Hoenig Warns on Leveraged Loans and Derivatives, Loss of Glass-Steagall

FDIC Vice-Chairman Thomas Hoenig again called for “separating commercial banking, and its inherent safety net, from broker-dealer and proprietary trading activities,” in a speech to the Institute of International Bankers annual conference in Washington March 2. His speech included a warning on the current status of leveraged loans and derivatives in the U.S. banking system, and a plug for the Glass-Steagall Act.

On junk bonds’ cousins, the “leveraged loans,” Hoenig said that the FDIC’s extensive national review of assets of large banks, known as the Shared National Credit Review, showed very large issuance of leveraged loans in 2014: to an $800 billion bubble from just $280 billion one year earlier. Leveraged loans were “highly criticized” in the review: “Examiners noted excessive leverage against gaps in borrower repayment capacity, questionable evaluations”, etc., “weak underwriting and deficiencies in risk management.” He concluded, “This portfolio has systemic implications, whether held in the originating bank or [securitized].”

Derivatives are a still more serious matter. Hoenig said that

“In recent years commercial banking firms in the United States have been allowed to simultaneously own commodities, trade commodities and their derivatives, and own and control transportation and warehousing of these commodities.”

Citing the dangers, he said that

“the United States has insisted historically that banking remain separate from commerce.”

“The precursor to this conflict [of interest],” he noted, “was the repeal of the Glass-Steagall Act in the late 1990s, which permitted commercial banks to significantly expand their presence in trading derivatives and related contracts.”

Citing the notional value of derivatives contracts at the five most-exposed U.S. banking organizations at roughly $300 trillion, Hoenig says that this corresponds to $4 trillion of unstated assets [“value at risk”] on their balance sheets using international accounting rules.

“Also, among these derivatives contracts are more than $25 trillion of notional amounts of uncleared credit default swaps, equity derivatives, and commodity derivatives, which hold the highest risk to these banks. Derivatives activities conducted in the insured bank at lower costs have proven to be quite profitable, which explains why bank managers are so adamant that they stay there” — referring to the strong-arming and bribing of Congress in December.

“Subsidizing such derivative activity with its unbridled leverage should end,” Hoenig concludes.