Friday, October 21, 2011
The global economy is stalling out again, possibly entering another recession as severe as 2008, and the largest US financial institutions have already carried out their escape plan so that can live to speculate another day.
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.
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. 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.
Yves Smith of naked capitalism explains the brazenness of this action in relation to Bank of America:
So, for any of you out there planning to attend a general assembly at OWS or any other Occupy Together location, please bring this matter to the attention of the participants if they are unaware of it.
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.