Econintersect: An article Tuesday (October 18) by Bob Ivry, Hugh Son and Christine Harper for Bloomberg reveals that Bank of America has been reported (by unnamed sources) to have moved large quantities of their derivatives that were still held by the Merrill Lynch part of the business to Bank of America NA, the FDIC deposit insured part of the business. Bloomberg says that BofA held about $75 trillion of derivatives at the end of June (data compiled by the OCC). (The OCC is the federal Office of the Comptroller of the Currency.) At the end of June $53 trillion in derivatives were already held by Bank of America NA.Bloomberg says that JP Morgan Chase NA, the deposit taking division of JP Morgan holds 99% of that company’s $79 trillion in derivatives. A regulatory battle is reported underway over the BofA situation. The Fed is approving the move and the FDIC is objecting, again according to anonymous sources.
When the Gramm-Leach-Bliley Act was passed in 1999 the former prohibition of any institution acting as any combination of f an investment bank, a commercial bank and an insurance company was removed. This restriction had been in place since the Glass-Steagall Act was passed in 1933 to address the financial system abuses that had contributed to the Great Depression. It was generally believed that, even with Gramm-Leach-Bliley, firewalls could be maintained within multi-functional institutions so that trading and speculative risks could be kept separate from the depository functions insured by the FDIC.
From the Bloomberg article:
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, saidSaule 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.
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.
Yves Smith at Naked Capitalism connects the dots:
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.
Editor’s note: Now, some will point out that all these trillions mentioned are notional values of derivatives that are composed of complex off-setting positions. Thus, the “accountants” will point out, the value at risk nets out to a very small amount. Thus, the argument goes, it doesn’t matter how many trillions are out there if they nearly completely offset each other.
The problem with this argument has a famous portrait child: Lehman Brothers. Lehman had only a few billion in derivatives but their bankruptcy almost brought down the entire global financial structure with hundreds of trillions (notional) in derivatives. Yes, these positions were largely offsetting. Yes, bank capital was probably sufficient to cover all value at risk (the net liabilities). But, when one little domino tipped over, the entire offsetting position structure became potentially unstable and the gigantic global chain of dominoes was at risk of going down. Once Lehman collapsed the entire question of how counterparties would be affected and how that could cascade through the entire global financial system brought the world to the edge of collapse.
The notional value of derivatives today is larger than it was before the financial crisis. A good question: What did we learn from the 2008 collapse?
Naked Capitalism points out that much of the derivative book at JPM Chase NA – and (presumably) much of the $53 trillion at BofA NA on June 30 – was significantly “plain vanilla, low margin derivatives, specifically interest rate and FX swaps.” The latest derivatives in question for BofA, coming from Merrill Lynch, were likely of the higher risk CDS (credit default swaps) variety. That is why Naked Capitalism is saying this situation is different from what has gone on before, at BofA, JPM and other banks. The summary (from NC):
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.