Securities, who called the move a speculative bet. “They left money on the table in the short term.”

Mr. Hamm, he said, is “the guy you’re investing in, as much as the company.”

Since selling Continental’s hedges, Mr. Hamm has lost about $4.4 billion of his personal fortune as Continental’s shares have fallen—a loss that could be compounded by Mr. Hamm’s divorce. A judge recently awarded the former Mrs. Hamm, Sue Ann Arnall, a nearly $1 billion settlement; she appealed that decision on Friday. Mr. Hamm now owns about $9.2 billion of company stock.

Some investors say Continental’s primary acreage in the Bakken and elsewhere renders the hedging decision less important in the long-term.

“Cash flow next year will be lower and more volatile, assuming prices stay under pressure,” said Joe Chin, an analyst at Obermeyer Wood Investment Counsel LLLP, an Aspen, Colo., firm that owned 340,000 Continental shares at the end of the third quarter. “But we remain confident about management’s ability to deploy capital.”

Write to Erin Ailworth at Erin.Ailworth@wsj.com, Gregory Zuckerman at gregory.zuckerman@wsj.com and Daniel Gilbert at daniel.gilbert@wsj.com

5 U.S. Banks Each Have More Than 40 Trillion Dollars In Exposure To Derivatives

5 U.S. Banks Each Have More Than 40 Trillion Dollars In Exposure To Derivatives
SEPTEMBER 25, 2014 AT 9:11 PM
Zero Hedge / Tyler Durden
Submitted by Michael Snyder of The Economic Collapse blog,

When is the U.S. banking system going to crash? I can sum it up in three words. Watch the derivatives. It used to be only four, but now there are five “too big to fail” banks in the United States that each have more than 40 trillion dollars in exposure to derivatives. Today, the U.S. national debt is sitting at a grand total of about 17.7 trillion dollars, so when we are talking about 40 trillion dollars we are talking about an amount of money that is almost unimaginable. And unlike stocks and bonds, these derivatives do not represent “investments” in anything. They can be incredibly complex, but essentially they are just paper wagers about what will happen in the future. The truth is that derivatives trading is not too different from betting on baseball or football games. Trading in derivatives is basically just a form of legalized gambling, and the “too big to fail” banks have transformed Wall Street into the largest casino in the history of the planet. When this derivatives bubble bursts (and as surely as I am writing this it will), the pain that it will cause the global economy will be greater than words can describe.

If derivatives trading is so risky, then why do our big banks do it?

The answer to that question comes down to just one thing.

Greed.

The “too big to fail” banks run up enormous profits from their derivatives trading. According to the New York Times, U.S. banks “have nearly $280 trillion of derivatives on their books” even though the financial crisis of 2008 demonstrated how dangerous they could be…

American banks have nearly $280 trillion of derivatives on their books, and they earn some of their biggest profits from trading in them. But the 2008 crisis revealed how flaws in the market had allowed for dangerous buildups of risk at large Wall Street firms and worsened the run on the banking system.

The big banks have sophisticated computer models which are supposed to keep the system stable and help them manage these risks.

But all computer models are based on assumptions.

And all of those assumptions were originally made by flesh and blood people.

When a “black swan event” comes along such as a war, a major pandemic, an apocalyptic natural disaster or a collapse of a very large financial institution, these models can often break down very rapidly.

For example, the following is a brief excerpt from a Forbes article that describes what happened to the derivatives market when Lehman Brothers collapsed back in 2008…

Fast forward to the financial meltdown of 2008 and what do we see? America again was celebrating. The economy was booming. Everyone seemed to be getting wealthier, even though the warning signs were everywhere: too much borrowing, foolish investments, greedy banks, regulators asleep at the wheel, politicians eager to promote home-ownership for those who couldn’t afford it, and distinguished analysts openly predicting this could only end badly. And then, when Lehman Bros fell, the financial system froze and world economy almost collapsed. Why?

The root cause wasn’t just the reckless lending and the excessive risk taking. The problem at the core was a lack of transparency. After Lehman’s collapse, no one could understand any particular bank’s risks from derivative trading and so no bank wanted to lend to or trade with any other bank. Because all the big banks’ had been involved to an unknown degree in risky derivative trading, no one could tell whether any particular financial institution might suddenly implode.

After the last financial crisis, we were promised that this would be fixed.

But instead the problem has become much larger.

When the housing bubble burst back in 2007, the total notional value of derivatives contracts around the world had risen to about 500 trillion dollars.

According to the Bank for International Settlements, today the total notional value of derivatives contracts around the world has ballooned to a staggering 710 trillion dollars ($710,000,000,000,000).

And of course the heart of this derivatives bubble can be found on Wall Street.

What I am about to share with you is very troubling information.

I have shared similar numbers in the past, but for this article I went and got the very latest numbers from the OCC’s most recent quarterly report. As I mentioned above, there are now five “too big to fail” banks that each have more than 40 trillion dollars in exposure to derivatives…

JPMorgan Chase

Total Assets: $2,476,986,000,000 (about 2.5 trillion dollars)

Total Exposure To Derivatives: $67,951,190,000,000 (more than 67 trillion dollars)

Citibank

Total Assets: $1,894,736,000,000 (almost 1.9 trillion dollars)

Total Exposure To Derivatives: $59,944,502,000,000 (nearly 60 trillion dollars)

Goldman Sachs

Total Assets: $915,705,000,000 (less than a trillion dollars)

Total Exposure To Derivatives: $54,564,516,000,000 (more than 54 trillion dollars)

Bank Of America

Total Assets: $2,152,533,000,000 (a bit more than 2.1 trillion dollars)

Total Exposure To Derivatives: $54,457,605,000,000 (more than 54 trillion dollars)

Morgan Stanley

Total Assets: $831,381,000,000 (less than a trillion dollars)

Total Exposure To Derivatives: $44,946,153,000,000 (more than 44 trillion dollars)

And it isn’t just U.S. banks that are engaged in this type of behavior.

As Zero Hedge recently detailed, German banking giant Deutsche Bank has more exposure to derivatives than any of the American banks listed above…

Deutsche has a total derivative exposure that amounts to €55 trillion or just about $75 trillion. That’s a trillion with a T, and is about 100 times greater than the €522 billion in deposits the bank has. It is also 5x greater than the GDP of Europe and more or less the same as the GDP of… the world.

For those looking forward to the day when these mammoth banks will collapse, you need to keep in mind that when they do go down the entire system is going to utterly fall apart.

At this point our economic system is so completely dependent on these banks that there is no way that it can function without them.

It is like a patient with an extremely advanced case of cancer.

Doctors can try to kill the cancer, but it is almost inevitable that the patient will die in the process.

The same thing could be said about our relationship with the “too big to fail” banks. If they fail, so do the rest of us.

We were told that something would be done about the “too big to fail” problem after the last crisis, but it never happened.

In fact, as I have written about previously, the “too big to fail” banks have collectively gotten 37 percent larger since the last recession.

At this point, the five largest banks in the country account for 42 percent of all loans in the United States, and the six largest banks control 67 percent of all banking assets.

If those banks were to disappear tomorrow, we would not have much of an economy left.

But as you have just read about in this article, they are being more reckless than ever before.

We are steamrolling toward the greatest financial disaster in world history, and nobody is doing much of anything to stop it.

Things could have turned out very differently, but now we will reap the consequences for the very foolish decisions that we have made.

Why Thomson Reuters and Markit could give Bloomberg a run for its money

The privacy scandal that shook Bloomberg in May could be coming back to bite it. Today, Markit and Thomson Reuters formally announced their new messaging system for finance professionals, Market Collaboration Services. It seems designed to compete with the chat function on Bloomberg terminals, to which Bloomberg owes part of its dominance as a data provider. The two companies said today that Bank of America Merrill Lynch, Barclays, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan Chase and Morgan Stanley were all on board.

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We’ve written before that Thomson Reuters will have a hard time unseating Bloomberg. But traders, bankers, and other financial services professionals we’ve spoken to over the last few months have raised a number of points that lead us to believe that Thomson Reuters and Markit could be more successful than we thought:

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Concerns about snooping and data privacy really shook bankers up. In May, Bloomberg admitted that its reporters had access to information about its customers’ usage of their Bloomberg terminals, and there were complaints that they were using it to write stories. Though the fury may have faded, the message has not; third-party technology can pose a threat to the secrecy of the firm. The Markit/Thomson Reuters offering was created in close collaboration with banks and is more customizable, so it may enjoy a certain level of trust.

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Not everyone needs a Bloomberg. Bloomberg terminals cost around $20,000 per year, something Wall Street has long seen as a necessary evil. But maybe no longer. “For some big banks, it’s an incredibly expensive instant messaging device,” an executive at one market infrastructure company told the Financial Times (paywall). “They’re saying, ‘we’re spending $120m a year on Bloomberg. That needs to come down’.”

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Sharing is caring… about costs. Major banks have already made the decision that employees can share a terminal in some cases, and used the savings to buy cheaper plans from Thomson Reuters that can be customized to fit an employee’s role. A commodities trader, the thinking goes, doesn’t need all the same tools a banker advising on tech mergers does. By contrast, Bloomberg terminals are one-size-fits-all; if you buy a terminal, you have to take all the features it offers even if you don’t need them.

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This is already happening; one banker who was not authorized to speak on his bank’s behalf said his team had seen its number of Bloomberg terminals cut down to one, replaced by Thomson Reuters Eikon terminals. The team shares the remaining Bloomberg terminal.

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A stand-alone chat function makes a lot of sense. In an email, Thomson Reuters said it “aims to create the largest financial markets messaging community and remove barriers to cross-market communication.” This means installing the messaging service on as many machines as possible, even ones that don’t even receive data feeds. Therefore, employees across the business could have access to the secure chat feature. If fewer bankers have their own Bloomberg terminals, they will need an alternative chat service to communicate with those colleagues that don’t have them.

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Clearly, this isn’t a transition that will happen overnight. But with cost pressures mounting and reception already warm, Markit and Thomson Reuters seem to have a better shot at taking on Bloomberg than you might think.

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Bloomberg declined to comment.

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