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Banks Tread a Fine Line in Trading

When JPMorgan Chase revealed its $2 billion loss last week, it looked as though the big Wall Street banks were up to their old tricks, using their government-backed funds to make risky trades in a misguided effort to improve their profits.

New York Stock Exchange (NYSE)
Oliver P. Quilla for CNBC.com
New York Stock Exchange (NYSE)

But even banks that focus mainly on good, old-fashioned lending do their fair share of high-stakes trading.

While few other banks, if any, pursue the complex strategies that led to JPMorgan’s losses, many traditional lenders regularly buy and sell securities, and make bets with derivatives, as part of their core operations. Financial firms say such activities allow them to earn a basic return on the deposits they collect and to offset risks on their balance sheets.

These ubiquitous trading practices are creating a headache for regulators who are trying to devise new rules to prevent another financial crisis.

Regulators are putting the finishing touches on the so-called Volcker Rule, which would ban banks from making speculative bets with their own money. But they face a basic problem: What exactly is proprietary trading?

Such activities are easy to spot when financial firms run independent trading units devoted to making profits. Already, most big banks have moved to exit these businesses in preparation for the Volcker Rule. But regulators are having a harder time telling when other trading activities — like market-making and portfolio hedging — cross the line.

“Proprietary trading is in the eye of the beholder. There’s a fine line,” said Nancy Bush, a banking analyst and a contributor to SNL Financial, an industry publication. "That’s what the regulators are now forced to confront, and it will be really difficult to do.”

Regulators are focused on making the financial system safer.

They worry that a federally insured bank will experience a trading disaster, which would force the government and taxpayers to come to its rescue.

So far, regulators don’t seem overly concerned that the JPMorgan blowup will have broader ramifications on the banking system. The Financial Stability Oversight Council, the committee set up in the wake of the crisis to identify and respond to threats to the banking sector, is not planning a special meeting to discuss JPMorgan, according to a person briefed on the council’s activities who spoke on the condition of anonymity because the matter is not public.

Big banks, even those with little presence on Wall Street, contend that their trading activities are part of prudent risk-management. Without the ability to invest in bonds and other securities, companies argue that they would not be able to make loans or extend credit as easily.

Big banks, even those with little presence on Wall Street, contend that their trading activities are part of prudent risk-management. Without the ability to invest in bonds and other securities, companies argue that they would not be able to make loans or extend credit as easily.

To understand regulators’ dilemma, look at a big bank like Wells Fargo. It focuses on plain-vanilla lending like mortgages, credit cards and corporate loans, and like JPMorgan emerged relatively unscathed from the financial crisis.

Over the last 12 months, Wells Fargo, based in San Francisco, has substantially increased its core bond portfolio, known as “available for sale” securities. At the end of March, the bank held $230 billion of such bonds, up 37 percent compared with a year earlier. At the same time, Wells Fargo’s loans grew by 2 percent over the same period.

By comparison, Citigroup cut its available-for-sale portfolio by 7 percent over the same period. Bank of America’s holdings fell by 10 percent.

Wells Fargo used money from a flood of new deposits to buy the new bonds. In essence, the bank is trying to earn extra interest.

“As the Fed has indicated rates will remain low for some time, there was less risk in investing at today’s low rates, so we have in recent quarters deployed some of the liquidity in this way,” Mary Eshet, a spokeswoman for Wells Fargo, wrote in an e-mail.

But the holdings can also leave Wells Fargo at risk. If the bank makes a wrong assumption about interest rates, the portfolio can take a hit.

While a large proportion of the available-for-sale bonds are in instruments considered safe, like Treasuries or debt backed by the federal government, the securities can produce big trading gains, especially if their purchases are well-timed. At the end of March, Wells Fargo was sitting on $8.3 billion of paper gains on its available-for-sale bonds at the end of March, up from $6.6 billion at the end of 2011.

But these bond portfolios have also been a source of huge losses for banks.

In the darkest days of the financial crisis, available-for-sale securities showed paper losses of over $70 billion across the banking system, according to data from the Federal Reserve.

The holdings remain enormous. At JPMorgan, Bank of America, Citigroup and Wells Fargo, these bonds totaled $1.17 trillion at the end of March.

Given the size of such portfolios, banks sometimes decide to hedge against potential losses in them. But that only adds a layer of trading to the equation.

JPMorgan said its $2 billion loss stemmed from a hedge related to its available-for-sale securities. Specifically, the bank was using a relatively new type of credit derivative that mostly trades off exchanges in opaque markets.

The value of a credit derivative is tied to the prices of corporate bonds, which is why many banks make heavy use of them to protect against losses on their loans and bonds.

But hedges often lead to their own losses, as JPMorgan discovered. In its latest quarterly securities filing, Bank of America said a certain batch of credit derivatives was showing a paper loss of $493 million at the end of March. That loss should be offset against $128 million of gains on the assets being hedged, a Bank of America spokesman, Jerome F. Dubrowski, said via e-mail.

Even with the Volcker Rule on the horizon, banks are still using credit derivatives for proprietary trading. Citigroup, in its latest quarterly securities filing, says one of its uses for credit derivatives is “to take proprietary trading positions.” A Citigroup spokesman, Jon Diat, said in an e-mail, “Yes, we sometimes use credit derivatives in a proprietary trade but this type of activity is a relatively small portion of our credit derivative activity.”

After the JPMorgan losses, some analysts say banks could deliver more nasty surprises as they build up big positions in bonds and derivatives, especially if the economy remains weak and interest rates don’t behave as banks expect.

“The biggest issue for the next five years in banking is how banks manage their balance sheets in such unprecedented times,” said Michael Mayo, a banking analyst with Crédit Agricole Securities.

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