BofA

(image: Thomas Hawk)

The Bank of America (BAC) recently moved derivatives out of its Merrill Lynch subsidiary into a subsidiary plump with FDIC insured deposits. Bloomberg says the Fed wants to protect the bank holding company without increasing its own obligations. The FDIC opposes the transfer because it increases their risk. Dday’s take is here.

Three of the five biggest derivatives players have already done this. The OCC Quarterly Report on Bank Derivatives Activities gives information about derivatives held by banks, and by bank holding companies, separately. AS of June 30, 2011, the numbers are nearly identical for JPMorgan Chase, Citigroup and Goldman Sachs. Only Morgan Stanley and BAC had a significant part of their derivatives outside the warm embrace of the FDIC.

BAC apparently held $21.7 trillion in notional value outside of banking subsidiaries at June 30, and it has now moved that into FDIC insured institutions. [Compare Tables 1 and 2 of the OCC Report.] The Bloomberg article doesn’t say exactly how much, and it isn’t reported in BAC’s earnings release for the third quarter. A reporter asked about this in the earnings call. Bruce Thompson, the Chief Financial Officer of BAC, said he was surprised by the article, and that the move was in the normal course of business.

The OCC Report gives some idea of the increase in risk. It uses a measure of risk called Total Credit Exposure, which is equal to the sum of Net Current Credit Exposure and Potential Future Exposure. The first is the net amount owed to the bank if all contracts were suddenly liquidated. The second is an attempt to estimate the potential future losses, using a formula developed by regulators. This number is compared to the Total Risk-Based Capital, which is the sum of Tier One Capital and Tier Two Capital. This calculation effectively excludes Tier Three Capital, the assets for which there is no liquid market and no clear method of calculating value.

According to the OCC Report dated 6/30/11, the ratio of Total Credit Exposure to Total Risk-Based Capital at BAC was 182%, meaning that regulators calculated the potential losses from derivatives at nearly double the total of the assets subject to valuation in liquid markets.

So let’s assume that substantially all of the $21.7 trillion in derivatives in the holding company moved to the FDIC-insured bank. If we assume that those derivatives were at least as risky as those already held by the bank, and Yves Smith thinks they are much more risky, we can estimate that the risk to capital ratio moved from 182% to at least 257%. In numbers, the estimated exposure increases by $115 billion, from $281 billion to $396 billion. With reserves at about $3.9 billion, it’s no wonder the FDIC is concerned.

Of course, the Fed loves it. Bank holding companies can do no wrong as far as the Fed is concerned. The risk to taxpayers, and the moral hazard issues are utterly irrelevant to Ben Bernanke and his buddies. Of course, given the vast conflicts of interest at the Fed, this isn’t a surprise.

There are reasons to be worried about this. First, BAC moved the derivatives at the request of counterparties. The counterparties have a right under their derivative contracts to demand collateral from BAC, as they did after the company’s rating was reduced earlier this year. BAC estimates that would require an additional $3.3 billion in collateral. The downgrade was due to judgment by the ratings agencies that the government was less likely to bail out BAC if it got into trouble. Thus, the effect of the downgrade was to increase the direct risk to the FDIC, by forcing it in effect to guarantee the derivatives of Merrill Lynch. Nice opinion, ratings agencies. I wonder who paid them for it?

Second, if the FDIC has to liquidate BAC, it will have to borrow from the Treasury to pay depositors, and it will have to bill the largest banks for additional fees to pay off the Treasury loans to the extent of actual losses. We have no idea of the interlocking relations of these giants, so we have no idea whether the collapse of one would wreck others. Media reports say there are concerns about the relationships between European banks and US banks, so there is reason for concern about the relations among US giants. If one collapse could lead to others, where is the money coming from to repay the Treasury?

The following shows the Total Credit Exposure/Total Risk-Based Capital ratio for four of the largest banks at 6/30/11:

JPMorgan Chase: 274%
Citigroup: 203%
BAC: 182%
Goldman Sachs: 788%

That’s pretty chilling.

Third, 82% of derivatives in notional amount are interest rate swaps. Interest rates are at historic lows. What happens when they go back up to normal levels? The OCC Report says that the values of interest rate derivatives increased because interest rates dropped during the second quarter. That may be a problem when interest rates rise.

Fourth, BAC has a huge position in credit default swaps, with a notional value of $4.1 trillion. Oddly, the bank subsidiary seems to have a position of $5 trillion, and I don’t know what happened to the other $900 billion. (See Tables 1 and 2 of the OCC Report). Anyway, as we saw with AIG, when CDSs go sour, the counterparty has the right to demand collateral right up to the moment the entity fails. In this case, that collateral would be cash, and it would directly reduce the amount of cash in the Bank. That would be a disaster for the FDIC, which would have to pay off the depositor losses up to the insured limit. Using figures provided by bank analyst Richard Bove of Rochdale Securities, we can estimate that the FDIC obligation to depositors at the bank is about $800 billion, compared to the FDIC’s reserves of $3.9 billion.

If the FDIC took over the bank subsidiary, it could reject the derivatives contracts immediately. That would staunch the outflow of cash, but it would be bad for unsecured creditors, including bond-holders, and holders of uninsured deposits, whose claims would be diluted by the massive claims of holders of derivative contracts. One potentially nasty outcome is that big depositors will start demanding collateral for their accounts. If the bank complies, it reduces its ability to lend. If it doesn’t, big depositors will start to pull out.

A number of smart skeptics have weighed in on this transaction, calling it everything from outrageous to criminal, and saying that the regulators are cheating taxpayers to pay for losses by the rich.
Here are Yves Smith, Bill Black, and Christopher Whalen.

Brian Moynihan, the CEO of Bank of America, says the bank has a right to make a profit. Apparently he has a right to dump risks on other people if it increases bank profits.