If you have any doubt that Bank of America is in trouble, this development should settle it. I’m late to this important story broken this morning by Bob Ivry of Bloomberg, but both Bill Black (who I interviewed just now) and I see this as a desperate (or at the very best, remarkably inept) move by Bank of America’s management.
The short form via Bloomberg:
Bank of America Corp. (BAC), hit by a credit downgrade last month, has moved derivatives from its Merrill Lynch unit to a subsidiary flush with insured deposits, according to people with direct knowledge of the situation…
Bank of America's holding company — the parent of both the retail bank and the Merrill Lynch securities unit — held almost $75 trillion of derivatives at the end of June, according to data compiled by the OCC. About $53 trillion, or 71 percent, were within Bank of America NA, according to the data, which represent the notional values of the trades.
That compares with JPMorgan's deposit-taking entity, JPMorgan Chase Bank NA, which contained 99 percent of the New York-based firm's $79 trillion of notional derivatives, the OCC data show.
Now you would expect this move to be driven by adverse selection, that it, that BofA would move its WORST derivatives, that is, the ones that were riskiest or otherwise had high collateral posting requirements, to the sub. Bill Black confirmed that even though the details were sketchy, this is precisely what took place.
And remember, as we have indicated, there are some “derivatives” that should be eliminated, period. We’ve written repeatedly about credit default swaps, which have virtually no legitimate economic uses (no one was complaining about the illiquidity of corporate bonds prior to the introduction of CDS; this was not a perceived need among investors). They are an inherently defective product, since there is no way to margin adequately for “jump to default” risk and have the product be viable economically. CDS are systematically underpriced insurance, with insurers guaranteed to go bust periodically, as AIG and the monolines demonstrated.
The reason that commentators like Chris Whalen were relatively sanguine about Bank of America likely becoming insolvent as a result of eventual mortgage and other litigation losses is that it would be a holding company bankruptcy. The operating units, most importantly, the banks, would not be affected and could be spun out to a new entity or sold. Shareholders would be wiped out and holding company creditors (most important, bondholders) would take a hit by having their debt haircut and partly converted to equity.
This changes the picture completely. This move reflects either criminal incompetence or abject corruption by the Fed. Even though I’ve expressed my doubts as to whether Dodd Frank resolutions will work, dumping derivatives into depositaries pretty much guarantees a Dodd Frank resolution will fail. Remember the effect of the 2005 bankruptcy law revisions: derivatives counterparties are first in line, they get to grab assets first and leave everyone else to scramble for crumbs. So this move amounts to a direct transfer from derivatives counterparties of Merrill to the taxpayer, via the FDIC, which would have to make depositors whole after derivatives counterparties grabbed collateral. It’s well nigh impossible to have an orderly wind down in this scenario. You have a derivatives counterparty land grab and an abrupt insolvency. Lehman failed over a weekend after JP Morgan grabbed collateral.
But it’s even worse than that. During the savings & loan crisis, the FDIC did not have enough in deposit insurance receipts to pay for the Resolution Trust Corporation wind-down vehicle. It had to get more funding from Congress. This move paves the way for another TARP-style shakedown of taxpayers, this time to save depositors. No Congressman would dare vote against that. This move is Machiavellian, and just plain evil.
The FDIC is understandably ripshit. Again from Bloomberg:
The Federal Reserve and Federal Deposit Insurance Corp. disagree over the transfers, which are being requested by counterparties, said the people, who asked to remain anonymous because they weren't authorized to speak publicly. The Fed has signaled that it favors moving the derivatives to give relief to the bank holding company, while the FDIC, which would have to pay off depositors in the event of a bank failure, is objecting, said the people. The bank doesn't believe regulatory approval is needed, said people with knowledge of its position.
Well OF COURSE BofA is gonna try to take the position this is kosher, but the FDIC can and must reject this brazen move. But this is a bit of a fait accompli,and I have no doubt BofA and the craven Fed will argue that moving the risker derivatives back will upset the markets. Well too bad, maybe it’s time banks learn they can no longer run roughshod over regulators. And if BofA is at that much risk that it can’t afford to undo moving over unacceptably risky exposures measure, that would seem to be prima facie evidence that a Dodd Frank resolution is in order.
Bill Black said that the Bloomberg editors toned down his remarks considerably. He said, “Any competent regulator would respond: “No, Hell NO!” It’s time that the public also say no, and loudly, to yet another route for running a drip feed from taxpayers to banksters.
Update: Brett in comments raise the question that since JP Morgan books virtually all of its derivatives in a depositary, is this really all that sus?
The short answer is that while this on paper looks similar, in fact the JPM derivatives exposures (and those of the other big banks) are pretty different than those of Merrill. The big commercial banks traditionally were the big players in plain vanilla, low margin derivatives, specifically interest rate and FX swaps. They are ALSO in credit default swaps, so there is no denying that there are risky derivatives included in the mix.
JPM runs a massive derivatives clearing operation, and a lot of its exposure relates to that. This and the businesses of the other large banks have been supervised by the regulators for some time (you can argue the supervision was not so hot, but at least they have a dim idea of what is going on and gather data). By contrast, no one was supervising the derivatives book at Merrill. The Fed long ago gave up supervising Treasury dealers, and the SEC does not do any meaningful oversight of derivatives. And Chris Whalen confirms that Merrill was and is the cowboy among derivatives dealers.
You can argue that this is just normal business, the other big banks have their derivatives operations largely in the depositary. But BofA has owned Merrill for over a year and a half, and didn’t undertake this move until it was downgraded. Goldman and Morgan Stanley reamin big players in this business and don’t have a large depositary. If this was all normal business, BofA would have done this a while ago, and not in response to market pressure, and they would have gotten the FDIC on board. The way this was done says something is amiss.
This surely means that any sensible depositor will withdraw all funds from BAC?
Why would anyone leave money there.
I think small depositors well below the FDIC limit could leave their money there.
I can’t imagine anybody with deposits greater than the FDIC limits will want to keep money there as part of their cash management plan. There are many safer, better options.
I assume that this is the equivalent of a poison pill anti-take-over defence. Nobody will want to make BAC fold because the losses would be too high to FDIC and others.
I consider any move of defective assets into a publicly insured institution a criminal act. There is no justification other than to shift the loss to the public, i.e. to defraud the government. I haven’t been a Federal Reserve hater in so many words, but the mere fact that the Fed as presently led and constituted is endorsing such a move is, ipso facto, the decisive evidence that a complete reformation or replacement of the present Federal Reserve system is necessary immediately.
If the Fed is conspiring to openly defraud the public, which is what the present announcements amount to, we are so far beyond a system that functions in the public interest that such a mission isn’t even a memory, just an historical relic. Yes, the Fed may be, justifiably, worried about an uncontrollable derivate failure cascade. Pushing the costs off onto the depository banking system and hence into the lap of Congress is despicable, and in no way in any interest of the 99%. We could have a massive derivative failure and still have a functional banking system if the depository system is to some extent walled off and preserved. That is _exactly_ the action which the Fed seems hellbent on undermining, in the interest of the 1% and the Five Pits of Abysm of which BoA is certainly one.
Seems improper to say the least, but the details are sketchy.
A. What do they mean it has been requested by counterparties? I assume that means companies Merrill Lynch sells derivatives with/to want those positions moved to an the FDIC insured portion of BAC? If so, I don’t think the next logical conclusion is BAC is admitting it’s about to go under. Sounds more likely that their counterparties want the insurance from FDIC that they’ll be made whole no matter what happens in the future. As I said, that’s improper and should be prevented by regulators.
B. This paragraph of the Bloomberg story:
Bank of America's holding company — the parent of both the retail bank and the Merrill Lynch securities unit — held almost $75 trillion of derivatives at the end of June, according to data compiled by the OCC. About $53 trillion, or 71 percent, were within Bank of America NA, according to the data, which represent the notional values of the trades.
That compares with JPMorgan's deposit-taking entity, JPMorgan Chase Bank NA, which contained 99 percent of the New York-based firm's $79 trillion of notional derivatives, the OCC data show. __________________________________________________________
Am I reading this wrong, or does that mean that JP Morgan has 99% of its derivatives exposure located under its FDIC insured subsidiary, while BAC only has 71% of its derivatives under its FDIC insured subsidiary? If so, isn’t JP Morgan even worse than BAC in this regard? And wouldn’t that also suggest that maybe the “worst” derivatives are staying with Merrill?
Brett,
What you are missing is this is a suspect move. Black and I read it the same way. At best, this is an awfully bizarrely timed cleaning up operation.
JP Morgan isn’t comparable (even thought you would think it ought to be) because it runs a huge derivatives clearing business. The risks in the books are totally different, as in much lower. And the regulators have been looking at those books a long time, while per a conversation I just had with Chris Whalen, Merrill has been the outlier in risk, and no one was supervising these books (the Fed quit supervising Treasury dealers in the early 1990s and the SEC does not do derivatives).
The normal behavior would be to post more collateral. But they decided not to. That says they are at awfully eager to preserve profits, and at worst worried about their ability to meet the collateral posting requirements if markets get roiled.
Now it is true that the other big banks do book their derivatives in subs. But the old investment banks always took more risks here, and booked more trades with hedgie counterparties than the old commercial banks did. Even if the books are similar in size, Citi is much bigger in plain vanilla, low risk derivatives like interest rate swaps and currency swaps.
BofA could have done this any time after it acquired Merrill. The fact that this was triggered by a downgrade, and the other surviving investment banks (Goldman and Morgan Stanley) remain big players in derivatives without having a depositor to stuff says something does not smell right here.
I think you mean they want to preserve “cash.” They don’t seem to have any “profits” to preserve (if you disregard the accounting gimmicks).
But I bet those faux “profits” will make for really nice bonuses, huh?
Ah, that’s right. I recall reading this in the FCIC report. Interesting…
Totally not surprising (also not surprising is I’ve NEVER had an account w/ BAC in any of its many iterations).
The maneuvering was underway before Buffett ‘bought’ in, the game was clearly ‘good bank (Buffy) bad bank (the rest of us)’.
Funny, Nixon bombed Cambodia with B52s and a million boomers hit the streets. Bernanke just bombed America w/ ‘T(rillion) 2′ and nobody will even care …
I had the same question.
Thanks, Yves, for this important and insightful explanation.
Yay, Yves! Great post. BofA and the Fed need to be taken down.
As for who banks with B of A? I can’t fathom.
If Congress thinks they are compelled to protect the depositors with another TARP like deal, then that just might broaden and deepen the power of OWS. Could be fun to watch.
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