Opinion

Felix Salmon

BofA puts taxpayers on the hook for Merrill’s derivatives

By Felix Salmon
October 20, 2011

Bloomberg had a story, a couple of days ago, about BofA moving Merrill Lynch derivatives to its retail-banking subsidiary. The story was quite long and hard to follow: there were lots of detours into explanations of what a derivative is, or explorations of what the BAC stock price was doing that day. So let me try to cut away the fat.

Bank of America is being hit with downgrades. And as we saw with AIG, when a derivatives counterparty gets hit with downgrades, it has to post lots more collateral. In BofA’s case, the numbers are very large indeed:

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.

On the other hand, retail banks are much safer, because they’re protected by the FDIC. If a retail bank is a derivatives counterparty, then it doesn’t need to post nearly as much collateral. The derivatives aren’t themselves insured by the FDIC, but they have extremely senior status, which means that the bank can use its deposit base to pay off derivatives counter parties. And then if there isn’t enough money left to pay depositors, the FDIC will step in and make those depositors whole.

So Bank of America decided to move some unknown quantity of derivatives from Merill Lynch — which doesn’t have an FDIC-insured deposit base — over to its Bank of America retail subsidiary, which does.

The FDIC was not happy about this — it makes it more likely that they will have to pay out in the event that Bank of America runs into trouble. And when the FDIC pays out, that’s a hit to taxpayers, the letter of the law notwithstanding. Jon Weil explains:

The market harbors serious doubts about whether Bank of America has enough capital…

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

Now it’s worth pointing out here that other big derivatives houses, most notably JP Morgan, have used their retail-banking subsidiary as their derivatives counterparty for years. Now that Merrill is part of BofA, there’s no obvious reason why it should be worse off than JP Morgan is with access to Chase. But Yves Smith makes the case that the two are in fact significantly different:

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.

I’m not entirely convinced by this. I don’t think that JP Morgan’s derivatives operations are particularly assiduously regulated — certainly not to the point that would make the FDIC happy. But I also hate the “everybody’s doing it” defense. The whole point of the Volcker Rule was to stop banks with retail-banking privileges from abusing those privileges in their risky investment-banking operations. And that’s exactly what’s going on here. And as Bill Black points out, the whole thing is dubiously legal in any case:

I would bet large amounts of money that I do not have that neither B of A’s CEO nor the Fed even thought about whether the transfer was consistent with the CEO’s fiduciary duties to B of A (v. BAC).

The point here is that regulators care much more about Bank of America, the retail-banking subsidiary which holds depositors’ money, than they do about BAC, the holding company which owns Merrill Lynch. And the senior executives at Bank of America have a fiduciary duty to Bank of America — never mind the fact that their shareholdings are in BAC. The Fed, in allowing and indeed encouraging this transfer to go ahead, is placing the health of BAC above the health of Bank of America. And that’s just wrong. Holdcos can come and go — it’s the retail-banking subsidiaries which we have to be concerned about. The Fed should not ever let risk get transferred gratuitously from one part of the BAC empire into the retail sub unless there’s a very good reason. And I see no such reason here.

Comments
29 comments so far | RSS Comments RSS

Bank of America has booked its own derivatives through a FDIC insured bank for years, $38 trillion worth of notional, prior to the Merrill takeover. Consolidating the Merrill positions is common sense and both are a matched book just like JPM (although not expecting Bill Black or Yves Smith to know what that means).

Posted by alea | Report as abusive
 

Hey Alea – you should do a post explaining what you mean in detail. pretty please. thanks in advance!

Posted by KidDynamite | Report as abusive
 

more details:
as of end of q2-2011, BofA had $54 trillion of notional with the FDIC insured bank and that will increase to $74 trillion after the switch. Total credit exposure to capital less that JPM and much less than GS.

Posted by alea | Report as abusive
 

@KidDynamite:
what I mean is that all banks (except MS) book the bulk of their derivatives to the FDIC insured bank, so don’t see why Bank of America should keep 25% of it (the Merrill part) to the bank holding corp to pacify Yves Smith.

Posted by alea | Report as abusive
 

How are we going to fit that on a sign at #OWS?

Posted by ucgoldenbears | Report as abusive
 

@Alea – yes, and the Bberg article that everyone is quoting notes that JPM has 99% of their positions in the FDIC insured side.

as Nemo put it when I questioned him why no one was talking about JPM’s balance sheet alignment:

“JPM did not suddenly move them there in response to a credit downgrade and over the objections of the FDIC?”

thoughts? optics are bad for BAC?

Posted by KidDynamite | Report as abusive
 

a) Theoretically (!) all the positions that JPM has could be “valid” ones, which are in there for the express purpose of hedging exposure (ForEx, etc.).
b) And, Theoretically, JPM could be pure as driven snow, and not have stuffed their positions with Grade A Financial Crap (TM) .
c) And Theoretically, BAC could just have figured that they had *not* put their ‘risk mitigation’ positions in the retail banking part, and as part of Project New BAC, are just cleaning house and moving them.

Ok,even assuming that (a) and (b) are valid (desperately trying to not choke on my coffee as I type this), would anyone seriously believe (c). I’m with @KidDynamite – the optics on this are hideously horrifically bad…

Posted by dieswaytoofast | Report as abusive
 

@Alea: you write “both are a matched book just like JPM”

I’ve looked at the 10-Qs for credit derivatives pretty closely and what BAC reports does not reflect a matched book. See page 123 of JPM’s latest 10-Q reporting an unmatched notional of $145 Billion in credit derivatives on a $3 trillion credit derivatives book versus pages 143-44 of BAC’s latest 10-Q reporting $1.1 trillion in offsetting identical underlying reference names on $2 trillion of credit derivative notional value.

It’s possible that other aspects of Merrill/BAC’s derivatives books are balanced (please tell me where to look in the 10-Qs for evidence), but given our recent experience with credit derivatives when a dealer reports that 45% of its book is not identically matched trades, there’s something to worry about.

Of course, we can’t tell whether the credit derivatives are the ones being moved, but it’s hard to be comforted by the claim that BAC runs just as careful a matched book as JPM, because that claim is not reflected in the 10-Qs.

Posted by csissoko | Report as abusive
 

I am sorry you have thrown your lot in with folks like Henry Bloget having given up analysis and moved into the propaganda business. This is a shame.

You wrote a reasonable article back in 2008 about Countrywide being bankruptcy remote. Why don’t you write an article on that topic again? You keep writing as though Bank of America has absorbed all the potential liabilities and I think you know that this simply is an argument that has been rejected by all but a single New York judge who has allowed discovery on the topic to proceed. Allowing discovery is a long way from saying BAC is liable but you continue to ignore this simple fact along with the decisions from courts in other States. How about it Mr. Whalen? You are a very bright fellow, why not write an article on the topic?

Now you write an article saying that Merrill Lynch selling some derivative contracts to the bank holding company is an indication that the parent company is about to file bankruptcy. This is so absolutely weird that I have a hard time even knowing what questions to ask. How is this for a starter, every company I have ever worked for had transactions between different subsidiaries for good business purposes and yet none of them ever filed bankruptcy. I’m just completely baffled as to why you would write something so misleading when I think you know better.

Oh well. I guess this sort of thing is the way of the world. Maybe I’m just missing something but I think your intent is to create fear and we all know how fear and panic impacts banks.

Posted by JeffBoyd | Report as abusive
 

@csissoko:
“I’ve looked at the 10-Qs for credit derivatives pretty closely and what BAC reports does not reflect a matched book.”
I have gone through this with you before.

Posted by alea | Report as abusive
 

alea, I think Mr Salmon has a bet on with his colleagues as to how many times he can fundamentally misrepresent how different bits of a bank work.

Posted by Danny_Black | Report as abusive
 

“…clearly Reuters does not bother to fact check blogs.”
http://blog.rivast.com/?p=5007

Posted by alea | Report as abusive
 

alea, was it necessary to add the word “blogs”. Although to be fair I recollect Mr Salmon saying that blogs were like his opinion and as such no one should expect it to be factually correct, which I personally find a strange position for anyone to take, let alone a “journalist”.

Posted by Danny_Black | Report as abusive
 

Hey, thanks a lot for this post I found it really interesting and insightful. Recently I have been using some investment analysis software which has really kept me on track with my finances. There is a really good Derivatives pricing model too. It was all a bit daunting at first but now it has been amazing for me because it is online tool I can access their help forums 24/7. Thanks again for the post.

Posted by Ksween | Report as abusive
 

@csissoko, I have not read the exchanges in which alea has gone through this with you before. So, at the risk of duplicating alea’s post, I am going to take your question seriously and answer it.

A “matched book” with respect to, say, IR or FX means matched with respect to market risk. But in the nature of things, this overall matching will involve being net long or short to individual counterparties. After all, if we had a truly matched book with a single CP, we could just scratch it, right?

Consequentially, our “matched book” is then not matched with respect to credit risk without further action. The conventional way to achieve this is to go into the market and buy (or sell) credit protection according to the CVA (DVA) arising from the rest of the book. The result is that it is impossible for a bank to be running a book that is matched overall unless the CDS portion of it is not matched. A matched CDS book means that the bank is running dangerous credit risks and is a signal that it probably is not charging business lines correctly for the credit they are consuming.

Your observations are drawing hostile commentary because they implicitly rest on a position that is value-destroying; dangerous for banks and for society generally.

Posted by Greycap | Report as abusive
 

@alea: I have no memory of going through this issue with you. Were you using another @name (besides @jck)?

@Greycap: You and I did go through this issue before.

So given what you write are you implying that JPM, because it is not protecting itself sufficiently with CDS is running dangerous credit risks?

I didn’t notice any hostile commentary on my observation, and find remarkable the claim that reading 10-Qs (and the information that the FASB/SEC require them to include) and comparing them is a value-destroying activity. Are you sure you didn’t mean to claim that the opacity of bank books is value-destroying?

Posted by csissoko | Report as abusive
 

@csissoko:
I use alea or jck. I don’t remember when or where, but I am pretty sure I went through this before with you, but since I am getting a bit ancient I may be wrong.
Matched book means matched/hedged for risk, so the “derivatives book” can be matched while the *credit derivatives book” isn’t. For ex, if you are long a bond and long protection with a CDS, you are matched for risk (i.e. hedged) but you have a credit derivative position that looks unmatched because the counterpart is not another CDS. The DTCC also reports net notional that way, a CDS is matched if hedged with a CDS on the same name, not matched if hedged with bonds, or CDS indices or CDS on other names, yet risk is mitigated in all cases.
It is impossible to run a derivatives books in the trillions without being matched.
Best to look at the quarterly OCC report table 6, gross positive and negative fair value of the book are a fraction of notional and the difference between the 2 (profit if book could be liquidated instantly) is minuscule and has little volatility indicating a matched book for risk and that these banks are essentially picking up a spread.
http://www.occ.gov/topics/capital-market s/financial-markets/trading/derivatives/ dq211.pdf

Posted by alea | Report as abusive
 

@alea. Thanks for the response. The fact that “gross positive and negative fair value of the book” are close to equal does not strike me as clear evidence that the book is matched (i.e. necessary but very far from sufficient). Basically the question seems to come down to one of whether or not we can trust bank management to run their derivatives books competently. I certainly hope it is true that BAC is competent enough to run a well-matched derivatives book without excessive basis risk.

BTW, do you have any ideas on why the 6-30-11 credit derivatives book in Table 12 of the OCC report (for derivatives held by Bank of America’s bank only) is $0.5 trillion greater than the 6-30-11 credit derivatives book “where the Corporation is the seller of credit protection” reported in the 10-Q?

Posted by csissoko | Report as abusive
 

@csissoko:
Indeed derivatives book on aggregate are run competently, look at the OCC report over time and it is crystal clear that if banks have problems, it’s not because of these books, losses there have been very small.
For your last question, I believed it’s related to difference in the treatment of netting in the call report(less netting) and financial statements. but not guaranteed, I haven’t look at this for a while.

Posted by alea | Report as abusive
 
 

Seems to me that Alea_ and Rootless_e, whoever they may be, do protest too much. The mere fact the FDIC opposed this move, while the Fed approved it, speaks volumes doesn’t it? Also Lisa Pollock has explained precisely why the manoeuvre leaves such a bad taste in the mouth in today’s FTAlphaville blog post http://ftalphaville.ft.com/blog/2011/10/ 24/710126/merrill-lynchs-derivatives-set -sail-for-safe-harbors/ As Simon Johnson put it on Bloomberg today the manoeuvre “condones the continuation, or perhaps escalation, of taxpayer-backed gambling on a grand scale” http://www.businessweek.com/news/2011-10 -23/bank-of-america-is-too-much-of-a-beh emoth-to-fail-simon-johnson.html This is not something to be welcomed and if Alea and the Obamabot Rootless_e believe it to be such a wonderful move the very least they could is to do so publicly rather than masquerading behind aliases.

Posted by IanFraser | Report as abusive
 

rootless_e, did Yves Smith ever have any credibility? Always seemed to me that she did a good job of cynically cashing in on the mood post crash, along with others ( cough PragCap, cough Barry Ritholz ).

IanFraser, firstly you know Yves Smith is an alias right? Secondly, “journalists” use their real names all the time despite being consistently wrong. I would trust an Alea, bondgirl, economicsofcontempt and kiddynamite each and every single time over any financial journalist.

Posted by Danny_Black | Report as abusive
 

Of course I know it’s an alias. And her real identity is well known. The bitchiness of some of the above comments surprises me.
Nobody has a monopoly of wisdom. Some may like to think they do, but they’re only fooling themselves.
Also Danny_Black, from your comment above I assume that you never trust anything you read on Dow Jones, Bloomberg, Reuters, Wall Street Journal, The Economist, Financial Times etc, etc and that you happily discount the output of the thousands of financial journalists they employ?

Posted by IanFraser | Report as abusive
 

btw Danny_Black I was interested to note that one of your favoured bloggers, Bond Girl, not only hangs her entire blog post on the derivatives switch controversy (https://self-evident.org/?p=933) on a Bloomberg story, but also uncritically cites Yves Smith.

Posted by IanFraser | Report as abusive
 

Mr Ian Fraser: this is not about wisdom, this is about FACTS.
“The derivatives aren’t themselves insured by the FDIC, but they have extremely senior status, which means that the bank can use its deposit base to pay off derivatives counter parties.”
FALSE. PERIOD.

Posted by alea | Report as abusive
 

Ian Fraser: The person who has to use the word “obamabot” in lieu of an argument is the one lacking in credibility, not the person who bothered to do some research. As for the alias, I’m not ashamed to stand with James Madison.

“The mere fact the FDIC opposed this move, while the Fed approved it, speaks volumes doesn’t it?”

No. Your idea of journalism might be to extrapolate motives from anonymous comments about what someone in an agency might have said, but mine does not.

I like your quoting of a number of worthless sources,all of whom go back to a misunderstanding of the same over-sensationalized Bloomberg article, none of whom seem to have bothered to read Dodd-Frank or think about the meaning of both BoA and JP Morgan already having most of their derivative positions in the depository bank might mean. I suppose, however, that if it is widely reported, it’s factesque and that’s good enough for some.

Posted by rootless_e | Report as abusive
 

What’s remarkable about Ian Fraser’s (if that’s who he really is) remarks is that the obvious level of expertise displayed by Alea only makes him mad – because his pre-existing narrative is being contradicted.

I suggest a little introspection about your need to lead with personal attack when exposed to dissent from the sad group think that passes for “left wing” these days.

Posted by rootless_e | Report as abusive
 

Danny Black: I still give Nomi Prins the prize for factesque indignation. She wrote once that the Fed had trillions of dollars of agency mortgage bonds for which there was no bidder. I asked her what she could possibly mean, since the agency bond market is not defunct and she said she had not meant it literally but had instead meant “no bidder” in the sense one might say “raining cats and dogs”. You could not make stuff like that up.

Posted by rootless_e | Report as abusive
 

IanFraser, well frankly, Yves Smith is just dishonest. I have difficulty believing that she is unaware that she is making factually incorrect statements, especially given she is strongly financially motivated to make them.

I am also afraid to say that, yes, I don’t trust what I read in any of those publications. Bloomberg, for instance, seems to have just gone downhill since buying Businessweek. Reuters has been dodgy for as long as I have been around, not only in terms of letting the rather homogeneous ideology of the journalists shine through but in employing people with a shocking ignorance of the basics of their chosen field. Ft was always a mix. One of the reasons I like this blog is that it links to original documents – I tend to skip the commentary and read them.

rootless_e, I think this is at the base of the issue of journalism. It might seem there are “thousands of financial journalists” beavering away, acting as a natural overlapping fact checking machine and I am sure they like to see themselves as harden, cynical men and women who take nothing on faith but the reality is that most of them just cut and paste from each other. I have seen over and over, a single dodgy article become “fact” from sheer repetition from other sources.

I wouldn’t mind except there are real consequences for such nonsense. One only has to look at the focus of financial regulation to see how bad “journalism” can impact the world. In particular, the focus on prop trading vs say money market funds or capital requirement vs liquidity management.

Posted by Danny_Black | Report as abusive
 

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