Primary Dealers and Their Loss Experience

Author: Bob Eisenbeis, Post Date: August 18, 2008
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Bianco Research periodically has published a compilation of the losses that have accumulated in major banks and investment banks as a result of the so-called subprime crisis.

(1) When Chairman Bernanke hinted in his July 12, 2007 Congressional testimony that losses might reach $100 billion, this seemed alarmingly large.  But the Bianco data now show that this was a very conservative estimate indeed.

Losses recognized to date now amount to nearly $500 billion and clearly are likely to grow larger as foreign institutions begin to release their second-quarter financial statements.  To their credit, the institutions reporting have successfully raised more than $350 billion to replenish capital depleted due to loss recognition.  But a large hole still remains, and there is now reason to suggest that those institutions that have experienced the largest losses – namely Citigroup, UBS, Wachovia, Morgan Stanley, and the others – will need to raise substantial additional capital as a result of having to take nearly $50 billion of auction rate securities back onto their balance sheets as part of the settlements with the attorneys general of New York and other states.  Clearly, there are more securities to bring back on balance sheet and Cumberland’s estimates are that they could go as high as $100 billion.

While the financial turmoil has received wide attention, the extent to which the losses and impacts have been experienced by a relatively few institutions has drawn little notice.   It is noteworthy that most of these institutions are also among the subset of large, complex financial intermediaries that function as primary dealers.  These are the so-called elite institutions qualified, because of their supposed sophistication and financial strength, to deal directly with the Federal Reserve as it conducts its daily open market operations.  Their role in the monetary policy transmission process also explains the special treatment they have received by being granted access to the Primary Dealer Credit Facility (PDCF).

To illustrate the loss concentration, the Bianco data in the table attached, (the document is no longer available at the original site) were first sorted by primary dealer status (the firms listed in bold type) and then by the sizes of the losses institutions have recognized to date.  Four facts are important to note about this list.  First, the 16 primary dealers are among the nearly 60 firms listed but they dominate the universe having experienced $280 billion or (56%) of the total losses reported to date.  Second, these primary dealers have raised about $184 billion in new capital, but they are still are nearly $100 billion short of covering even their reported losses, which is seriously impacting their ability to deleverage as financial markets are now demanding.  Third, only two of the primary dealers have actually successfully replenished their capital, while the remainder has suffered in some cases significant capital impairment.  Finally, Bianco notes that losses aren’t concentrated solely in US firms.  Combined European and Asian losses are virtually equal to those of US institutions, with most ($ 222 billion) being in European headquartered institutions.

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