Bank of America Deathwatch: Moves Risky Derivatives from Holding Company to Taxpayer-Backstopped Depository

If you have any doubt that Bank of America is in trouble, this development should settle it. I’m late to this important story broken this morning by Bob Ivry of Bloomberg, but both Bill Black (who I interviewed just now) and I see this as a desperate (or at the very best, remarkably inept) move by Bank of America’s management.

The short form via Bloomberg:

Bank of America Corp. (BAC), hit by a credit downgrade last month, has moved derivatives from its Merrill Lynch unit to a subsidiary flush with insured deposits, according to people with direct knowledge of the situation…

Bank of America’s holding company — the parent of both the retail bank and the Merrill Lynch securities unit — held almost $75 trillion of derivatives at the end of June, according to data compiled by the OCC. About $53 trillion, or 71 percent, were within Bank of America NA, according to the data, which represent the notional values of the trades.

That compares with JPMorgan’s deposit-taking entity, JPMorgan Chase Bank NA, which contained 99 percent of the New York-based firm’s $79 trillion of notional derivatives, the OCC data show.

Now you would expect this move to be driven by adverse selection, that it, that BofA would move its WORST derivatives, that is, the ones that were riskiest or otherwise had high collateral posting requirements, to the sub. Bill Black confirmed that even though the details were sketchy, this is precisely what took place.

And remember, as we have indicated, there are some “derivatives” that should be eliminated, period. We’ve written repeatedly about credit default swaps, which have virtually no legitimate economic uses (no one was complaining about the illiquidity of corporate bonds prior to the introduction of CDS; this was not a perceived need among investors). They are an inherently defective product, since there is no way to margin adequately for “jump to default” risk and have the product be viable economically. CDS are systematically underpriced insurance, with insurers guaranteed to go bust periodically, as AIG and the monolines demonstrated.

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.

The FDIC is understandably ripshit. Again from Bloomberg:

The Federal Reserve and Federal Deposit Insurance Corp. disagree over the transfers, which are being requested by counterparties, said the people, who asked to remain anonymous because they weren’t authorized to speak publicly. The Fed has signaled that it favors moving the derivatives to give relief to the bank holding company, while the FDIC, which would have to pay off depositors in the event of a bank failure, is objecting, said the people. The bank doesn’t believe regulatory approval is needed, said people with knowledge of its position.

Well OF COURSE BofA is gonna try to take the position this is kosher, but the FDIC can and must reject this brazen move. But this is a bit of a fait accompli,and I have no doubt BofA and the craven Fed will argue that moving the risker derivatives back will upset the markets. Well too bad, maybe it’s time banks learn they can no longer run roughshod over regulators. And if BofA is at that much risk that it can’t afford to undo moving over unacceptably risky exposures measure, that would seem to be prima facie evidence that a Dodd Frank resolution is in order.

Bill Black said that the Bloomberg editors toned down his remarks considerably. He said, “Any competent regulator would respond: “No, Hell NO!” It’s time that the public also say no, and loudly, to yet another route for running a drip feed from taxpayers to banksters.

Update: Brett in comments raise the question that since JP Morgan books virtually all of its derivatives in a depositary, is this really all that sus?

The short answer is that while this on paper looks similar, in fact the JPM derivatives exposures (and those of the other big banks) are pretty different than those of Merrill. The big commercial banks traditionally were the big players in plain vanilla, low margin derivatives, specifically interest rate and FX swaps. They are ALSO in credit default swaps, so there is no denying that there are risky derivatives included in the mix.

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.

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.

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  1. Lord Wellington

    This surely means that any sensible depositor will withdraw all funds from BAC?

    Why would anyone leave money there.

    1. rd

      I think small depositors well below the FDIC limit could leave their money there.

      I can’t imagine anybody with deposits greater than the FDIC limits will want to keep money there as part of their cash management plan. There are many safer, better options.

      I assume that this is the equivalent of a poison pill anti-take-over defence. Nobody will want to make BAC fold because the losses would be too high to FDIC and others.

      1. Marta

        rd, why leave money in BOA, even if you are under the FDIC limits? It just means you’re going to be one more account we taxpayers will have to pay off to make that depositor whole if BOA goes down. This is just one more example of why every US citizen/taxpayer should should flee BOA and every other TBTF bank: i.e. to protect the taxpayer. Less depositors, less FDIC money to have to bailout.

        We can’t count on the fed or the regulators or the TBTF banks to do anything right (or to do right by us, their clients/constituents). Let’s not continue to give them any ammunition to screw us, starting with our bank deposits.

        1. Calltoaccount

          Remember, Remember the 5th of November: BANK TRANSFER DAY

          Together we can ensure that corrupt crony-capitalist banking institutions will ALWAYS remember the 5th of November! If the 99% removes our funds from major banking institutions to non-profit credit unions on or by this date, we will send a clear message to the 1% that conscious consumers won’t support companies with unethical business practices.

          • Read the FAQ
          • RSVP to Bank Transfer Day
          • @BankTransferDay on Twitter
          • Download Flyers
          • Find an American Credit Union
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        2. Beowulf

          the FDIC does not have enough money to even begin to cover the accounts WHEN B of A goes under. It will get ugly fast!

    2. Richard Kline

      I consider any move of defective assets into a publicly insured institution a criminal act. There is no justification other than to shift the loss to the public, i.e. to defraud the government. I haven’t been a Federal Reserve hater in so many words, but the mere fact that the Fed as presently led and constituted is endorsing such a move is, ipso facto, the decisive evidence that a complete reformation or replacement of the present Federal Reserve system is necessary immediately.

      If the Fed is conspiring to openly defraud the public, which is what the present announcements amount to, we are so far beyond a system that functions in the public interest that such a mission isn’t even a memory, just an historical relic. Yes, the Fed may be, justifiably, worried about an uncontrollable derivate failure cascade. Pushing the costs off onto the depository banking system and hence into the lap of Congress is despicable, and in no way in any interest of the 99%. We could have a massive derivative failure and still have a functional banking system if the depository system is to some extent walled off and preserved. That is _exactly_ the action which the Fed seems hellbent on undermining, in the interest of the 1% and the Five Pits of Abysm of which BoA is certainly one.

      1. Lord Wellington


        What BAC are saying, and what the FED are condoning, is a threat that if there is a call on derivatives written “We’ll take done the deposit system with us”.

        FDIC don’t have the funds.

        Pretty disgraceful really.

        1. PL

          Is there no rule that derivatives are kept separate from deposits even if held by the same entity? Is it that easy for derivative counterparties to collect deposits that are FDIC insured from the holding entity?

          1. Mike

            There used to be a rule separating the investment banks from commercial banks (consumer deposits). It was enacted after the Great Depression and is called Glass-Steagall. It was repealed in 1999 by a bill called the Gramm-Leach-Bliley act, signed into law by Clinton.

            Reinstating the Glass-Steagall act is the best thing we could do to stop this crap and end Too Big To Fail for good.


      2. LucyLulu

        Agree completely with Richard. Either it shouldn’t be allowed or depositors get first priority.

      3. Jim Haygood

        ‘I haven’t been a Federal Reserve hater in so many words, but the mere fact that the Fed as presently led and constituted is endorsing such a move is, ipso facto, the decisive evidence that a complete reformation or replacement of the present Federal Reserve system is necessary immediately.’ — Richard Kline

        Welcome to the big tent, my man. I have a dream: of seeing the Eccles Building imploded like the Pruitt-Igoe houses, as a failed social experiment. And the Bernank sharing a cell with Bernie Madoff.

        Welcome to the Benny and Bernie Show … what a hoot!

  2. Brett

    Seems improper to say the least, but the details are sketchy.

    A. What do they mean it has been requested by counterparties? I assume that means companies Merrill Lynch sells derivatives with/to want those positions moved to an the FDIC insured portion of BAC? If so, I don’t think the next logical conclusion is BAC is admitting it’s about to go under. Sounds more likely that their counterparties want the insurance from FDIC that they’ll be made whole no matter what happens in the future. As I said, that’s improper and should be prevented by regulators.

    B. This paragraph of the Bloomberg story:

    Bank of America’s holding company — the parent of both the retail bank and the Merrill Lynch securities unit — held almost $75 trillion of derivatives at the end of June, according to data compiled by the OCC. About $53 trillion, or 71 percent, were within Bank of America NA, according to the data, which represent the notional values of the trades.

    That compares with JPMorgan’s deposit-taking entity, JPMorgan Chase Bank NA, which contained 99 percent of the New York-based firm’s $79 trillion of notional derivatives, the OCC data show.

    Am I reading this wrong, or does that mean that JP Morgan has 99% of its derivatives exposure located under its FDIC insured subsidiary, while BAC only has 71% of its derivatives under its FDIC insured subsidiary? If so, isn’t JP Morgan even worse than BAC in this regard? And wouldn’t that also suggest that maybe the “worst” derivatives are staying with Merrill?

    1. Yves Smith Post author


      What you are missing is this is a suspect move. Black and I read it the same way. At best, this is an awfully bizarrely timed cleaning up operation.

      JP Morgan isn’t comparable (even thought you would think it ought to be) because it runs a huge derivatives clearing business. The risks in the books are totally different, as in much lower. And the regulators have been looking at those books a long time, while per a conversation I just had with Chris Whalen, Merrill has been the outlier in risk, and no one was supervising these books (the Fed quit supervising Treasury dealers in the early 1990s and the SEC does not do derivatives).

      The normal behavior would be to post more collateral. But they decided not to. That says they are at awfully eager to preserve profits, and at worst worried about their ability to meet the collateral posting requirements if markets get roiled.

      Now it is true that the other big banks do book their derivatives in subs. But the old investment banks always took more risks here, and booked more trades with hedgie counterparties than the old commercial banks did. Even if the books are similar in size, Citi is much bigger in plain vanilla, low risk derivatives like interest rate swaps and currency swaps.

      BofA could have done this any time after it acquired Merrill. The fact that this was triggered by a downgrade, and the other surviving investment banks (Goldman and Morgan Stanley) remain big players in derivatives without having a depositor to stuff says something does not smell right here.

      1. Jackrabbit

        I think you mean they want to preserve “cash.” They don’t seem to have any “profits” to preserve (if you disregard the accounting gimmicks).

        But I bet those faux “profits” will make for really nice bonuses, huh?

      2. steve from virginia

        Totally not surprising (also not surprising is I’ve NEVER had an account w/ BAC in any of its many iterations).

        The maneuvering was underway before Buffett ‘bought’ in, the game was clearly ‘good bank (Buffy) bad bank (the rest of us)’.

        Funny, Nixon bombed Cambodia with B52s and a million boomers hit the streets. Bernanke just bombed America w/ ‘T(rillion) 2’ and nobody will even care …

      3. Siggy

        This is a very serious move on the part of B of A.

        It is also a very serious shift of liability to the FDIC.

        The Fed and the FDIC should be intervening, do not hold your breath, we are soon to have a financial shit storm.

  3. Don Smith

    Yay, Yves! Great post. BofA and the Fed need to be taken down.

    As for who banks with B of A? I can’t fathom.

  4. Bob Spencer

    If Congress thinks they are compelled to protect the depositors with another TARP like deal, then that just might broaden and deepen the power of OWS. Could be fun to watch.

    1. Sufferin' Succotash

      “Could be fun to watch.”

      Especially the part where we see Cantor & Co. babbling about how we really really need to save BAC otherwise it’ll mean The End Of Civilization As We Know It, etc., etc..

  5. steelhead23

    Yves, actually this could lead to an interesting bit of theater. According to Bloomberg, Bernanke supports this move while the FDIC does not. FDIC has the power to reconcile banks it ensures and must have the authority to deny insurance to banks that take unacceptable risks. Section 23a of the Federal Reserve Act requires a separation between the investment banking arm of the holding company and the commercial banking arm. Yet, Bernanke has penned numerous exemptions to the act. This should bring the Admin and the Fed to loggerheads – yet I doubt it will. The bottom line is this: too big to fail institutions MUST NOT FAIL. Hence, they are de facto authorized to do whatever it takes to meet that edict. We now have government of the bankers, for the bankers, by the bankers.

  6. Carter the Examiner

    Think of this as “systemic risk protection.” Having the derivatives with a more stable counterparty could likely prevent a run. It certainly would be easier to fund any possible collateral shortfalls through central bank access.

    If Europe breaks bad, do you want BAC to be vulnerable to a run? Not if you are the financial authorities.

    Do you honestly believ that the FDIC could resolve an entity as large and complex as BAC\ML\CW? It cannot. Don’t kid yourself or your readers. Bill Black may imagine in his dreams that he could have handled this while he was at the FDIC. He couldn’t have. Didn’t you read the completely incredible FDIC argument about how they could have easily resolved LEH?

    Imagine LEH to the power of 10.

    1. Foppe

      Nice exercise in There Is No Alternative there.. You seem oddly fond of the suggestion that everything happening now is rational, or at least that there are no better actions to be taken.

      So, let’s start with #1: what kind of run are you hoping to prevent, exactly? You could just as easily argue that this makes it more rewarding for counterparties to make collateral calls.
      As for your suggestion that this is ‘systemic risk protection’: I don’t quite follow your suggestion (it’s not really an argument, sorry). By creating an even bigger organizational muddle, you decrease risk? Do people pay you to give courses in wishful thinking, or what?
      As for your counterfactual about how “Bill Black could’ve never coped with this”: I’m sure he couldn’t have, if you hired him today and told him to resolve BAC tomorrow, but isn’t the more important point that he (or like-minded regulators) might’ve prevented stuff from getting quite so bad earlier on? I don’t really understand why you are so intent on suggesting that nothing can (or could have) been done (at any time).

      1. Lord Wellington

        “There Is No Alternative”.

        In Ireland, and perhaps elsewhere, we call that TINA.

        Soon to be followed by the WAWWA excuse from TPTB.

        We Are Where We Are.

        1. Jim Haygood

          In an alternate universe, perfect candor prevails among the banksters, who chant WASAWKI:

          ‘We Are Sh*T And We Know It’

      2. Carter the Examiner

        I agree that there is a difference between ex-ante policies, and those policies that we must adopt now. Smaller, more resolvable institutions would likely reduce systemic risk without giving up too much efficiency benefit.

        However, as you ave stated, things are not normal now.

    2. Pitchfork


      You stepped up to the plate, big guy, so here’s the pitch: what exactly do you and others mean when you assert (knowingly, without argument) that FDIC couldn’t resolve a TBTF like BAC?

      I’m just asking for a detailed and plausible scenario of what might make a resolution impossible. Bernanke couldn’t give one. Paulson couldn’t give one. Nor could Geithner. And yet we’ve based three years of policy action on the unsubstantiated assertion that resolution of a TBTF is impossible.

      1. Carter the Examiner

        Several factors:
        1. International coordination – US resolution law does not apply extraterritoril;y. Other countries regulators will take action independently (or the local boards of the subsidiaries may have specific fiduciary responsibilities that force them to take action, as was observed in LBIE)
        2. Funding foreign sibsidiaries – to the extent that a foreign subsidiary is deposit funded and requires funding, distress or BK at the US subsidiary will likely lead depositors to withdraw funds. The only way to prevent this would be deposit guarantees – and I cannot imagine the FDIC guaranteeing foreign deposits, and if it does it then distorts the funding of other institutions).
        3. Herstatt (or FX settlement risk) – Bank Herstatt is the classic central bankers concern – a bank fails when receiving funds on the settlement of an FX trade, but before paying out the other leg. Not all FX is yet settled through CLS – there is still material bi-lateral exposure.
        4. Payment systems – TBTF banks tend to be large participants in multi-lateral settlemet systems. A failure of one of these players could cause payment gridlock (Citi is the classic example here) – BAC internalizes a tremendous amount of settlement exposure on its books.
        5. Derivatives – if books are not perfectly square with each major counterparty, the closeout process is akin to having an asset firesale as other dealers may need to be rebalanced. This can push asset markets in ways that could jeapordize other financial institutions solvency in the short run (a cascade of defaults).

        There are many other significant effects.

        The basic point is not that a failed bank should penalize the equity and debt holders – it certainly should. But there are ways to manage the winddown of a large institution in a way that is less distressful to the financial system and the economy (and ultimately to the consumer).

        Now, I imagine that the readers of this blog may dispute the extent that this will occur. But I’d ask you to consider the recapitalization of Citigroup, where the equity holders were very significantly diluted, and trups and other preferred holders were forced to convert to equity. Not perfect market discipline, but market discipline nonetheless.

        1. Jim

          Carter –

          What if tomorrow it was announced that BAC was now a nationalized institution – the executives and board are dismissed, the shareholders are wiped out, but everything else is business as usual? Appoint a fdic official as CEO with the charter tomwidn it down gracefully, perhaps over years? WhT is so impossible about this?

    3. craazyman

      I bet it would be a piece of cake.

      It’s like exercising, thinking about it is usually a lot harder than just doing it.

      You can totally exhaust yourself thinking about how hard it’s going to be, but once you actually start to sweat and pump you say Whoa, I’m one buff dude. ha ha. ecce homo.

      I’d say let it rip.

    4. Seattle Andrew

      Carter, you’re missing Yves’ overall point. There are certainly pragmatic reasons to allow BofA to shelter derivatives in its depository sub given the current state of banking markets or regulation. The point,however, is that banking markets and regulation are ineffective, corrupt and indisputably dangerous. Quick fixes that provide taxpayer cover for gambling banksters may be “necessary” but the system that necessitates them is unacceptable.

      1. Carter the Examiner

        Regulation, I fear, will never be sufficiently effective to deal with what we have seen. But the root causes (as Yves has articulated at times) goes far beyond regulation (trade and fiscal balances; incentive structures created at the GSEs; competition that collapsed the traditional chain of due-diligence in pursuit of efficiency, etc.)

        I have met very few bankers that are corrupt. Many more than tend to be like Alfred E. Newmann.

        Bankster is a loaded and pejorative term that does not help encourage dialogue, but merely demagogs.

        1. PL

          Do you really believe that the bankers and their enabling attorneys who designed MBS and CDOs were merely youthful pranksters? I know a few bankers and corporate attorneys too and they knew precisely what they were doing when they created bankruptcy remote entities with smirks on their faces. Moreover, their frequently uttered belief in narcissistic entitlement, right wing ideology and disregard for societal norms all point to intentional acts.

          Deadbeat is a loaded and perjorative term that does not encourage dialogue. It is freely tossed about by bankers, servicers, and their attorneys even where there’s overwhelming evidence of mortgage loans designed to fail, job loss and illness as reasons for default. You cannot credibly argue that they use responsible language in a respectful dialogue when inflammatory language and smear jobs are routine utterances by bankers and their ilk.

          1. Carter the Examiner

            I don’t believe they are pranksters, but neither do I blieve they are inherently corrupt. I believe they respond to incentives, and that the incentives created by the firms were misaligned. I also believe that they couldn’t naturally conceive of the downside. They viewed their job as “meeting customer demand” for investable assets.

          2. Nathanael

            Another name for “meeting customer demand” for things which don’t exist is *fraud*. Think about that and look at the fake-AAA-rated MBS again, then decide whether the bankers were criminals.

            I suppose you could just say that they were stupid and deluded themselves, but once it became clear that they’d defrauded their investors, they doubled down rather than committing sepukku as honorable people would. *That* indicates malice.

        2. steelhead23

          -snicker- Right after equating those who run the banks with Alfred E. Newman, you decried our use of the term ‘bankster’ because it stifles dialog. This suggest that our banksters would be offended by comparison with the likes of Frank Nitty, but are perfectly comfortable with comparisons to Mad Magazine’s poster boy. Looking at things like the Magnetar trade, naked CDS, and the chutzpah to demand and get 23a exemptions rather than forcing bondholders to exchange debt for equity really is more of a Nitty kind of thing, don’t you think?

        3. Nathanael

          Structural regulation (such as Glass-Steagal) and bright-line regulation (such as usury laws) have been very effective in the past at preventing banks from getting turned into risky, criminal operations.

          Right now, the major megabanks are run by *banksters* — gangsters who are also bankers. I know some decent small-town bankers, totally away from the megabanks. I’ve also met some people who *quit* the megabanks *because* they were run by criminals. You are naive if you don’t realize what’s going on at these criminal banking operations.

    5. decora

      there is a run right now on the entire existence of modern civilization. go read Aristotle’s The Politics. if the middle class disappears, the society degenerates into some kind of perversion of it’s normal state; you have either quasi-anarchy or a tyrannical dictatorship.

      There Is No Alternative To Having a Viable Middle Class.

      that means you cant rip off their tax money over, and over, and over, and over, and over, and over, and give it to people who spend it largely on cocaine, prostitutes, child support, and alimony. the christians will link arms with the hippies and it will be an ungodly fucking firestorm that will rain down upon whoever the mob thinks is responsible for the mess.

      1. 2little2late

        “…the christians will link arms with the hippies and it will be an ungodly fucking firestorm that will rain down upon whoever the mob thinks is responsible for the mess.”

        A born again Christian I know keeps talking about the end times, telling me that before we know it, cats and dogs will start screwing in the streets. I have no idea what he’s going on about, but I’m like fuck yeah! Let’s do this!

        Seeing as how my previous business dealings with Countrywide has me walking down this dirt road feeling like Granma Joad with my change of clothes tied to a stick over my shoulder, do I give even a slight shit about any of this?

        Bring on this ungodly fucking firestorm you talk of. The entire universe will sigh collectively, then it’s nothing but butterflies and puppies from there on out. Oh, and the ashes of banksters falling from the sky should make for a pretty nice sunset.

        1. liberal

          “A born again Christian I know keeps talking about the end times…”

          Actually, as the _Onion_ pointed out, the world ended three years ago.

    6. anon48

      OK so you’re saying the Fed makes the right move allowing this to happen? That’s the answer? Taxpayer’s get to pay for this, no questions asked? No moral hazard? What keeps this from happening again?

      Your response is a nothing but a rationalization that enables the flaws of the current system to continue, exponentially increasing the risks down the road until the point at which the FED or even a direct explicit US Government guarantee, could not prevent a future catastrophic collapse.

      IMO, make BOA suffer the consequences of its own doing. Force it to retain the CDS risk that it itself created. Then work to change the law so that CDS protection buyers get made whole by government guarantee only if they hold an “insurable interest” in the underlying asset for which the default protection was purchased. Under that scenario, it would be BOA investors, management and CDS speculators that would take the hit, and not the other 99%.

      1. skippy

        “Then work to change the law so that CDS protection buyers get made whole by government guarantee only if they hold an “insurable interest” in the underlying asset for which the default protection was purchased.”

        Sorry defective here (me), how do you ascertain the *insurable interest* of an under]lying asset, comprised of ginned electronic assumptions, which may have been relative when executed lawfully, although after those that decided such norms were no longer applicable (bonus requirements superseded future ramifications), and every thing is an exercise in future [crystal ball?) valuations…cough…maturity.

        Skippy…Time horizons don’t give a fook about paper mathematics or black box assumptions…they don’t have *all* the data…”it does not exist yet”[!!!] or did someone invent a forward looking time machine and told no one?

        PS. no offense implied, just scratching my pointy head.

        1. anon48

          You’re right. The suggestion was overly simplistic. I’m on board with those who say CDS’s should just be banned outright.

          1. marc fleury

            CDS are useful tools for industrial financing. It is naked CDS that can be dubious in more than one way. Contrary to the above it is pretty easy to tell if you are naked or not, you either own the underlying asset or not.

            The diarrhea of the mouse is strong on this site.

          2. skippy

            “The diarrhea of the mouse is strong on this site.” — mark fleury.

            I concur wholeheartedly. See:

            A working paper, Computational complexity and informational asymmetry in financial products, Sanjeev Arora, Boaz Barak, Markus Brunnermeier, Rong Ge. sheds some light on the complex mathematical models upon which credit default obligations and other derivatives are based.

            What Arora et al. prove is not only are many derivative mathematical models impossible to compute, never mind in real time, because they require more computing power than the world possesses, the missing information to run a mathematical model is a very good place to cheat with.


            The pitfalls

            Yes, it is unfair! In fact, CDO is a lot riskier than bank deposits, but Lehman Brothers, like many investors, didn’t seem to know that. Let’s go back to our original model. The first source of error is that we have assumed that each investor has a 3% chance of defaulting. How do we know that? It must be from historical data. The problem is, there hasn’t been a national drop of housing price since the great depression in the 1920s, so the chance that a borrower defaults was calculated on the basis of a good period when the housing prices surged. However, the housing market crashed in 2007. Many borrowers’ properties are now worth even less than the loan they have to pay in the future, so many of them refuse to pay. To worsen the situation, 22% of these borrowers are the so-called subprime borrowers — those who had little income and had little hope of returning money. Banks were not afraid of lending money to them because even if they defaulted, the insurance would pay them back. The participation of the subprime borrowers makes lending much riskier than before.


            We’ve known for a long time now that tranching was a giant cheat. That top tier looked safe only because of a lie. It was only safe if the chances of individual mortgages in the bundle failing to be repaid was an independent event. But the mortgages that were given out like candy to kids weren’t independent in that sense: the events that caused one to fail would cause almost all of them to fail. The supposed safety of even the top tranch was a bad joke.

            Making matters worse, the banks didn’t just sell these bundles of mortgages. They layered them. They’d take a bundle of mortgages, package them into CDOs, and sell them. Other banks would buy parts of those CDOs, wrap up bundles made up of slices of other CDOs, and sell those. And so on, layer upon layer.

            In my opinion, this was, in an ethical sense, simple fraud. Unfortunately, it’s also entirely legal. It shouldn’t be, but most of this stuff is far beyond anything that was imagined by the people who wrote the laws.

            The institutions involved were effectively printing money. They were issuing loans that they knew wouldn’t be repaid, but they still claim the interest from the loans as a profit. They were taking bad loans, and selling them at a profit, to someone else who claimed them as a profitable investment, and who then used the non-existent expected profits from that to buy more stuff – which was frequently repackaged versions of the same stuff. The same garbage was being packaged, sold, repackaged, resold, re-re-packaged, re-re-sold, and so on, over and over again, making a “profit” on each sale. But the profit was fake: bank A would make a CDO, and sell it to bank B. Bank B would wrap that up with some other CDO and sell it to bank C. Bank C would wrap that and sell it to bank A, which would buy it with the “profits” from it’s sale to bank B. Bank B would then buy more stuff from A using the profits of its sale to C. And so on. Each transaction created “profit” that didn’t really exist.

            Skippy…Mark if you like I can unpack the math for you too ie…N is the mother of all assumptions…and that’s if the law (What I payed fore) is followed. Now take that and apply it to all collateralize, securitized debt, tranching, student loans, credit card, auto loans (which in my book is next to go boom). Any who, if you need I’ll provide the basic formulas and splane them for everyone.

            PS. hope to here from ya.


          3. Nathanael

            CDSes are either insurance or gambling. As such, they need to be regulated as either insurance or gambling.

            This was prevented by the odious “Commodity Futures Modernization Act”, which is actually one of the most important pieces of evil legislation leading to the current economic disaster. This piece of evil from the pen of Phil Gramm needs to be repealed immediately.

            As long as CDSes are exempt from insurance regulation, they are evil and need to be abolished. If they were regulated like insurance, then they would be OK.

          4. Skippy

            Nathanael, if the base mathematical assumptions are crap, does it matter whether there regulated or not?

            Insurance or gambling[?] all bets on *future out comes* are a form of a gambit…eh…so whats the distinction you allude too?


            Government regulation

            In the context of a 2010 examination of the ICE Trust, an industry self-regulatory body, Gary Gensler, the chairman of the Commodity Futures Trading Commission which regulates most derivatives, was quoted saying that the derivatives marketplace as it functions now “adds up to higher costs to all Americans.” More oversight of the banks in this market is needed, he also said. Additionally, the report said, “[t]he Department of Justice is looking into derivatives, too. The department’s antitrust unit is actively investigating ‘the possibility of anticompetitive practices in the credit derivatives clearing, trading and information services industries,’ according to a department spokeswoman.”[25]

            Large notional value

            Derivatives typically have a large notional value. As such, there is the danger that their use could result in losses that the investor would be unable to compensate for. The possibility that this could lead to a chain reaction ensuing in an economic crisis, has been pointed out by famed investor Warren Buffett in Berkshire Hathaway’s 2002 annual report. Buffett called them ‘financial weapons of mass destruction.’ The problem with derivatives is that they control an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets. Investors begin to look at the derivatives markets to make a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes a leading indicator. (See Berkshire Hathaway Annual Report for 2002)


            Skippy…how do you regulate N in the exponential magnitude computational world markets now function by, the speed and mass, the HFT algo unknowns? Hell time to price discovery has the self life of an exotic sub atomic particle….shezzz. Humanity’s fate relegated to N’s machinations FTW.

      2. LucyLulu

        Why does government have to make any holders of CDS whole? There’s no federal guarantee backing default swaps, either explicit or implicit.

      3. Carter the Examiner

        At the end of the day, the sovereign owns the deep-tail risk of a financial system collapse. They have a clear interest. Constructing an apriori system that is safer is what is needed.

        Also, if you review their 3Q filings, you will see that BAC has sold off its super-senior book (thereby taking any losses required on that specific book).

        1. anon48

          “At the end of the day, the sovereign owns the deep-tail risk of a financial system collapse. They have a clear interest…”

          True-as things stand now. But but solely relying upon this rationalization assures that the same problems will continue

          “Constructing an apriori system that is safer is what is needed.”

          Really? You think it’s even possible to begin to develop an apriori system capable of evaluating the infinite number of both quantitative AND qualitative variables as exists in the current CDS universe?

          “Also, if you review their 3Q filings, you will see that BAC has sold off its super-senior book (thereby taking any losses required on that specific book).”

          So you think that since potential losses might have been somewhat mitigated your argument becomes- don’t worry… be happy?

  7. skippy

    If the CDOs are shite, then the CDS is squared, cubed, orders of shite…

    Skippy…assumptions are the mother of what[?], then ye leverage that…with a fulcrum of frauds….ROFLOL!

  8. YankeeFrank

    I’m naive I know, but if one of us mere mortals tried to shift assets to, say a relative, prior to bankruptcy; or in the case of an individual transferring assets prior to entering a nursing home to avoid seizure by medicaid, such transfer would be nullified and the assets would be reclaimed and seized. The fact that the Fed is justifying this blatant crime of similar kind just shows, once again, that they don’t give a crap about anything in the world except their precious owners. Let’s see how tough the FDIC is…

    1. Carter the Examiner

      Bad analogy. It is not shifting the risk to a relative, but rather shifting from the right hand to the left.

      Anyway, let’s assume the FDIC takes over and liquidates the institution – where does the initial liquidity come from? The backup line with the US Treasury. How are the losses beyond equity borne? Assessments by the FDIC on other banks (which ultimately will result in higher costs to consumers). Let’s also remember that the FDIC participated in both the Citi and BAC bailouts by holding a mezzanine position in the risk.

      1. beowulf

        That’s no longer true (that FDIC and its member banks bear losses), In January, the Federal Circuit Court of Appeals ruled in Slattery v US that FDIC obligations are also direct Tsy obligations, see my post below at 12:58am.

        1. Carter the Examiner

          And believe me that should the Treasury bear actual losses, they have inumerable ways of getting the funding back from the bankers (taxes anyone?).

          A larger and rarely commented upon issue is the pittifully unfunded FDIC insurance program. The FDIC, with congressional support, suspended fee collection in advance of the crisis for several years. One thing is certain, the price for insurance should never be zero.

          1. Nathanael

            Of course the Treasury has numerous ways of getting its money back from the thieving banksters.

            The problem is that *it is not doing so*.

  9. Marc

    October 18, 2011, 7:37 am
    Investment Banking
    Bank of America Notches $6.2 Billion Profit

    Buoyed by one-time gains from accounting changes and the sale of assets, Bank of America reported a $6.23 billion profit for the third-quarter Tuesday, even as weakness on Wall Street hammered underlying results and the firm surrendered its position as the country’s largest bank by assets.

    1. Mark C

      Well, yeah. they have to justify their bonuses somehow don’t they? Xmas is coming up after all…

    2. Maximilien

      See? Even zombies can be profitable!

      Accounting changes (read: attending physician replaces death certificate with chart saying “patient has improved dramatically”); and asset sales (read: organ-harvesting) have miraculously put “life” back in BofA’s corpse.

      Dead bank walking…..No! It now appears to be RUNNING!

      Just in time for Hallowe’en!

  10. lambert strether

    Typo? You write:

    “Goldman and Morgan Stanley reamin big players”

    but I think this should read:

    “Goldman and Morgan Stanley are reaming big players”

    No thanks necessary, glad to be of help.

    1. Jim Haygood

      Good one! In vino veritas …

      But seriously: anyone who objects to B of A turning its FDIC-insured sub into a garbage barge should OBJECT LIKE HELL to the two investment bank imposters — Goldman Sachs and Morgan Stanley — who are not even legitimate deposit takers.

      Courtesy of Benny Bubbles, the Vampire Squid and its little brother MS get not only Federal Reserve liquidity backing, but FREE MONEY at zero percent to speculate in crude oil, CDSs, whatever.

      This is the scandal of the century — an evergreen Looterfest. But we have defined deviancy downward to the point that to most people, it appears normal.

  11. Xavier

    I fully agree with you and the public has to say NO once and forever. Enough of this constant free lunch that the Government gives to these guys. Are elected politicians employees of Wall Street? We are screwed from every angle that the Government can while these guys are free to do whatevert they want with taxpayer money and at the same time make personal fortunes with salaries and bonuses that nobody can dream of!!! When is someone going to stand against that seriously?? When are these people going to be hold responsible and go to jail?

    1. Maximilien

      “When is someone going to stand against that seriously??”

      Xavier: I was going to answer your first question, but lambert deftly took care of it.

      So great. I’m stuck answering your second, far more difficult question. But here’s my attempt:

      If something is possible then given enough time it will happen. I believe that someone taking a stand against the current corruption “seriously” IS possible. Therefore, it WILL happen sometime in the future. As to WHEN…..well, sorry Xavier, I can’t answer that.

  12. Jeff Boyd

    Thinking out-loud for a minute:
    1) BAC parent could engage in fraud by shifting assets from one legal entity to another without sufficient compensation. Maybe that could be the case but I tend to doubt Bloomberg just stumbled onto another Enron.
    2) Merrill could have paid banking company to assume responsibility for the CDS. To my knowledge there is nothing illegal about subsidiaries doing business with each other.

    I’m just baffled as to what you are suggesting here. Is it conceivable that you have been used by others to spread false rumors?

  13. Hugh

    I’m opting for criminality, conspiracy to commit fraud. Of course in a kleptocracy this is really all business as usual. This example just shows how baldfaced the looting has become.

  14. rotter

    The zombie monstrosity that is the present global banking system needs a silver bullet in the head. Then western civilization should return to real economies which provide real wealth in minerals, agriculture, manufactured producted and materials etc., this is what civilization is. The “economy” of swapping and loaning money and charging a fee for touching it, usury in other words, is not wealth, it cannot sustain us, and we should return it to its once usefull and respectable position as a necessary if distasteful service, like garbage collection or military service.

    1. decora

      silver bullet is werewolves.

      zombies you have to cut the head off.

      vampires – stake through the heart.

      ironically, you have captured exactly the sort of Congressional incompetence that Dodd Frank represents – a silver bullet shot into a zombie, who responds by pausing for half a second, and then saying “need more brains”

  15. problem is

    Thanks Yves… I knew you would give us the whole run down and put it in banking industry context in your analysis…

    Thanks for filling in the holes and uncensoring William K. Black.

  16. brian

    it must be about that time for obama to say again nothing illegal here just immoral

    then continue on the campaign trail

      1. Aleealee

        She wants to rattle some sabres at Iran…don’t you know? You should read that Correntewire stuff. That’s some good stuff.

  17. rf

    Aside from the Bloomberg article and a bunch of opinions of that article is there any actual disclosures from the fed or BAC on this subject? I could not find anything so far.

    There’s way to much supposition here and really no solid details, only the headline. Even the bloomberg story uses a bunch of fill because the reporter has no detail.It would be interesting to read a disclosure with details.

  18. Richard


    A quick question about the FDIC and its new resolution authority. Does the FDIC have the ability to be act in a pre-emptive fashion and resolve a financial institution before it collapses? If so, why doesn’t it exercise this authority and put Bank of America out of the taxpayers’ misery?

    1. Yves Smith Post author

      BofA admitted to it in the investor conference call today but tried to pretend nothing was amiss. This story has to have come either from someone at BofA who didn’t like it, an unhappy counterparty, or the FDIC, with the odds strongly favoring the last.

      1. Nathanael

        OK. So who is the current head of the FDIC? Apparently this person clearly knows perfectly well that BoA (the insured depository bank) is making itself insolvent, from the complaint. Apparently the FDIC has the power to seize it and shut it down right now.

        The FDIC moves fast, so it seems implausible that the FDIC head could be removed after deciding to shut down BoA but before shutting it down. Or is there a reason that that could happen? Who has authority to remove the current FDIC head, anyway?

        Barring that possibility, we are left with the conclusion that the only reason the FDIC *isn’t* doing this is that the person at the head of the FDIC is being blackmailed or bribed in some fashion to prevent him/her from doing his/her job. So what is the evidence regarding said bribes and blackmail?

  19. Jackrabbit

    If BAC goes belly up and a new bailout is “requested” then I’m sure we will be told that: no one could have foreseen such an event – not even warren buffet!

    A cynic would probably bet that (somehow) BAC’s need for $ will become most acute in the winter months when protests are likely to be not well attended.

  20. F. Beard

    It’s the deposit insurance. Without the FDIC and if the government as the monopoly issuer provided a risk-free storage service for its fiat then most people would not use the banks. Hence banks would have tiny reserves. And without a lender of last resort, the banks would not dare extend much credit.

    There it is. The banks screw us because they are privileged by government to do so. Our money system is fascist.

    Well, at least we know the free-market did not fail. It was just a failure of fascism.

  21. SteveA

    The question is whether these derivatives are “qualifying financial contracts” under the law — if so, yes, this is rape, because FDIC is obligated to honor qfc’s in the event of a bank’s insolvency.

    1. SteveA

      To clarify about qfc’s: this means that counterparties on qualifying contracts will be made whole (ultimately at taxpayer expense), without the Fed or Treasury intervening directly, as they did with Bear and AIG. So they’re preparing for another back-door bailout for Wall St, without that messy issue of getting Congress to vote the funds.

      Btw, I take this transfer of liabilities from Merrill to the depository as a sign that BoA is, in fact, quite likely to fail.

  22. nonsense

    i’ve been reading documents from all the banks in the last 3 years as part of an array of the securities class actions going on against all the big firms in new york–including lehman and bear of course.

    my take is that these bankers only know the game they are playing against each other, like monopoly. they are also fully aware that they have no clue how all this nonsense number games will end— (defined in the trillions of notional and positions marked to whatever you can make your internal risk managers and counterparties believe) —but they know full well it will end. many of the mid levels are in denial or have no clue. the higher ups no full well, this is not a game that goes on forever because of some organized chaos. it is fully disorganized chaos waiting to explode and theres no reason any one of them should jump off a cliff before the others until they have a good reason ( they’ve already made enough money to leave wall street )

    it will take a long time, but eventually americans will suffer so much poverty that more people will suffer from malnourishment than obesity. maybe it will take 50 years and another 2 full financial collapses, first of the federal reserve, than of the treasury, to get back there. a full generation may pass. but one day, this nation will be impoverished. the brain drain will take people to where there is money and dictatorships.

    this democracy charade perpetrated by the military industrial complex is a race to the bottom of the stupid barrel.

  23. Tom Parsons

    Help an old science person here, who is only learning about modern economics.

    This BofA move sounds to me the same as if I saw that my comprehensively insured house was well ablaze, and then shoved a bunch of the old junker cars in my yard into the garage so that I could claim them as fire losses at whatever value I tell the insurer to accept.

    We all know how well that would work for us ordinary people. Or am I misunderstanding this?

    Are you saying that the political reality is that FDIC will have to accept BofA’s claim for losses on stuff that was never in the insurance policy to begin with, and that would have been refused coverage if the request had been made?

      1. skippy

        Dang forgot to ask, were the old clapped out vehicles checked for any…BODY’S…dead or still breathing…eh.

  24. Charles


    Let’s assume what you say is true.

    What is Dick Bove going to say in BOAs defense? Dick seems to have an answer for everything these days and will probably call this move “shrewd” or “brilliant”….

    Also, do you think that they cleared this with Warren and he gave them the go-ahead on this?

  25. psychohistorian

    Thanks for the posting Yves.

    Any thoughts on who might have pushed BofA into this? How about Warren B with his recent infusion. Will we ever know?

    If so many people weren’t being hurt by this it would be fun to watch. The global inherited rich need to be removed from societal policy making positions and taken to the Hague to be prosecuted for crimes against humanity.

  26. beowulf

    But it’s even worse than that… 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.

    ITS WORSE THAN EVEN WORSE THAN THAT. In January, the Federal Circuit Court of Appeals ruled in Slattery v US that FDIC obligations are also direct Tsy obligations. Congress doesn’t even have to vote on it, FDIC creditors may now elect to file suit at their local US District Court against FDIC or in in DC at the Court of Federal Claims against Tsy directly. Geithner might have to mint those platinum coins after all.

    Because the majority rules that the FDIC is not a NAFI, the United States is now directly liable for the FDIC’s contractual commitments. Mr. Slattery and future plaintiffs like him can now sue the United States in the Court of Federal Claims… The FDIC, however, has no statutory obligation to reimburse the government for any damages paid out of the Judgment Fund. Accordingly, from this date forth, taxpayers, not the FDIC, shall bear the burden of the FDIC’s contractual commitments… the majority has by judicial fiat created a more direct bailout than the 1989 Congressional bailout of the savings and loan industry

  27. Paul Tioxon

    Yves, this in not Machiavellian nor is it plain evil. Although I get your drift. This is extortion, a tactical move with only one choice do or die. Death is never chosen, no matter how much people say they want to go to heaven and meet god.

    These are moves that are no different than the planned default by the republicans under the leadership of Harvard educated, Wall St trained derivative trader and current US Senator from PA. Yves, these people are no longer running capitalism as a productive force in coalition with other networks of powerful people, they are at war with one another for survival as the problems of capitalism cause disruptions or run into barriers whether man made government regulations or no more new worlds to open up to their surplus capital.

    Just as the world has broken up into a mult-ipolar system, not just Soviet vs USA and company anymore, but 5 or 6 or more players coming along, the wealthy class has broken up into innumerable networks, all moving in different directions, determined by where and how they make their money. If the government is wrecked and the citizenry shell shocked, their are those that do care, although you don’t believe it. That doesn’t mean there is any high level movement to enlightened power sharing and a transition to a rational political economy. It does mean, that people in management like BofA, are desperate and will do anything to maintain. Capitalism has worked around many, much more serious problems, such as overpowering aristocratic political systems, and building a new social order around them. It is designed to do that. This small maneuver is no more than a clever logical play, based on the structure built up around them that they have navigated for decades.

    It’s devastating consequences are another in a long line of mortal blows to Americans, and every institution that made this nation a livable and fortunate place to be born into. Not any more. The people are cracking up. Not just protesting in the streets, but in the privacy of their homes, Americans are abusing their children, killing 20,000 kids in domestic murders in the last 10 years. More than have died in the military in AfRaquistan. The chickens have come home to roost. I am sorry to see even more brinksmanship played out on Wall St with the nuclear fallout wafting into my lungs. But this is who they always were, even before they blew up America, they have been blowing up everybody else in the world. It has just come to pass that we are not truly needed, even a little by the banks, in order to make billions in profits each and every quarter. Plan on fighting for a long time, this is going to go on until one side does not function.

  28. Conscience of a Conservative

    Of course the FDIC was against it. They have to backstop the losses, and this again proves how the banks are not practitioners of Free Market Capitalism when they constantly use the Tax Payer to shoulder losses, but not profit.

    I doubt this was an honest discussion with the FDIC. Sheila Bair in her exit interview with the Times was famously quoted: “They would bring me in after they’d made their decision on what needed to be done, and without giving me any information they would say, ‘You have to do this or the system will go down.’ If I heard that once, I heard it a thousand times. ‘Citi is systemic, you have to do this.’ No analysis, no meaningful discussion. It was very frustrating.” “

  29. roy partridge

    The FDIC objection is probably just a CYA move. FDIC is under Treasury and Timmy probably approved the move.

    1. Conscience of a Conservative

      Of Course Timmy supported this. He has to support the current system because to not do so would mean acknowledging the failure of what he put in place both at the NY Fed and while under Rubin at the Clinton administration. He helped destroy Glass Stegal, prevented regulation of derivatives and supported Bank America in their bid to buy Countrywide and Merrill.

    2. Yves Smith Post author

      The FDIC is NOT under Treasury. It’s an independent regulator and its budget comes from deposit insurance premiums.

      The FDIC is more vulnerable than usual because it has only an acting director right now.

      1. beowulf

        Well that’s the twist. On the one hand, current law (as of this year) says that obligations of independent agencies like the FDIC are also obligations against the credit of the United States (think 14th Amend).
        Meanwhile, our elected President is not allowed to supervise and control over the independent agencies which are exercising federal executive power (and incurring federal obligations) every day.

        I daresay, the sooner Chief Justice Roberts and his crew blast into full-on unitary executive mode and put the independent agencies under the President’s authority (who could delegate supervision to Tsy Sec and other cabinet secretaries), the better.
        “No one doubts Congress’s power to create a vast and varied federal bureaucracy. But where, in all this, is the role for oversight by an elected President? The Constitution requires that a President chosen by the entire Nation oversee the execution of the laws.” Free Enterprise Fund v. Public Co. Accounting Oversight Bd..

        1. steelhead23

          Beo – You are correct that the recent appellate court decision making FDIC debt, U.S. debt while there is no corresponding administrative oversight of the FDIC is untenable. But I despise your proposed solution – more executive power. There is another route – legislation. The Congress could simply revise the authorizing statutes to place FDIC in Treasury. I would prefer the appellate court decision be vacated, but the Roberts court is unlikely to do that. BTW – I greatly appreciate your being on this forum – it is useful to get the views from the belly of the beast.

          1. beowulf

            From the belly of the beast? I don’t work in DC (or for the government, if that’s what you meant).
            I’m just a simple country lawyer.

            As to your point about Congress putting the FDIC inside Tsy, how is that not exactly the same result as I suggested? In either case, the Secretary always serves at the pleasure of the President. He’s a busy man and he can’t get everything done himself. Simply put, the executive branch consists of 1. the President and 2. his agents.

  30. Bill G

    And this from a business with gold plated executive toilets (Thain) – shocking, just shocking. But seriously, what are the odds B of A did this without consulting their regulators and our representatives in Treasury that will pay off all the derivatives once B of A’s rotting carcass can’t stand up any more. Don’t be surprised if it turns out this is a Federally approved transaction!

  31. rc whalen

    I am going to riff of Yves fine post and gently correct some perceptions on a couple of issues later today. FDIC can always reject a contract, period, especially when moved into the bank. So Merrill CPs should only be so happy for so long until the exposure is squared off.

    1. beowulf

      Right and Dodd-Frank did enhance FDIC powers in a couple important ways, among others: It can block Fed exemptions to Article 23A bank/affiliate deals; it was given “backup enforcement authority” over banks’ whose conduct puts Deposit Insurance Fund at risk. So I agree, by hook or crook, FDIC can reject this, both before BoA transitions from undead to dead, and after.

  32. Jeff Boyd

    Financial markets are in large part based on confidence about the future. Sure if BAC engaged in a fraudulent transfer that is one thing but to see so many people so sure this is what happened with so little evidence is incredible. I have only read the Naked Capitalist on occasion but I thought it was a well respected blog and I still think that. If this what intelligent folks who have never had the opportunity to work in a corporate setting think then I am very pessimistic about the future.

    I’d say nationalize the banks, renounce all credit and say all transactions henceforth shall be in cash so we could get away from this destructive cycle but getting there would just be too difficult. We will have to muddle through.

    1. PL

      Now you’re the one making assumptions. How do you know that NC readers haven’t worked in corporate settings? Or at ivy league institutions where the vast majority of those in finance got their MBAs? Perhaps one reason that NC readers are so pessimistic is because they have been on the inside with ethically compromised bankers and know the crackpot economic theories that informed their so-called education.

    2. Lefty

      François Mitterrand was the last true social democrat elected in the West. He did try to implement a left-Keynesian economic program and was attacked by the financial markets. One mistake he made was his nationalizations. He didn’t just nationalize them by buying a controlling share, he took 100% control of them.

      That would be a horrible idea here. I think the government should treat finance as a utility but it should set up its own institutions, not nationalize corrupt institutions drowning in debt. If you nationalize these zombies you take on their debt. Just let them die and protect the little folk when that happens the best you can.

      Propping up the debt overhead in the economy, not letting it massively shrink relative to the real economy, is killing us. Kill off the new rentier class in finance.

      1. Nathanael

        FDR knew that when it came to banks, the right thing to do was to set up his own government-run banks, rather than to nationalize the old, failing banks.

        (It’s different when it comes to operations with meaningful physical assets, like roads, railroads, power lines, internet lines, or water or sewer systems. There you have something genuinely valuable which would be difficult to replicate, and you may want to nationalize. Banks have nothing physical which is hard to replicate.)

  33. wat

    Yves, thank you for your blog. I wish the Facebook posting came with a NakedCap logo we could choose alternative to ECONNED icon. Not that your book doesn’t deserve more distribution, but I don’t want people to be mistaken about the content of the posts if they just glance cursorily.

    Thanks Wat

  34. BondsOfSteel

    Isn’t spinning off Merrill part of the self imposed death plan for BAC? This move would also make it much more valuable and easy to sell.

  35. financial matters

    A great example of a company being destroyed as top execs still walked away with large compensation…

    Stanley O’Neal relinquished his title as chairman and CEO of Merrill Lynch & Co. in October, after a 21-year career there, and less than a week after the company reported an $8 billion loss on subprime related investments.

    O’Neal was eventually replaced by John Thain, the former chief of NYSE Euronext. In 2006, O’Neal received $46 million in total compensation, including an $18.5 million bonus and $26.8 million in stock awards, according to SEC filings.

  36. Hugh

    No more bailouts? Or just bailouts by another name? What we are seeing with the Twist, the Fed’s dollar swaps program, and deals like this are backdoor bailouts. Why else would BAC attempt this move? Does anyone think BAC just did this on its own without getting it greenlighted by the PTB?

  37. JMNYC

    BofA started moving as many derivative positions as possible into BANA ASAP after the merger closed. Regulatory and tax reasons meant some ML positions stayed in ML but BANA always has the cheapest capital so that’s where they want these trades booked. Its a no brainer. The reason JPM has 99% in the bank and BAC only 70% in BANA is the logistics around combining major platforms. For example, BANA had no equity derivatives business to speak of so perhaps it was best to keep that in ML. CDS were pushed to BANA since BANA had a major CDS platform already. When the merger closed, the combined entity had multiple ISDAs with each counterparty. So, task #1 for derivatives trading was to pick a legal entity and pick a trading platform. As the older ML deals age and roll off, the 71% number will only go up. The gross generalizations about why its probably ok for JPM to have all its derivatives in its bank but not BANA are pulled out of thin air with no support whatsoever. No derivatives dealing should be conducted out of an insured depository institution. If its bad for one, its bad for both. But it will never change since if the US banks were limited, deriviatives would just be traded off shore and with European and Asian universal banks.

  38. Market Prophet

    Great investigative reporting. But, I can’t seem to become outraged anymore when there’s absolutely nothing the public can do about it. The people running the show are in charge of enforcement, but they’re the ones being complicit in these schemes. Knowing the facts doesn’t really change anything.

  39. Lefty

    I have a question for some folks here. Is this legal? Is it possible that people can sue the government, or stop them from transferring their losses onto us?

    I ask this because Eric Toussaint has been talking for a while now to do an audit of the debt that governments (recently with countries in the EU) have taken on from finance and to see which debt is or isn’t legitimate. If the debt was transferred over to tax payers without there being any debate or vote and if it will result in vital programs being cut, what logic could be used to justify this? How could a handful of unelected people push this through at the expense of the vast majority of the public?

    Is there a way to stop this legally?

    1. Nathanael

      Our legal system is crap at this point. Federal judgeships have been stacked since Reagan with corporate stooges, but that’s not the worst. It’s impossible to bring private criminal suits. (This *is* possible in the UK.) This means that a corrupt Department of Justice can let criminals get away with practically anything. Fraud against the people as a whole isn’t considered sufficient standing to sue, either, unless you are the government, which gets back to the corrupt Department of Justice. Don’t get me started on the smaller ways in which access to the courts is denied — the US was rated as being worse than Mexico recently in an international comparison of transparency and access to the court system.

      The best move you can make is a run on Bank of America. Get your money out now.

  40. Rodger Malcolm Mitchell

    “Moves Risky Derivatives from Holding Company to Taxpayer-Backstopped Depository”

    No, no, no. I’m amazed the headline writer doesn’t know taxpayers do not pay for federal spending. If he/she understood Monetary Sovereignty he would realize there is no connection between federal taxes and federal spending.

    If taxes fell to $0 or rose to $100 trillion, neither event would affect by even $1 the federal government’s ability to spend.

    This will have zero impact on taxpayers (unless Congress and the President continue to pursue their ridiculous, Tea Party, “reduce-the-deficit” efforts).

    Rodger Malcolm Mitchell

  41. DanPorter

    To Yves Smith,

    I would actually agree with commneter Brett that there is just as much concern for JPMorganChase as BankofAmerica, despite your update suggesting otherwise.

    It’s alarming that BankofAmerica is pulling this off right now at this moment, as it’s a recent development in an ongoing — and ever-growing — crisis.

    But what if Chase has been worrying about things for a tad longer and, as of such, has had more time to pull off such similar tactics?

    Remember that JPMorganChase absorbed both BearStearns and WashingtonMutual, one coming with a government sponsored or induced buy with compensation and the latter with significant overhead costs.

    The story goes that the Fed told JPMorganChase that they would take BearStearns and would cover the toxic assets under their holding with a lump sum.

    I wouldn’t be surprised, however, if those toxic assets are alive and well and that the money to cover them was never spent on them directly in the first place, and that JPMorganChase saw newfound opportunities to shuffle around bad capital and take free money in the process. Nor would I be surprised if the Fed did this with a wink and a nod, merely implying that it was a suggestion. It makes perfect sense to think that the powers that be at JPMorganChase would calm some watching eyes by letting them know that the problems at hand are heavily insured, albeit by the FDIC.

  42. Nathanael

    Does the FDIC have the authority to simply shut down Bank of America’s insured banking operation *right now* on the grounds that management are proposing to make the bank insolvent?

    I think it does. The FDIC’s powers to shut down banks are very broad. An expert can correct me if I’m wrong.

    The FDIC should probably shut BoA down THIS WEEKEND, or early, before this derivatives scam goes through.

    1. SteveA

      Insured banks are shut by their primary regulator, not by the FDIC. In BoA’s case, the primary regulator would be the OCC, which is part of Treasury. FDIC does have the authority to yank deposit insurance coverage but I don’t believe they have ever done so.

  43. Economic Maverick

    Is it correct to claim that the 2005 bankruptcy law changes would apply if BofA went under? If BofA became insolvent, it would go into FDIC receivership, NOT bankruptcy.

    Wouldn’t that put depositors ahead of derivatives contract holders because depositors are higher in priority than senior debt holders? I’m not sure.

    Anyone know what the prioritization is of an FDIC receivership? Is it necessarily the same as bankruptcy?

    1. SteveA

      Google FDIC “qualifying financial contract” or FIRREA.

      QFC’s are a statutory exception to the FDIC’s prerogative as Receiver to cancel executory contracts.

      Yes, the counterparties to qfc’s are made whole. This (mis)feature of the deposit insurance laws dates back to 1989–it was passed over the strenuous objections of then-Chairman Bill Seidman.

      In the case of BoA, FDIC could argue that the contracts BoA assumed from Merrill were completely unrelated to its banking business and point to specific language in the law to avoid paying them — but the chances of this happening are zero.

  44. Lex

    A word of clarification about fraudulent conveyance/fraudulent transfer (the latter is just a more modern term for the same doctrine): the term is a bit of a misnomer, as it does not require actual fraud. What the term refers to most ordinarily is a transaction which is subject to set aside by a creditor which aggrieved by the transfer of assets by a debtor, because debtor did not receive fair value in return and therefore shrank the pool of assets available to satisfy debts.

    Fraudulent transfers are creatures of civil not criminal law (more specifically, bankruptcy.) And they are voidable (not void) within a certain period of time looking back prior to an insolvency.

      1. Xenos

        Who? Bankruptcy court. FDIC, as a creditor, could sue to put the bank in bankruptcy, then file a motion to have the transaction reversed as a fraudulent transfer or preference (unfair preference of one creditor over another).

        Probably not necessary, as the FDIC should have the power to demand this without going to court. This is a matter of administrative law, so the FDIC should have a lot of discretion. Beyond that, find the right kind of regulatory lawyer for an answer.

  45. nuke

    Citi is doing the same thing.

    It’s motivated by the new Resolution rules. Not an indication of an intent to go into bankruptcy but, rather, desire to have more control — to a degree via blackmail — over what gets sold in what order if stuff hits the fan.

    Sandy Weill built the Citi supermarket, then told Congress, “Guess what — we’re not in compliance with Glass-Steagall. What you gonna do about it? ” Congress of course repealed the law.

    Something similar is going on now in reaction to dodd-frank. The big banks are throwing all their stuff into the NA bank unit to make it too multifarious and perhaps confusing for regulators to easily handle.

  46. DaveG

    Not too much comment on the details of these derivatives – whether the clients are domestic or international, CDS or not – and who the counterparties were that’demanded’ that they be shifted to the deposit taking unit of B of A.

    Any thoughts or ideas? Seems to me that if they were CDS written on either Eurobanks or sovereigns this event could indeed be the ‘big one’.

    Commentors have some terrific insights here. Thanks for pointing out the implications.

  47. Ray Phenicie

    Can somebody explain two things that are pointed out in a Bloomberg analysis which Black at New Economic comments on also:

    –Bank of America posted a $6.2 billion third-quarter profit today, compared with a loss of $7.3 billion a year earlier, as credit quality improved and the firm booked one-time accounting gains.
    Huh? are these real profits or were accounting tricks performed?

    —Bank of America’s holding company — the parent of both the retail bank and the Merrill Lynch securities unit — held almost $75 trillion of derivatives at the end of June, according to data compiled by the OCC. About $53 trillion, or 71 percent, were within Bank of America NA, according to the data, which represent the notional values of the trades.

    I’ve attempted 20 times to understand a derivative-took calculus 1,2 and 3 and read a learned a lot about mathematical meanings for the word which I have connected to the financial world’s use of the word.
    $75 Trillion though-is that anything meaningful?

    1. DaveG

      Somewhere I read that the average real exposure is about 10% of the notional value of these derivatives. So lets say 10% of that 10% goes bad ($750B) – B of A is toast and because of the bankruptcy laws explained above, after liquidation of assets, the bank first pays the counterparties to these derivatives and if anything is left then the depositors. The tax payer through FDIC is on the hook for the rest.

      From what I gather, if the bank did not assume these liabilities, the risk to the taxpayer would be much much lower.

      There are others who know more about this and this forum seems to the best place to work this through.

  48. DaveG

    Just an aside to the above. The bankruptcy law that put derivative payouts in front of depositors was put into law under – drum roll – George Herbert Walker Bush. Thanks for that.

  49. Mike

    I read elsewhere that all of these derivatives were of the “level 3” (SFAS 157) variety, aka they are valued by black-box methodology without observable market inputs. I would like to see confirmation though as to whether they indeed are of the “level 3” sort…

    RE level 3 (wiki)

    //However, significant assumptions or inputs used in the valuation technique are based upon inputs that are not observable in the market and, therefore, necessitates the use of internal information. This category allows “for situations in which there is little, if any, market activity for the asset or liability at the measurement date.”//

    //Also known as mark to management. //

  50. Steve

    Here we go again with the doom and gloom with no evidence to support. The internet sure is full of BS. BoA has an investment grade bond rating from all 3 credit ratings agencies and only downgraded due to anticipation of less systemic support from the gov’t. The downgrade has zero to do with balance sheet or viability. The bank has 400 billion in liquid assets balance sheet, a 5 billion investment from Warren Buffet, a profitable quarter, 2 trillion in total assets and will take years to work through the litigation. There is absolutely zero evidence that BoA is even close to going under. They moved the derivatives into the core bank only because the investors of the credit default swap demanded greater assurance of return on investment. They got it in the form of FDIC backing now. It’s remarkable the shittt you read on the internet.

    1. Karla Rove

      The problem with $75 TRILLION, not $BILLION, is that $400 BILLION in liquid assets isn’t going to go very far when all those Wall Street Bankers want their bets paid. B of A would need at least that much cash on hand to pay out these contracts. With only 400 billion assets and a 30 to 1 leverage, that’s only $12 TRILLION. And they just got downgraded. Even with 0.25% loan that’s a big hunk of change. That’s why they aren’t going to get much systemic support from the government, without a bunch of folks getting lynched.

  51. Steve

    Karla, all the big banks, including Citigroup, JP Morgan, etc. and not just BoA have huge derivatives exposure. JP Morgan holds 78 trillion of derivatives exposure and Citi at 50 trillion. They did before the financial crisis and they do now. That’s how the game works and a major reason for what set off the financial crisis when people began defaulting on their mortgages and the big banks then became liable to pay up on the derivatives. The derivatives currently, as in the past, are helping banks earn a profit and shore up their balance sheets. THe only way they become toxic is if something catastrophic happens, for example an EU default, etc. But if that were to happen, the world would be in a load of shittt, not just BoA or Citi or JP. We’re talking global financial meltdown and you can bet the Treasury would come in to rescue the banks again. After all, 99% of US derivatives market is concentrated among the 4 largest banks. Bottom line is that there is always risk in the financial system as 2008 showed. However, the risk is now even MORE concentrated. These large banks will not be going under anytime soon and “Too Big To Fail” is still alive and well. Just ask ole Warren.

    1. DaveG

      Steve, you identify the risks these banks face. The question is why should Treasury, aka, the government, aka the taxpayer be forced to shoulder risks that are not even disclosed, let alone appropriate.

      By placing the counterparties in front of depositors in the event of bank failure due to a miscalculation, BofA and Merrill have forced the US taxpayer – not the bank shareholders, which is where the risk should be – to bail out any entity the bank has sold CDS on should it fail. The judge and jury of this tainted process are the credit raters, rather than the bank regulators.

      And worth means size, nothing else. The bigger the better. The higher the level of extortion, the more impossible to say no.

      You are right to say these banks cannot make a profit without these activities. But is that really the tax payers problem, to guarantee the counterparties to deals megabanks make?

      How did this come to pass is a question that needs to be addressed. The lawmakers who repealed Glass Steagall are the first people to ask. Then the lawmakers that enabled the Bankrutcy act of 2005 are next that included this onerous provision placing CDS counterparties ahead of depositors.

      You will eventually come to the conclusion that these people have set up the multi-trillion dollar extortion scheme that you and I and 300 million others are now the victim of.

  52. Steve

    Dave, the gov’t was the entity that failed to regulate and therefore should be the one on the hook. Deregulation of the mortgage and financial sector was a disaster. If the taxpayers don’t want to be on the hook for all these mortgages, they should have voted for our gov’t to regulate rather than electing republicans and libertarians into office to deregulate. THis is the fault of the gov’t, the taxpayer AND the banks. We all hold fault so simply blaming everything on banks is ridiculous. How about all the people who took out mortgages they couldn’t afford or lied on their loan applications (Liars Loans?). But this issue is different from the one posed on this site about the “Deathwatch of BoA”. There is zero evidence to support such a scenario of a deathwatch, at least in the next few years. The balance sheet is strong and improving, the credit rating is investment grade, and the last quarter was profitable. If it truly is death watch for BoA then it’s deathwatch for every single major bank because they all have similar risks, exposures, etc. These major banks are actually a reflection of the underlying state of the US economy. ANd if the economy deteriorates to such an extent to drive any of these 4 major banks under, then you better hope for a bailout or else we’re all screwed. In any case, the doom and gloom on this site and of the “Deathwatch” mentality is simply ridiculous.

    1. DaveG

      I agree with your view, just that we are really the patsy here.

      As far as BofA and Citi goes, share prices are down 90% or so from their peak. Just wonder in retrospect (since FDIC) how many financial companies actually survived after such a beating. As you know mkt does not accept their numbers, bk value is three times share value. Thats a tell.

      I say bust’em up before they bust us up.

  53. Pacard

    I have to believe this was negotiated a long, long time ago. My bet is BoA negotiated the ability to move the derivatives to an FDIC insured subsidiary at the time they “purchased” Merrill Lynch.

  54. Doutor Amorestranho

    I have a few questions.

    What is the FDIC’s liability with respect to CDOs?

    When a bank that is a member of the FDIC fails, depositors are compensated by the FDIC up to the legal limit, but nobody gets compensated for their investment in a CDO, I would think. Is that correct?

    When the FDIC seizes a failed member bank, it mitigates the cost of compensating depositors by selling the failed bank’s assets, and in the case of assets in the form of CDOs, the FDIC can expect to receive a fraction of the nominal value, yes?

    As the nominal value of all CDOs is estimated to exceed five to ten years worth of global annual GDP, it is not possible for all the deposits in all the banks in all the world to amount to more than a small percentage of the nominal value of all CDOs, no?

    If this recent move by Bank of America is part of a last-ditch effort to forestall failure, and if that strategy fails, wasn’t it too late for Bank of America anyway, and won’t the FDIC’s liability be pretty much the same as it was before the move?

    I’m just trying to assess the scope of the potential problem here. Beyond that, I very much regretted the demise of Glass-Steagall in 1999, and similar reckless behaviour of recent decades. I am not in the least bit interested in trying to defend financiers. I’d just like to put it in perspective.

    1. Doutor Amorestranho

      Steve –

      The situation I posed with respect to a last ditch effort for BoA to save itself was meant to be hypothetical. You answered a question I didn’t ask, but in the process, I think you at least partly answered the questions I did ask. Thanks.

  55. Steve

    This is nowhere near a “last-ditch” effort to forestall anything as Douter wrote above. A last-ditch effort would be BoA putting Countrywide into bankruptcy, management selling their shares, and the dividend payout on the stock being reduced to nothing. Countrywide is the only aspect of BoA’s business hurting them now and as soon as they jettison that you will see a much more profitable company. The fact that some fool writes a deathwatch article about BoA putting CDS into the core banking operation when every other major bank has done exactly the same thing is ridiculous beyond comprehension. BoA was just late to the game doing it and required to do so by investors due to recent worry over Greece, the economy and BoA’s sunken share price. Reduced stock prices, while correlated with default are extremely imprecise in predicting default. BoA maintains a strong balance sheet, investment grade bond rating and has the capacity to jettison Countrywide if needed. They haven’t done it yet due to legal complexities and don’t want to create a panic.

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