The US Federal Reserve today released a list of 15 large financial firms that “may pose elevated risks to U.S. financial stability and are supervised by the Federal Reserve,” according to a statement released by the bank regulator today.

As Buffett, Singer Warn of Derivatives Implosion, Fed Posts Watch List

Significant commonality on list is many are 2008 repeat offenders

An important commonality of members of the infamous list is many engage OTC derivatives trading where the contract structures violate long established principles of transparency, proper margin to equity and simplicity of terms.  The list includes well known repeat offenders from the 2008, including American International Group Inc (NYSE:AIG), Bank of America Corp (NYSE:BAC), Citigroup Inc (NYSE:C), Goldman Sachs Group Inc (NYSE:GS), JPMorgan Chase & Co. (NYSE:JPM) and Morgan Stanley (NYSE:MS).

When considering which firms could pose systematic problems that could create an ending or expiration to the economy, the Fed said it “takes into account a number of factors such as the size of the financial institutions, their interconnectedness, lack of readily available substitutes for the services they provide, their complexity, and their global (cross-jurisdictional) activities.” Translated: mostly issues associated with the same unregulated derivatives that imploded the world economy in 2008 – except this time the implosion could be the worst. Just ask Warren Buffett.

Warren Buffett joins chorus warning of big bank derivative exposure

In a recent Forbes Magazine article, Buffett says that the big bank derivatives book could lead to massive financial “discontinuity,” which is defined as a “ending, expiration, halt, lapse, a shutdown, a stoppage.”  This derivatives led event would likely be much worse than the 2008 derivatives implosion simply due to the size and complexity of the financial instruments in place.

“Someday it won’t matter how large the level of assets on JPMorgan Chase & Co. (NYSE:JPM)’s balance sheet,” he was quoted as saying in the Forbes article. “There is no risk control system that is effective if the numbers get big enough.”  The estimated $600 trillion in notional derivatives the large banks hold are many multiples of the estimated book value of the banks.  As one example, the entire world economy is valued at $72 trillion.  Thus, the large banks could potentially wipe out the world economy over six times with the notional derivatives exposure that is similarly structured to those in 2008: Opaque, complex by design and structurally unsound.

Buffett’s comments come after warnings made by numerous hedge fund professionals. Paul Singer, who warned European central bankers of impending collapase before 2008, has famously warned, as have Ray Dailo and Ken Griffin to various degrees.

New Fed committee will oversee “problems,” oddly untangle complexity

In describing their committee structure, the Fed statement waxed poetic.  The Financial Stability Oversight Council (FSOC) for supervision by the Board of Governors apparently created a sub committee, the Large Institution Supervision Coordinating Committee (LISCC) to handle the task of making the complex easy to understand.  This was an odd task for the Fed, which typically does a very good job at obfuscating financial frameworks. “The LISCC is comprised of senior officers representing various functions at the Board and Reserve Banks, bringing an interdisciplinary and cross-firm perspective to the supervision of these large, systemically important financial institutions. This approach to the supervision of systemically important financial institutions fosters rigorous supervision of individual firms while formalizing the use of horizontal reviews and analyses of activities and risks across the portfolio.”

Is most significant unintended consequence of lack of 2008 big bank criminal prosecutions the spread of these derivatives?

As the 2008 derivatives implosion has yet to land any bank executive in jail, one might assume the unintended consequence of Eric Holder’s official “too big to prosecute” mandate might be that the banks can do anything they want – even if it destroys the world economy.  Now that is truly untouchable.