Bank of America came under further scrutiny this week after Bloomberg reported that the company moved risky derivatives from its investment bank arm to its retail banking unit following a Moody’s downgrade last month.(To clarify: Bank of America Corp. is the holding company that oversees Merrill Lynch — the investment banking division — and Bank of America — the retail banking branch everyday people use.
Derivatives are financial instruments or contracts in which the worth is determined by the quality of the assets they are derived from, such as loans and stocks.)
Although Bloomberg did not attempt to put a number on the value of the derivatives that BofA shifted, the New York Post is reporting that BofA’s shift had a notional value of over $55 trillion.
The benefits for BofA — and the possible risks to the federal government — in this transaction can be whittled down to two points that many people feel is unfair, because it sounds like another bailout:
1. BofA can save money. Due to the Moody’s downgrade, the company will have to set up increased collateral payments or termination fees on contracts (estimated at up to an additional $3.3 billion in a regulatory filing). But shifting the derivatives to the higher rated retail branch may allow them to avoid that loss, Bloomberg columnist Jon Weil pointed out. In addition, BofA will be able to keep Merrill clients happy (they reportedly asked BofA to move the derivatives) and retain their business. Bloomberg reported that a large part of the push behind moving the derivatives came from “clients” and “partners” on their investment banking side.
2. Moving the derivatives to the commercial bank branch means the federal government will be backing the financial instruments. The Federal Deposit Insurance Corp. insures retail banks because it holds people’s (taxpayer’s) deposits. In the case that the bank collapses, the FDIC is allowed to borrow money from the Treasury to help run the bank and pay back its customers. Although the FDIC does not insure derivatives, Felix Salmon at Reuters points out the banks can use funds in its depository to pay off counterparties – and when there isn’t enough, the FDIC will continue payments. That’s effectively transferring responsbility from BofA’s investment banks to the federal government – from private debt to public debt. (Although, would the really government allow BofA to collapse?)
Another caveat: The move has created a rift between the Federal Reserve and FDIC. BofA believes it has the right to move its derivatives without regulatory approval, according to Bloomberg. The bombshell in the Bloomberg exclusive was that the FDIC is against moving the derivatives — naturally because they do not want to be held responsible in the case the derivatives fail. The Fed, however, has indicated they support the measure, focusing their concerns on the fiscal health of the holding company.
Since the Bloomberg story was published, financial bloggers and columnists across the web spectrum have weighed in on the measure, mostly with a negative sentiment. From calling the Fed criminal and corrupt to speculation that Bank of America is restructuring to file for bankruptcy, they’ve said it all.
Their worries and anger are logical. This kind of movement of derivatives by BofA might technically not be legal. Section 23A of the Federal Reserve Act limits the amount and regulates the quality of assets that can be moved between non-bank factions and banks because of the risk it poses to federally-insured deposits, according to Bloomberg.
But after the financial crisis, several banks were granted exemptions from Section 23A (they were later taken away). As for BofA — they were allowed an exemption until March 2010, and another exemption was granted in September 2010. So BofA may technically be allowed to move these derivatives, but as Bill Black pointed out in his column — someone should really figure out the composition of the derivatives that were moved around.
Also, there’s been a ton of speculation on the stability of Bank of America these days. The company’s stocks are down over 50% year-to-date and CEO Brian Moynihan has been closing branches and cutting thousands of jobs. And no one’s sure how much capital the bank has on hand — that’s an important figure because it’s a cushion the bank can use against risk. Also — they’re still not off the hook for all the toxic assets and mortgage securities they picked up through the the Countrywide acquisition, there are ongoing lawsuits.
And if the derivatives or bank do collapse, Weil surmises the taxpayers may have to bail them out again. Though the Dodd-Frank Act no longer allows bank bailouts — the FDIC has the power to use Treasury funds to run a government-seized bank. (That sounds a lot like a bailout.) The law stipulates that the banks will have to pay back the fees, but will a bank ever be able to pay back the costs to bail out a trillion-dollar company?
Of course, there are also reasons to remain calm and let the storm pass.
For one, putting derivatives into the commercial lending branch is something that all banks have done. As we noted before, the Fed granted Section 23A exemption to a lot of banks, and they used it. Derivative-holding giant J.P. Morgan has almost all its derivatives held in its retail operations. (Though some say J.P. Morgan’s derivatives are regulated differently than BofA’s.)
Another interesting thing that Weil points out is that most of BofA’s derivatives are already in its retail side.
Overall, there are underlying questions here that challenge the complex system between the federal regulators fearful of another recession, the financial giants and an economic livelihood that hinges on the industry’s survival.
Also, what the symbolic significance of the Fed’s support for BofA means for the Volcker Rule — meant to separate the risk of investment banking from retail operations — is another interesting angle to ponder.