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"The Bankers Have Gone Through This Before. They Know How It Ends, And It’s Not Pretty"

When even the commodity traders got caught in the crossfire of the energy rout - those supposedly smartest men (and women) in the room who were so smart, they not only never saw the commodity price crash nor did they hedge for any such possibility, leading to such snafus as both Glencore and Noble Group calling their investors and assuring them day after day that they won't go bankrupt overnight - one question many have asked is how have the major banks gotten through unscathed so far.

This is especially true when one considers that the energy exposure of the big 3 TBTF banks is just over $150 billion. According to Bloomberg calculations Citigroup’s energy portfolio, including loans and unfunded commitments, swelled to $59.7 billion as of June 30, Bank of America’s to $47.3 billion, and JPMorgan’s to $43.6 billion, according to company filings.

And while some smaller banks such as Jefferies took massive charge offs on their energy prop book, which pushed Q3 FICC revenue negative for the first time ever, none of the big banks have disclosed any material, or even immaterial impairments on their tens of billions in energy loan books.

One explanation, and by far the simplest and most logical one, is that banks floating on $2.5 trillion in excess reserves, can not reveal, or otherwise mark to market, their loan book simply because they are, well, soaking in liquidity. This is what happened in late 2008, when instead of excess reserves banks were huddled by the Fed's discount window liquidity spigot, pledging such "collateral" as the stock of bankrupt companies (as we have previously shown). That, and also cranking up leverage to 35x, 40x or more. The repricing of all this leverage and Fed generosity once Lehman could no longer kick the can on its day to day funding, is what led to the great financial crisis. 

This time, everyone is in on it, and if a TBTF bank fails, it will drag not only the Fed, but all central banks down with it, and everyone knows it, so why would or should Jamie Dimon bother telling the truth about his true energy exposure? It is not as if the regulators will make him tell the truth, even if they know he is lying: case in point - all those "unsavory" events that JPM has spent $35 billion in legal settlements "neither admitting nor denying" they happened.

There is another explanation, one suggested by Bloomberg, namely that banks have allowed US shale producers, most of whom would otherwise already be insolvent, to kick the can by selling $61.5 billion in equity and debt in 2015, generating more than $700 million in fees. Half the money was raised to repay loans or restructure debt, the data show. This follows nearly half a trillion in loan originations and stock and bond underwriting in 2014.

Case in point, Whiting Petroleum. Bloomberg has the details:

When Whiting Petroleum needed cash earlier this year as oil prices plummeted, JPMorgan Chase, its lead lender, found investors willing to step in. The bank helped Whiting sell $3.1 billion in stocks and bonds in March. Whiting used almost all the money to repay the $2.9 billion it owed JPMorgan and its 25 other lenders. The proceeds also covered the $45 million in fees Whiting paid to get the deal done, regulatory filings show.

In other words, JPMorgan was paid by its clients for the privilege of repaying JPM. Meanwhile the energy risk was offloaded to the dumbest men in the room, those who bought the stocks and bonds JPM had to sell. Which, naturally, is not how JPM sees it: "Being there for our clients in all market environments, particularly the tough ones, is something we feel very strongly about," says Brian Marchiony, a JPMorgan spokesman. “During challenging periods, companies typically look to strengthen their balance sheets and increase liquidity, and we have helped many do just that."

Actually, what JPM did is find a way to offload its risk to third parties. As for the fate of Whiting, it all depends on where the price of oil goes:

Analysts expect Whiting, one of the largest producers in North Dakota’s Bakken shale basin, to spend almost $1 billion more than it earns from oil and gas this year. The company has sold $300 million in assets, reduced the number of rigs drilling for oil to eight from a high of 24, and announced plans to cut spending by $1 billion next year. Eric Hagen, a Whiting spokesman, says the company has “demonstrated that it is taking appropriate steps to manage within the current oil price environment.” Whiting has said it will be in a position next year to have its capital spending of $1 billion equal its cash flows with an oil price of $50 a barrel.

Maybe it will. For now, however, anyone who took advantage of the JPM underwritten stock and bond offerings, has lost dearly: "the stock is down 36 percent, as of Oct. 14, since the March issue, and the new bonds are trading at 94¢ on the dollar. More than 73 percent of the stocks and bonds issued this year by oil and gas producers are worth less today than when they were sold, data compiled by Bloomberg show."

In any event, it is clear that banks are taking advantage of the rabid chase for yield and FOMO, and while most are pitching an "imminent" rebound in the price of oil (over and over), are actively derisking their energy book, and letting others benefit from the upside should oil indeed surge. Or as Bloomberg summarizes it, "Banks’ sell-the-risk strategy underpins the shale oil boom."

Lenders extended low interest credit to wildcatters desperate for cash, then—perhaps remembering the 1980s oil bust—wheeled the debt off their books by selling new stocks and bonds to investors, earning sizable fees along the way. “Everyone in the chain was making money in the short term,” says Louis Meyer, a special situations analyst at Oscar Gruss & Son. “And no one was thinking long term about what they’re going to do if prices fall.”

Still, something doesn't quite add up: $700 million 2015 fees is about 0.5% of the total energy exposure by the big banks, if one trusts Bloomberg's calculation laid out above. In the current illiquid, volatile market, that kind of capital loss can take place in minutes if not milliseconds. To say that banks have hedged their exposure through underwriting fees is naive, and while many banks have "urged" their clients to refi out of secured debt and into unsecured junk bonds, few have actually succeeded. In other words, banks are still massively exposed to the energy sector.

Which is the opposite of Bloomberg's argument which notes:

When crude prices plummeted in the early 1980s, hundreds of banks failed across such oil-rich states as Louisiana, Oklahoma, and Texas. This time around, banks were keen to limit their exposure to a boom-and-bust industry. Every year since 2009, about half the debt and equity sold by North American exploration and production companies was intended, at least in part, to restructure debt or repay loans, data compiled by Bloomberg show. Often the banks selling the securities were the ones getting repaid.

Only that's not really true, because while banks are deleveraging their energy exposure to the shale companies such as Whiting, they are massively adding energy exposure to such names as Glencore, Noble Group, Trafigura, whose credit lines they have been boosting by billions of dollars to avoid even one imploding in a liquidity supernove, one which shows just how naked everyone in the energy space truly is.

So to say that banks have learned from the past, is disingenuous as best.

And while we believe Bloomberg had best intentions when "explaining" away bank risk, we don't buy it. To wit: when asked why lenders weren’t seeing more losses from energy defaults, BofA Chief Executive Officer Brian Moynihan said in a conference call, "A lot of that risk is distributed out to investors." Perhaps Brian can explain just which investors, because aside from a few hedge funds here and there, we are talking tens of billions in losses.

The final words belong to Oscar Gruss’s Meyer who says that "The bankers have gone through this before. They know how it works out in the end, and it’s not pretty. Most of the lenders have been more on top of things this time. They are not going to get caught short in the ways they got caught short before."

Unfortunately before every single crash someone says that bankers have learned their lesson, and every single time we find out - after the fact, and after billions in losses and/or taxpayer bailouts - that this never actually happened.

But assuming that all this is correct (which we doubt) and that banks have indeed "passed the energy risk" to other investors, that may be the worst possible outcome: after all the Big 3 banks getting hit with a $150 billion charge will be painful but hardly lethal at a time when the Fed still has a few trillion in excess reserves on bank balance sheets. For them, it would be a pinprick. However, a few dozen billion in the hands of smaller investors, those who never directly benefited form the Fed's QE generosity, and suddenly the ability to mask such losses becomes impossible (see Jefferies).

Because the cascade of events that brings down even the biggest dominoes, always starts with the fall of the smallest one.