Insight: Trades from 1990s come back to haunt Wall Street

Mon Aug 26, 2013 7:04am EDT
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By Lauren Tara LaCapra and Dan Wilchins

(Reuters) - In the 1990s, U.S. banks came up with a clever idea: using life insurance to bet that their employees would eventually die. Now those wagers are coming back to haunt Wall Street banks for reasons that have little to do with their employees' longevity.

For more than a decade, the lenders purchased life insurance policies, known as "bank-owned life insurance," on employees in bulk. These policies were unusual: banks chose how the premium would be invested; and were on the hook for investment losses or gains over time, unlike typical policies where the insurer invests the premium.

Banks loved the tax benefits of these products, but hated being exposed to market swings. JPMorgan's derivatives professionals found a solution: a product called a "stable-value wrap," which, for a fee, transferred much of the risk of losses to JPMorgan, often for the next 30 years or more, depending on the term of the policy.

That "wrap" amounted to a long-term derivatives contract, which is causing the pain now. Tough new international rules are forcing banks to use more capital for long-term trades, which means bank profits are being hit by derivatives tied to bank-owned life insurance and a host of other products.

From the 1990s through the beginning of the financial crisis in 2008, banks including JPMorgan, Morgan Stanley (MS.N: Quote), Bank of America Corp (BAC.N: Quote) and Citigroup Inc (C.N: Quote) routinely traded swaps that lasted for 30 years or more.

Customers asked for them: If a utility built a power plant, for example, it probably used a long-term derivative as part of its financing package to protect itself from risks such as steep increases in interest rates. Similarly, when housing finance giants Fannie Mae and Freddie Mac needed to reduce their exposure to interest rates, they used long-term derivatives. So did pension funds or governments that needed to better match the cash flows of their assets with their expected liabilities.

These positions are hard to unwind. The companies, governments, or pensions that entered long-term trades with banks still need those derivatives to help reduce their risk. And a bank cannot usually transfer its exposure to another dealer, because its rivals have the same capital constraints under global rules.

"Times have changed: There are a lot of long-term derivatives on financial institutions' balance sheets that have become very costly today, and will stay that way," said Martin Zorn, who was an executive in the corporate banking and capital markets unit of Wachovia Bank in the 1990s and is now chief operating officer at risk-management firm Kamakura Corp.   Continued...

A Wall Street sign is seen in front of the New York Stock Exchange in New York's financial district, March 4, 2013. REUTERS/Brendan McDermid