Goldman Sachs Group Inc. and JPMorgan Chase & Co., two of the biggest traders of over-the-counter derivatives, are exploiting their growing clout in that market to secure cheap funding in addition to billions in revenue from the business.
Both banks are demanding unequal arrangements with hedge fund firms, forcing them to post more cash collateral to offset risks on trades while putting up less on their own wagers. At the end of December this imbalance furnished Goldman Sachs with $110 billion, according to a filing. That's money it can reinvest in higher-yielding assets.
"If you're seen as a major player and you have a product that people can't get elsewhere, you have the negotiating power," said Richard Lindsey, a former director of market regulation at the Securities and Exchange Commission who ran the prime brokerage unit at Bear Stearns Cos. from 1999 to 2006. "Goldman and a handful of other banks are the places where people can get over-the-counter products today."
The collapse of American International Group Inc. in 2008 was hastened by the insurer's inability to meet $20 billion in collateral demands after its credit-default swaps lost value and its credit rating was lowered, Treasury Secretary Timothy F. Geithner, the president of the Federal Reserve Bank of New York at the time of the bailout, testified on Jan. 27. Goldman Sachs was among AIG's biggest counterparties.
Goldman Sachs' chief financial officer, David Viniar, has said his firm's stringent collateral agreements would have helped protect it against a default by AIG. Instead, a $182.3 billion taxpayer bailout of AIG ensured that Goldman Sachs and others were repaid in full.
Over the past three years, Goldman Sachs has extracted more collateral from counterparties in the $605 trillion over-the-counter derivatives markets, according to filings with the SEC.
The firm collected cash collateral that represented 57% of outstanding over-the-counter derivatives assets as of December 2009, while it posted just 16% on liabilities, the firm said in a filing this month. That gap widened from rates of 45% versus 18% in 2008 and 32% versus 19% in 2007, company filings showed.
"That's classic collateral arbitrage," said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York who previously worked as treasurer at Morgan Stanley and chief financial officer at Lehman Brothers Holdings Inc. "You always want to enter into something where you're getting more collateral in than what you're putting out."
The banks get to use the cash collateral, said Robert Claassen, a Palo Alto, Calif., partner in the corporate and capital markets practice at the law firm Paul, Hastings, Janofsky & Walker LLP.
"They do have to pay interest on it, usually at the fed funds rate, but that's a low rate," Claassen said.
Goldman Sachs' $110 billion net collateral balance in December was almost three times the amount it had attracted from depositors at its regulated bank subsidiaries.
The collateral could earn the bank an annual return of $439 million, assuming it's financed at the current federal funds effective rate of 0.15% and that half is reinvested at the same rate and half in two-year Treasury notes yielding 0.948%.
"We manage our collateral arrangements as part of our overall risk management discipline and not as a driver of profits," said Michael DuVally, a spokesman for Goldman Sachs. He said that Bloomberg News' estimates of the firm's potential returns on collateral were "flawed" and declined to provide further explanation.
JPMorgan Chase received cash collateral equal to 57% of the fair value of its derivatives receivables after accounting for offsetting positions, according to data contained in the firm's most recent annual filing. It posted collateral equal to 45% of the comparable payables, leaving it with a $37 billion net cash collateral balance, the filing showed.
In 2008 the cash collateral received by JPMorgan Chase made up 47% of derivative assets, while the amount posted was 37% of liabilities. The percentages were 47% and 26% in 2007, according to the data in company filings.
"JPMorgan now requires more collateral from its counterparties" on derivatives, David Trone, an analyst at Macquarie Group Ltd., wrote in a note to investors following a meeting with Jes Staley, the chief executive officer of JPMorgan Chase's investment bank.
By contrast, Citigroup Inc., a bank that's 27% owned by the U.S., paid out $11 billion more in collateral on over-the-counter derivatives than it collected at the end of 2009, a company filing showed.
Brian Marchiony, a spokesman for JPMorgan Chase, and Alexander Samuelson, a spokesman for Citigroup, both declined to comment.
The five biggest U.S. commercial banks in the derivatives market — JPMorgan Chase, Goldman Sachs, Bank of America Corp., Citigroup and Wells Fargo & Co. — account for 97% of the notional value of derivatives held in the banking industry, according to the Office of the Comptroller of the Currency.
Congress is considering bills that would require more derivatives deals be processed through clearing houses, privately owned third parties that guarantee transactions and keep track of collateral and margin. A clearing house that includes both banks and hedge funds would erode the banks' collateral balances, said Kevin McPartland, a senior analyst at the research firm Tabb Group in New York.
When contracts are negotiated between two parties, collateral arrangements are determined by the relative credit ratings of the two companies and other factors in the relationship, such as how much trading a fund does with a bank, McPartland said. When trades are cleared, the requirements have "nothing to do with credit so much as the mark-to-market value of your current net position."
"Once you're able to use a clearing house, presumably everyone's on a level playing field," he said.
