Most people agree a principal cause of the 2008 financial crisis was rooted in excessive use of derivative securities by major financial institutions. You remember derivatives. They’re securities created on the back of an underlying asset. They have no inherent value and essentially are bets as to the future performance of that asset. Some kinds of derivatives are more conservative in temperament and used as hedging tools. Others, however, are purely speculative and exist on behalf of a bank’s attempt to make a substantial profit.
Perhaps you think the risks posed by derivatives and bank contagion – the capacity of one bank’s financial difficulties to threaten other banks – became a relic of history in the wake of the crisis and financial reforms. One pair of writers says, “Think again.”
According to independent financial journalists Pam and Russ Martens, derivatives and the dangerous interconnectedness of the banking system remain a substantial threat to global financial health. In a recent article for Wall Street on Parade, the Martens detail why they think the horrendous performance of five megabank stocks during the early days of the pandemic illustrate that little has changed from the crisis.1
The Martens’s concerning piece underscores more than what they see as a persistent threat to the global financial system. It also highlights how important it is for retirement savers to be prepared to withstand risks to their financial security posed by forces far outside their control. One way to potentially mitigate such risks to savings is through the ownership of assets that often have shown a tendency to thrive under adverse economic conditions, including precious metals.
As both actual and feared economic fallout from the pandemic unfolded rapidly last year, financial markets sank as panic-driven selling seemed to take hold. From the beginning of 2020 to March 23 of that year, when the Federal Reserve announced it would do whatever is necessary to help right the nation’s economic ship, the S&P 500 index dropped just over 30%. Notably, a number of megabank stocks tumbled far further than the index itself. Goldman Sachs, JPMorgan Chase, Morgan Stanley and Bank of America all fell between 40% and 50% during the same period, while Citigroup’s collapse was even greater, at 55%.
The rapid tanking of these five bank stocks at a pace far in excess of the S&P 500 caught the attention of Pam and Russ Martens. In their article referenced earlier, the Martens recalled a 2015 report issued by the Office of Financial Research about the potential risks posed by the “interconnectedness” of highly leveraged megabanks.2 The pair highlighted the following passage from the report in their piece.
The larger the bank, the greater the potential spillover if it defaults; the higher its leverage, the more prone it is to default under stress; and the greater its connectivity index, the greater is the share of the default that cascades onto the banking system. The product of these three factors provides an overall measure of the contagion risk that the bank poses for the financial system. Five of the U.S. banks had particularly high contagion index values — Citigroup, JPMorgan, Morgan Stanley, Bank of America, and Goldman Sachs.
What Pam and Russ Martens find noteworthy is that the OFR identified those five banks in 2015 as so potentially risky to the rest of the financial system on the basis of their contagion capacity. They are, of course, the same five banks that fared so poorly as the pandemic was unfolding last year.
Referring to the S&P 500 index’s component companies, the Martens ask, “Why are the banks’ corporate customers performing better in a crisis than the banks? Why are the mega banks draining confidence from the financial system with tanking stock prices? Why is Citigroup, a basket case in the last financial crisis, performing like a new basket case in this crisis?”
Against the backdrop of the noted banks’ high contagion scores, they answer their own questions a little later in the article. “What caused the Wall Street bank stocks to tank so much worse than the broader market in March 2020,” she opines, “is the same thing that caused the banks to tank much worse than the broader market in 2008 – interconnectivity via derivatives and leverage.”
The Martens deliver the real punchline a little later in their piece. Citing a Q4 2020 report from the Office of the Comptroller of the Currency, they point out these same five banks held the notional (face) amount of $185.61 trillion in derivatives contracts as of December 31, 2020.3 That figure represents 85% of all derivatives in the banking system.
You might be wondering why these threats persist many years after passage of the highly touted 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act – known informally as “Dodd-Frank.” As you probably recall, Dodd-Frank was a direct result of the 2008 financial crisis.
Unfortunately, real financial reform remains elusive according to the Martens. In their article, they dismiss Dodd-Frank as something that simply “kicked the can down the road to the next crisis.” In my opinion, one of the problems with Dodd-Frank is that it hasn’t done a good job of instituting an effective firewall between investment banking and retail banking the way the Glass-Steagall Act once did.
Glass-Steagall was passed in 1933, after the historic 1929 stock market crash that triggered the Great Depression. Glass-Steagall contained a number of features, most notable of which was the mandated separation between investment banking and retail banking. Retail banks could no longer make risky investments with depositor funds, and investment banks could no longer have a controlling interest in retail banks.
Glass-Steagall was repealed as a part of the Financial Services Modernization Act of 1999 – a financial deregulation initiative effected during the Clinton administration. With the act’s passage, investment and retail banks had the opportunity to consolidate through holding companies, subject to added supervisory and capital requirements. These are the banks known as “systemically important financial institutions,” or “too big to fail.”
There was an effort to resurrect key sections of Glass-Steagall through Dodd-Frank, but that proved unsuccessful.4 However, one provision of Dodd-Frank that had some teeth to it with respect to this issue was something called the “push-out” rule. The push-out rule required institutions to move risky derivatives to non-bank affiliates that aren’t insured by the Federal Deposit Insurance Corporation (FDIC). So why am I referring to the push-out rule in the past tense? Because the push-out rule was eliminated in 2014, allegedly due to the advocacy of Citigroup, of all banks – notably, the worst performer from January to March 2020 of the five banks referenced by the Martens in their piece.5
There’s obviously a great deal more that can be said about the multitude of persistent threats to the global financial system. It’s likely I will bring this subject up again. But I saw Pam and Russ Martens’s insightful article this week and thought it would be a good idea to discuss it here. Not just in terms of the concerns they outline, but also as another reminder that there never will be a shortage of threats to retirement savings lurking about.
As far as how to most effectively deal with those threats, each person has to make his or her own decision about the best way to do so. One potential way to help achieve some risk mitigation could be through the acquisition of physical precious metals. Gold and silver often have shown a tendency to strengthen during periods of distinct turmoil and generally provide a way to offset losses in other asset classes. As I noted in last week’s article, precious metals were among the best performing assets of the Great Recession (financial crisis) and of a pandemic-riddled 2020, which saw the highest level of U.S. unemployment since the Great Depression.
It certainly is daunting to think about the significant threat posed by and to a highly interconnected financial system that continues trafficking in risky derivatives. Still, however powerless one might be to actually prevent any large-scale economic or geopolitical threat from becoming reality, no one is powerless to take steps that may be able to help lower the risk profile of their hard-earned financial resources. As far as that goes, some retirement savers might conclude that one way to help achieve that goal for themselves is by adding physical gold and silver to their asset base.
1 Pam Martens and Russ Martens, Wall Street on Parade, “The Fed Has Misled the Public about the “Strength” of the Wall Street Mega Banks” (April 26, 2021, accessed 4/29/21).
2 Meraj Allahrakha, Paul Glasserman, and H. Peyton Young, Office of Financial Research, “Systemic Importance Indicators for 33 U.S. Bank Holding Companies: An Overview of Recent Data” (February 12, 2015, accessed 4/29/21).
3 Office of the Comptroller of the Currency, “Fourth Quarter 2020 – Quarterly Report on Bank Trading and Derivatives Activities” (accessed 4/29/21).
4 Robert Scheer, The Nation, “McCain Gets It, Obama Doesn’t” (January 11, 2010, accessed 4/29/21).
5 Ben Protess, The New York Times, “Wall Street Seeks to Tuck Dodd-Frank Changes in Budget Bill” (December 9, 2014, accessed 4/29/21).
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