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
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.
The lingering pain from these trades underscores how long it will take banks to move past the excesses of the years leading up to the credit crunch. Many investors are eager for liabilities from the crisis to disappear. But that process could still take years as regulatory investigations continue, new rules come on line, and banks work through their bad assets, bank executives said.
To be sure, longer-term trades are likely only a small percentage of banks' fixed-income books.
At Morgan Stanley, for example, trades going back to the 1990's represent less than 1 percent of the bank's book of derivatives that trade off exchanges, a person familiar with the matter said. The bank is trying to shrink its assets for fixed-income, currency, and commodities by at least 51 percent by 2016, and has exceeded its targets so far despite these trades.
But long-term positions still consume disproportionate amount of Morgan Stanley's capital, rankling executives. At the bank's annual meeting in May, Morgan Stanley Chief Executive James Gorman called the positions "dead money," and noted that some trades stem back to the 1990's.
JPMorgan likely has the biggest holdings of long-dated swaps because it is the biggest swaps trader on Wall Street, responsible for about 30 percent of the market by some measures, traders at rival firms said.
A JPMorgan spokesman declined to comment.
Generally, banks offloaded the interest-rate risk from these positions and hedged other kinds of exposure, so the pain from these swaps comes not from market movements, but from regulatory changes. Under new international capital rules known as Basel III, longer-dated derivatives trades need to be supported by more capital than short-term positions.
The amount of capital the bank must hold depends on a swap's market value, the trading partner's creditworthiness and the possible losses the bank might suffer over the trade's lifetime - so the longer the trade, the more capital required.
Prior rules limited the amount of capital required for derivatives that do not trade on exchanges, but Basel III ends that limit, meaning that banks can be required to hold more capital than some trades are worth. Many of these derivative trades are custom-made, instead of being standardized contracts, so it is difficult to transfer them to a clearinghouse.
In addition, for more complicated over-the-counter derivatives trades, margin requirements will be 200 percent higher than they used to be under new regulations, said James Malick, a partner at The Boston Consulting Group who advises financial firms.
Banks are trying to find ways to reduce the exposure to long-term trades, and have even set up desks whose sole purpose is to reduce these positions, traders said.
Dealers' pullback from long-term swaps is evident, said Nancy Davis, a managing partner at the hedge fund Quadratic Capital, who previously held senior derivatives trading positions at JPMorgan and Goldman Sachs. The bulk of new activity happens in derivatives with durations of less than five years, according to the Depository Trust & Clearing Corporation, which clears such trades.
In the 1990s, insurers with high credit ratings would often trade long-dated swaps from their derivatives subsidiaries. Other players, such as asset managers and pension funds with big balance sheets, may eventually step in to provide liquidity where banks won't, Davis said.
"It's not the best use of a bank's capital at this point to be locking it up in a long-term swap - they'd rather spend their money elsewhere," Davis said.
(Reporting by Dan Wilchins and Lauren Tara LaCapra; Editing by Leslie Gevirtz)