October 20, 2011 / 8:45 PM / in 6 years

BofA puts taxpayers on the hook for Merrill’s derivatives

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.

Markopolos eyes a fortune from BNY whistleblowing

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.

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