Trades from 1990s come back to haunt Wall Street

'Dead Money': Bank profits are being hit by derivatives tied to bank-owned life insurance

Written by Reuters | New York | Published:August 27, 2013 3:02 am

In the 1990s,US 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,Bank of America and Citigroup 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.

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. 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.

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