Then, because the bankruptcy laws were changed in 2005 to make derivatives counterparties first in line for recovery (even over bondholders!), they can feast on the $1T deposits if (when?) the BK comes.
Then, the FDIC can come in and backstop the poor screwed-over depositors. "Sorry for stealing your money, good thing taxpayers exist, eh?"
This story is only coming out because someone (probably at the FDIC) is whistle-blowing to Bloomberg. I thank that anonymous someone. This is also why there is a ? in the thread title, though I've seen internet estimates of ~$50T in total notional risk.
Original B-berg Story:
Jonathan Weill editorialBofA Said to Split Regulators Over Moving Merrill Derivatives to Bank Unit
By Bob Ivry, Hugh Son and Christine Harper - Oct 18, 2011
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.
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.
Three years after taxpayers rescued some of the biggest U.S. lenders, regulators are grappling with how to protect FDIC- insured bank accounts from risks generated by investment-banking operations. Bank of America, which got a $45 billion bailout during the financial crisis, had $1.04 trillion in deposits as of midyear, ranking it second among U.S. firms.
“The concern is that there is always an enormous temptation to dump the losers on the insured institution,” said William Black, professor of economics and law at the University of Missouri-Kansas City and a former bank regulator. “We should have fairly tight restrictions on that.”
Accommodating Clients
Jerry Dubrowski, a spokesman for Charlotte, North Carolina- based Bank of America, declined to comment on the transfers or the firm’s discussions with regulators. The company “continues to accommodate the needs of our clients through each of our multiple trading entities, including Bank of America NA,” he said in an e-mailed statement, referring to the company’s deposit-taking unit.
Barbara Hagenbaugh, a Fed spokeswoman, said she couldn’t discuss supervision of specific institutions. Greg Hernandez, an FDIC spokesman, declined to comment.
Bank of America posted a $6.2 billion third-quarter profit today, compared with a loss of $7.3 billion a year earlier, as credit quality improved and the firm booked one-time accounting gains. The lender rose 7.3 percent to $6.47 at 1:54 p.m. in New York trading, making it the day’s best performer in the Dow Jones Industrial Average. Credit-default swaps on Bank of America eased 10 basis points to a mid-price of 380 as of 11:49 a.m. in New York, according to broker Phoenix Partners Group.
Moody’s Investors Service downgraded Bank of America’s long-term credit ratings Sept. 21, cutting both the holding company and the retail bank two notches apiece. The holding company fell to Baa1, the third-lowest investment-grade rank, from A2, while the retail bank declined to A2 from Aa3.
Moody’s Downgrade
The Moody’s downgrade spurred some of Merrill’s partners to ask that contracts be moved to the retail unit, which has a higher credit rating, according to people familiar with the transactions. Transferring derivatives also can help the parent company minimize the collateral it must post on contracts and the potential costs to terminate trades after Moody’s decision, said a person familiar with the matter.
Bank of America estimated in an August regulatory filing that a two-level downgrade by all ratings companies would have required that it post $3.3 billion in additional collateral and termination payments, based on over-the-counter derivatives and other trading agreements as of June 30. The figure doesn’t include possible collateral payments due to “variable interest entities,” which the firm is evaluating, it said in the filing.
Dubrowski declined to comment on collateral or termination payments after the downgrade.
‘Be Prepared’
Bank of America’s rating is now four grades below the one Moody’s assigned to JPMorgan Chase & Co. (JPM), the biggest U.S. bank by deposits at midyear, and a level below the rating given to Citigroup Inc. (C), the third-biggest. Bank of America is the only U.S. lender that lacks a rating of A3 or higher among the five firms listed by the Office of the Comptroller of the Currency as having the biggest derivatives books.
“We had worked very hard over the course of the last nine months to be prepared to the extent that we did receive a downgrade, and feel very good about the way that we’ve minimized the potential impact” Bank of America Chief Financial Officer Bruce Thompson said in a conference call today with analysts. “Since the downgrade, we have not seen any change in our global excess liquidity sources.”
Derivatives are financial instruments used to hedge risks or for speculation. They’re derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in the weather or interest rates.
Dodd-Frank Rules
Keeping such deals separate from FDIC-insured savings has been a cornerstone of U.S. regulation for decades, including last year’s Dodd-Frank overhaul of Wall Street regulation.
The legislation gave the FDIC, which liquidates failing banks, expanded powers to dismantle large financial institutions in danger of failing. The agency can borrow from the Treasury Department to finance the biggest lenders’ operations to stem bank runs. It’s required to recoup taxpayer money used during the resolution process through fees on the largest firms.
Bank of America benefited from two injections of U.S. bailout funds during the financial crisis. The first, in 2008, included $15 billion for the bank and $10 billion for Merrill, which the bank had agreed to buy. The second round of $20 billion came in January 2009 after Merrill’s losses in its final quarter as an independent firm surpassed $15 billion, raising doubts about the bank’s stability if the takeover proceeded. The U.S. also offered to guarantee $118 billion of assets held by the combined company, mostly at Merrill. The company repaid federal bailout funds in 2009 with interest.
‘The Normal Course’
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.
The moves by Bank of America are part of “the normal course of dealings that we’ve had with counterparties since Merrill Lynch and BofA came together,” Thompson said today.
‘Created a Firewall’
Moving derivatives contracts between units of a bank holding company is limited under Section 23A of the Federal Reserve Act, which is designed to prevent a lender’s affiliates from benefiting from its federal subsidy and to protect the bank from excessive risk originating at the non-bank affiliate, said Saule T. Omarova, a law professor at the University of North Carolina at Chapel Hill School of Law.
“Congress doesn’t want a bank’s FDIC insurance and access to the Fed discount window to somehow benefit an affiliate, so they created a firewall,” Omarova said. The discount window has been open to banks as the lender of last resort since 1914.
As a general rule, as long as transactions involve high- quality assets and don’t exceed certain quantitative limitations, they should be allowed under the Federal Reserve Act, Omarova said.
In 2009, the Fed granted Section 23A exemptions to the banking arms of Ally Financial Inc., HSBC Holdings Plc, Fifth Third Bancorp, ING Groep NV, General Electric Co., Northern Trust Corp., CIT Group Inc., Morgan Stanley and Goldman Sachs Group Inc., among others, according to letters posted on the Fed’s website.
The central bank terminated exemptions last year for retail-banking units of JPMorgan, Citigroup, Barclays Plc, Royal Bank of Scotland Plc and Deutsche Bank AG. The Fed also ended an exemption for Bank of America in March 2010 and in September of that year approved a new one.
Section 23A “is among the most important tools that U.S. bank regulators have to protect the safety and soundness of U.S. banks,” Scott Alvarez, the Fed’s general counsel, told Congress in March 2008.
To contact the reporters on this story: Bob Ivry in New York at bivry@bloomberg.net; Hugh Son in New York at hson1@bloomberg.net; Christine Harper in New York at charper@bloomberg.net.
To contact the editors responsible for this story: Gary Putka at gputka@bloomberg.net; David Scheer at dscheer@bloomberg.net.
Yves Smith editorialBank of America Bosses Find Friend in the Fed: Jonathan Weil
October 19, 2011, 8:22 PM EDT
By Jonathan Weil
Oct. 20 (Bloomberg) -- One of the reasons so many Americans are ticked off at the Federal Reserve is a lingering sense that it puts big banks’ interests above those of ordinary taxpayers. The news that the Fed is taking Bank of America Corp.’s side in a dispute over where to park some of the company’s holdings only reinforces that impression.
Here’s the gist of the story, broken two days ago by Bloomberg News. Bank of America, which got hit with a credit- rating downgrade last month by Moody’s Investors Service, has moved an undisclosed amount of derivative financial instruments from its Merrill Lynch unit to its biggest commercial-banking subsidiary. The latter is loaded with insured deposits and has a higher credit rating than Merrill or the parent company.
The Federal Deposit Insurance Corp. is objecting to the transfers. That part is easy to understand: More risk for the retail lender means more risk for FDIC-insured deposits, which ultimately are backstopped by the U.S. government.
The Fed, however, has signaled to the FDIC that it favors the transfers. Shifting the derivatives to the commercial lender may let Bank of America avoid collateral calls and termination fees stemming from the rating downgrade. Some Merrill clients may prefer having their contracts with the higher-rated unit. In short, the Fed’s priorities seem to lie with protecting the bank-holding company from losses at Merrill, even if that means greater risks for the FDIC’s insurance fund.
Pushing an Agenda
Among the big questions we’re left with: Why is the Fed going to bat for Bank of America in the first place? If the FDIC doesn’t want its insurance fund exposed to potential losses from these investment-banking trades, why expose it? And how many other banks have managed to get the Fed to push their agenda in the same sort of way?
Unfortunately, none of the actors here went on the record to explain what’s going on. We don’t know what kinds of derivatives these are, or even the dollars at stake, only that they are big enough to make the FDIC upset. The entire story would be playing out in secret were it not for some unidentified whistleblowers who seem to have this crazy idea that the public should be informed about what the regulators and Bank of America are up to.
It’s not as if the FDIC’s deposit-insurance fund is flush with cash. It finally turned positive last June, when it finished with $3.9 billion of net assets, after seven consecutive quarters of negative balances. A surprise failure by even one community bank could easily wipe out that tiny surplus.
Capital Doubts
It’s also clear that the market harbors serious doubts about whether Bank of America has enough capital. Its shares trade for less than a third of the company’s common shareholder equity. Transferring the derivatives to the commercial-lending unit, where most of Bank of America’s derivatives are kept already, would let the holding company avoid a capital hit. For all we know, though, the derivative contracts Merrill wrote are far more exotic.
Keep in mind: Merrill and Bank of America each needed two rounds of federal bailout money, back in 2008 and 2009. As for whether taxpayers are still on the hook now, sure, we’ve been told the Dodd-Frank Act passed by Congress last year would end federal bailouts of large banks. It doesn’t exactly do that, though. Taxpayer money still would be at risk in the event that the FDIC has to exercise its new resolution powers.
Dodd-Frank lets the FDIC borrow money from the Treasury to finance a seized company’s operations for as long as five years. While the law says the FDIC is supposed to tap the banking industry to pay for any eventual losses, it’s hard to imagine the agency could ever charge enough to cover the costs from a failure at a company with $2.2 trillion of assets, or any other giant financial institution, for that matter. Plus, there’s always the chance Congress will change the law again.
If neither the regulators nor Bank of America will explain what’s going on here, the only hope may be for Congress to start asking its own questions. Perhaps then we might find out why the Fed seems to believe it’s a good idea to let a huge bank-holding company avoid a blow to its capital by shifting more of its trading risks onto the retail crowd. Taxpayers deserve to know.
(Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own.)
--Editors: James Greiff, David Henry.
To contact the writer of this column: Jonathan Weil in New York at jweil6@bloomberg.net
To contact the editor responsible for this column: James Greiff at jgreiff@bloomberg.net
TUESDAY, OCTOBER 18, 2011
Bank of America Deathwatch: Moves Risky Derivatives from Holding Company to Taxpayer-Backstopped Depository
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.
