Simon Johnson on Bank of America, the FDIC, Dodd-Frank

[Slimprofits]

http://www.bloomberg.com/news/2011-1...n-johnson.html

By Simon Johnson Oct 23, 2011 7:05 PM ET

Through the back door, U.S. regulators are facilitating another round of implicit bailouts, putting more taxpayer money on the line in the form of guarantees. Bloomberg News reported on Oct. 18 that regulators have allowed Bank of America to move highly risky derivatives contracts -- and the associated downside risk -- from Merrill Lynch into the insured retail deposit-taking part of the bank.

The move puts the Federal Deposit Insurance Corp. on the hook for any losses. The FDIC’s deposit-insurance funds come from its member banks, but because the agency can tap a U.S. Treasury line of credit if the fund runs dry, taxpayers could be at risk, too.

This condones the continuation, or perhaps escalation, of taxpayer-backed gambling on a grand scale -- and by people who aren’t very good at it. The U.S. is heading in the direction of Western Europe, where state-backed banks repeatedly bring everyone to the brink of disaster. Consider, for example, UBS AG’s recent rogue-trading episode.

Bank of America is a behemoth beyond control. The destruction of shareholder value in its recent history is shocking. The Wall Street Journal reported on Oct. 19 that the bank has spent $148 billion on acquisitions since 1998 and today its market value is only about $65 billion.

Bank of America is also a badly managed bank. In 2008, Ken Lewis, then the chief executive officer, agreed to pay about $4 billion to buy Countrywide, a disastrous foray into mortgage origination and distribution that will probably end up costing shareholders more than $60 billion. Eric Schneiderman, the New York state attorney general, is calling for a full investigation of mortgage abuses; egregious and allegedly illegal behavior at Countrywide must be very much in his sights.

Lewis bought Countrywide after a year’s worth of due diligence -- what was he thinking? -- and then grabbed Merrill Lynch over a weekend in September 2008, apparently without much thought. Significant additional losses were the result.

Why the FDIC would agree to escalate taxpayer subsidies now is a puzzle. According to people familiar with the situation, the Federal Reserve pressed for this move, which required an exemption from the usual rules. This outrage demands immediate congressional investigation.

Does Bank of America have enough capital to avert disaster? From its third-quarter results, it has $2.2 trillion in assets, making it the second-largest bank in the U.S. The book value of its tier-one common equity is about $117.7 billion -- hardly a robust buffer against the shocks that appear likely from mortgage litigation and from the European debt disaster. Investors believe that much of this capital will be wiped out -- hence the lower market valuation.

A large chunk of its most recently reported profit actually turns out to be due to the decline in the market value of its debt, precisely because investors realize it is in so much trouble. This ludicrous application of accounting standards should raise major flags for regulators.

If Bank of America really had enough capital, it wouldn’t have needed to move its derivatives risk onto its FDIC-insured deposit business. Nor would the Obama administration be strenuously resisting the New York attorney general’s efforts to organize a full and fair mortgage settlement based on all the facts.

Could the resolution authority be used on Bank of America? Definitely not in a way that would bring calm to the markets. Merrill Lynch is a global business and the resolution authority is purely domestic. I have discussed this point repeatedly with U.S. legal and financial experts and with members of the Group of20 nations. Their opinion on this point is unanimous: The Dodd-Frank resolution authority doesn’t help manage the orderly liquidation of a global bank.

There could be a conservatorship, but that is just a long word for full creditor bailout. Or there could be a bankruptcy, with the kind of disorganized collapse seen after the failure of Lehman Brothers Holdings Inc. Those are the choices.

Could the living-will provision make a difference? The FDIC claims it would have handled the problems at Lehman differently if the Dodd-Frank powers had been in effect and if it had full and timely information. But the essence of the argument is that the FDIC would have acted before the problems got out of control. Given the politics of the regulatory process and the predisposition of Treasury not to act early, I am skeptical.

So here is a fair test for this part of Dodd-Frank. Bank of America should clearly be broken up into pieces, spinning off Merrill Lynch along with other structural changes. Will the regulators pursue this course of action? Breaking up the bank would be good for the country, should help stabilize the financial system and could even create value for its shareholders.

[Chomsky]

Re: Simon Johnson on Bank of America, the FDIC, Dodd-Frank

I don't know enough about this to have an opinion, but I read this counterpoint today and thought I'd post it here.

Yves Smith's Credibility
Monday, October 24, 2011 | Posted by rootless_e at 7:40 AM
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Bank of America moved some derivatives from its Merrill-Lynch subsidiary to its depository bank and the so-called "progressive" blogs became very upset. One problem with their reporting is that apparently none of the "Progressive" financial experts understands what"notional" means so they really over-state how much money is at risk. But more importantly, they don't seem to understand what the Dodd-Frank law does. Contrary to what Yves Smith or Susie Madrak or any of the many others who wrote the same story say, the taxpayers and the FDIC are definitely not accepting additional risk - at least under the circumstances described in the Bloomberg article. The Democratic Party and the Obama administration, over bitter opposition from the Republicans and Wall Street changed the law to make stock and bond investors and corporate management liable when systematically important financial companies fail. Dodd-Frank is far from perfect, but there is a reason the Republican representatives of Wall Street hate it so much.

Smith's key point is that the 2005 bankruptcy law gives owners of derivatives ("derivatives counter-parties") a ticket the the head of the queue in a bankruptcy. Her argument is that these provisions mean that the counter-parties will grab the assets of the the bank, leaving the FDIC with the debts and the cost of guaranteeing deposits. But that's something the Dodd-Frank bill fixes. Here's Smith:

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.

The Dodd-Frank resolution provisions specifically permit the FDIC to (a) block "derivatives counterparties" from collecting collateral and (b) to move derivatives and other debts to a "bridge bank" which they create at the moment. This process is described in section 210 of the Dodd-Frank act - an act that specifically states that its provisions overrule any counter provisions of bankruptcy law. So the law anticipates that the FDIC will move derivative transactions to a new company where derivatives will "net out". There is extensive discussion of this provision available online - for example here and here. Clearly, it is possible that the FDIC will not do its job properly, that the law won't work out, or that there are problems in the resolution authority - but more clearly, it's just plain wrong to cite the 2005 Bankruptcy act as the controlling law.

It's also worth noting that most banks already have their derivatives in the bank and not in a trading company subsidiary and that even for BoA, most the of the derivatives exposure is already in the bank, not in the holding company or the subsidiary. Here's the original Bloomberg article with bold added to make the point clear.

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.

What this means is that BOA already had most of its derivatives in the depository bank and it seems to be standard practice to do so. In response to a reader pointing this out, Smith writes:

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

And that's correct, but why was BofA downgraded? It was downgraded by Moody's because as the government agencies issue rules under Dodd-Frank, it has become more clear that the government will not bail out bondholders of the "too-big-to-fail" (TBTF) banks anymore. Here's what Moody's says:

Moody's decision to assign a negative rating outlook reflects the possibility it may further reduce its systemic support assumptions in the future as a consequence of the process set in motion by the enactment of the Dodd-Frank Act. Under the rules recently finalized by the FDIC, the orderly liquidation authority included in Dodd-Frank demonstrates a clear intent to impose losses on bondholders in the event that a systemically important bank such as BAC was nearing failure. If fully implemented, the provisions of Dodd-Frank could further lower systemic risk by reducing interconnectedness among large institutions and could further strengthen regulators' abilities to resolve such firms.

So, what's happening is the direct opposite of what Smith says: Dodd-Frank is removing the implicit government guarantee that subsidized the TBTF banks and Dodd-Frank protects the public against costs of derivatives - that we were previously on the hook for. There is a good discussion in the comments at Salmons and also see this.

Finally, if that $75 trillion money at stake seems ridiculously large - that's because it's not really the amount of money at stake. "Notional" values of trades do not tell you anything about the actual risk. The notional value is just the sum of the size of the underlying asset. For example, common interest rate swaps have a notional amount that reflects the size of a loan, but the risk is only the difference between the interest rate of the loan and the interest rate on an exchange like the London interbank rate. Furthermore when a bank sells a derivative contract with a notional value of $1M and then buys 4 contracts that are notional value $250,000 each that bet the other way, so it hedges its risk, the notional value is $2M even though worst case is at most $1M. There is a good explanation here (h/t Karoli). They have a great example which I'll just quote

Transaction Scenario 1: A derivatives transaction example that illustrates the relationship between notional amounts and potential risk. An American firm holds $2 million in cash. This company is planning to buy equipment from a German manufacturer six months from today that, given today's exchange rate, is valued at $2 million US Dollars (USD). Given its plans to purchase this equipment, its cash position in USD actually represents a foreign exchange (FX) exposure to the exchange rate between USD and German marks (DM). The firm calls a derivatives dealer and enters into a FX contract that obligates the firm to sell DM six months from today at today's exchange rate. In so doing, the American firm locks in the USD price of the equipment, thereby hedging its foreign exchange risk. If DM appreciate, the equipment becomes more expensive in terms of USD; but the firm profits in its derivatives contract by roughly the same amount. After entering the transaction with the American firm, the dealer bank enters into a contract with a hedge fund to sell DM six months from today at today's exchange rate, thereby completely offsetting its exposure to the exchange rate between USD and DM. In actuality, the exchange rates used on both sides of the transaction might be slightly different, allowing the dealer bank to make a spread on the transaction to compensate it for making a market in DM forward agreements. The hedge fund enters the transaction because its managers believe that DM will weaken against USD in the next six months and the fund is willing to speculate in order to profit from that movement. In terms of the gross notional amount of derivatives outstanding in the banking system, the transactions in this example contribute $4 million: the sum of both the bank's FX contracts. In terms of market risk, these transactions contribute nothing. There is, however, credit risk associated with the dealer bank's position. While the transaction is open, the exchange rate that the market expects between DM and USD may change. If DM depreciate (a change unfavorable to the American firm's FX derivatives position), then the contract between the dealer and the American firm increases in value to the dealer. This increase in value and potential future increases in value during the contract's life represent credit exposure of the dealer to the American Firm.

PS If you really want an introduction to this try this via Alea at Salmon: http://www.occ.gov/topics/capital-ma...ives/dq211.pdf

http://www.thepeoplesview.net/2011/1...edibility.html

[doom&gloom]

Re: Simon Johnson on Bank of America, the FDIC, Dodd-Frank

On a sidebar, I have an opinion of Dodd-Frank -- they both belong in jail.

[mesyn191]

Re: Simon Johnson on Bank of America, the FDIC, Dodd-Frank

I don't know enough about this to have an opinion, but I read this counterpoint today and thought I'd post it here.

Finally, if that $75 trillion money at stake seems ridiculously large - that's because it's not really the amount of money at stake. "Notional" values of trades do not tell you anything about the actual risk. The notional value is just the sum of the size of the underlying asset. For example, common interest rate swaps have a notional amount that reflects the size of a loan, but the risk is only the difference between the interest rate of the loan and the interest rate on an exchange like the London interbank rate. Furthermore when a bank sells a derivative contract with a notional value of $1M and then buys 4 contracts that are notional value $250,000 each that bet the other way, so it hedges its risk, the notional value is $2M even though worst case is at most $1M.

Can't comment reasonably well on the rest of the article but this part here set off my BS alarm.

Its true that the $75 trillion amount is notional and will likely come out to be far less if default occurs. But even if the real value ends up being pennies on the dollar that still works out to trillions of dollars that'd have to be printed (well electronically anyways) up fast by the government to pay this off. Even with a massive 50% cut to the total cost you'd still end up with over $37 trillion that would need to be paid out. Either which way the results would likely be disasterous for other banks here and in the EU as well.

[Slimprofits]

Re: Simon Johnson on Bank of America, the FDIC, Dodd-Frank

Yes yes yes the true risk is probably a small fraction of that trillions figure, but is that really the point?

We don't know what BoA has hidden in there.

This is about Big Banks circumventing rules and laws with the help of the Federal Reserve (and Treasury?) people bossing the FDIC people around and no one does a damn thing about it. This must be another one of those government invasions into corporate affairs that conservatives are always complaining about.

Keep your eye on the ball folks.