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Which Bank Could Implode Next?

The G-20 leaders will meet in Pittsburgh Thursday to discuss slashing banker bonuses, but they’re focusing on the wrong threat. Nomi Prins handicaps who will prompt the next meltdown.

09.21.09 10:56 PM ET

The G-20 leaders will descend on Pittsburgh Thursday for a two-day financial summit, just as they did in London this past April. Exactly nothing of note followed that meeting, and the assembled figureheads are already focused on the wrong thing for this one. E.U. leaders, including French President Nicolas Sarkozy and German Chancellor Angela Merkel, have been adamant about the global need to address bankers’ pay. Sarkozy even threatened to walk out of the meetings if no agreement is reached on the topic of compensation. (President Barack Obama has said that he hopes the banks will curb bonuses before being compelled to—as if that will happen.)

There’s a far more immediate and larger threat to all of us: the trading strategies of the big banks that threaten to yet again cripple the financial system.

The E.U. heads have a point; insatiable bonus appetites spur risk-taking the way a gambling addict is driven to risk more money to win big, and it is maddening to know that bank leaders and their firms have had their bad bets subsidized by the public. But there’s a far more immediate and larger threat to all of us: the trading strategies of the big banks that threaten to yet again cripple the financial system.

Ironically, it was a year ago yesterday that Goldman Sachs and Morgan Stanley, petrified that they’d be caught in the same capital chokehold that had eviscerated Lehman Brothers, begged to be reclassified as something more like a commercial bank than an investment bank so that they could tap money from the Federal Reserve. The tradeoff was that they had two years to tone down their riskiest trading, which involved borrowing lots of money on each bet. In theory, this should have reduced the chances that any of these “too-big-to-fail” banks would prompt another economic meltdown. The reality is that the threats are greater than ever. So let’s take a look at prospects for the six biggest players, and in true Wall Street style, lay some odds on the chance each will prompt some kind of new financial panic in the next year:

Bank of America

The nation’s largest bank has total assets of $2.3 trillion, an increase of 24 percent from last fall. But the amount of money it’s had to put aside to cover looming credit losses has grown by 56 percent. In other words, their ratio of bad assets to good keeps increasing.

The firm posted positive news recently, with net revenue for the second quarter of 2009 almost double what it was for the same period last year, but much of that was due to a substantive increase in trading profits. That’s the problem. With so much more set aside for losses, the fact that trading profits jumped means the bank, notably its Merrill Lynch division, is taking on too much risk. Plus, it owes the government $108 billion. Global Panic Odds: 2-to-1

J.P. Morgan Chase

J.P. Morgan Chase, the nation’s second-largest bank by assets (after acquiring Bear Stearns and Washington Mutual), didn’t declare as many bad consumer loans as Bank of America, but other kinds of potential credit losses have increased significantly.

Like BofA, the bank’s profits were up, increasing by 36 percent compared to the same quarter last year, led by record trading profits. On the credit and consumer side, the firm has had to set aside nearly $12 billion (or more than double than last quarter) for new and future mortgage and other credit-related losses. By relying more on trading revenue amid growing credit problems, J.P. Morgan Chase is showing a buildup of risk taking, while hoping for the best. Still, it’s doing better than its competitors, as it has the best federal guarantees behind acquisitions, and a slower increase in loan problems. Global Panic Odds: 10-to-1

Citigroup

Citigroup's total assets have shrunk since it went on federal life support (it leads the banking industry in government bailout bucks, at $398 billion). Though its net revenue has shot up significantly—trading played a big role as well. Plus, much of Citigroup’s surprise profit last quarter, after a staggering loss during the crisis period, was due to a $6.7 billion after-tax gain from the sale of Smith Barney to Morgan Stanley. Without that, Citigroup would have reported a $2.4 billion loss. Citigroup doesn’t have much else to sell, so though their consumer loans are doing a bit better than their competitors', they will have some very tough times ahead. Global Panic Odds: 3-to-1.

Wells Fargo

Since Wells Fargo acquired Wachovia in another government-sponsored merger, its total asset size more than doubled, as did its profits. But another thing that doubled was the amount Wells has to put aside to cover future credit losses, which now stand at $23.5 billion. Last quarter, the losses stemming from its consumer loans decreased by 40 percent, a better showing than the competition, but its ratio of troubled assets to good is much higher than it was during the crisis period, so it’s likely more capital will get used to cover loan losses in the coming quarter. Wells will be fine, but won’t do as well next quarter as this last one. Global Panic Odds: 9-to-1.

Goldman Sachs

Goldman can’t be measured by the same parameters as other bank holding companies, since it doesn’t deal with mere mortals, or consumer loans, in the same way. But it did just post a record profit for last quarter. This was on the back of receiving a total of $64 billion in government subsidies (of which it paid back $10 billion in TARP money). Nearly three quarters of its stellar results, or $10 billion, came from trading. Thus, its risk is also much higher. Lucky for Goldman, it wields a great deal of influence on shaping financial policy. Global Panic Odds: 15-to-1

Morgan Stanley

An inferior cousin to Goldman Sachs, Morgan Stanley’s after-tax income was barely in the black last quarter. The lackluster performance contributed to last week’s announcement that James Gorman would succeed John Mack as CEO in 2010. Gorman was quick to emphasize that the firm’s sales and trading businesses are "critical" to its future success, meaning we can expect the firm to pile on more trading bets.

Indeed, it was trading that pulled the firm to a positive $5.4 billion in net revenue for the first half of 2009, after an abysmal loss during the crisis. Morgan Stanley will have serious issues if it doesn’t speculate right in this new strategy, as it tries to catch up to Goldman. Global Panic Odds: 8-to-1

So what does all of this bank jargon mean? It means that banks are beefing up their trading, or risky activities, to make up for the increasing losses in their consumer and credit oriented businesses. Because it takes real capital to trade, government subsidies are being sucked up into the trading-for-profits vortex, too. To make matters worse, the top five banks control 96 percent of the credit derivatives market—those risky securities, which are code for bets on how healthy firms and loans really are, that lie at the heart of the crisis. This means the top firms are as interdependent as they were when Lehman tanked (and for that matter, when we “rescued” AIG from credit derivative bets). If one company begins to have problems, the rest will suffer. And we, the public, will be bailout buddies again.

And where does all this leave us in terms reforming the global financial system? In a precarious position. As Obama promised, the U.S. will push for higher capital requirements for the largest global banks and tighter regulations on certain derivatives, and on this matter, there will likely be global agreement. But, anything tougher—like having a global financial regulator (which would anger the Fed) or most importantly, restructuring the very nature of banks, a la Glass Steagall—is less likely.

The G-20 leaders will need to do a lot more than just talk to stop the tide of growing risk, rising credit losses, and tenuous risk-predicated bank profits. They can spend their time hammering out compensation limits, which feels good, but does little, or truly restructure the system, rendering the largest financial institutions smaller and more easily managed in terms of risk. If the U.S. won’t push this, then for the sake of global calm, the E.U. should.

Nomi Prins is author of It Takes a Pillage: Behind the Bonuses, Bailouts, and Backroom Deals from Washington to Wall Street (Wiley). Before becoming a journalist, she worked on Wall Street as a managing director at Goldman Sachs, and ran the international analytics group at Bear Stearns in London.