Let me get this out of the way first: I believe Bank of America is evil and does unspeakably evil things. This post does not in any way change my mind on that nor is it intended to change yours. However, I do believe facts matter, and in the case of the mind-boggling "scare everyone half to death" headlines surrounding the Bank of America derivatives transfer, a few facts were left out that substantially change what has actually transpired. Without question, it should not be this difficult for anyone to report facts and actually understand what is going on. It is certainly an indictment of our complex and byzantine financial industry that it was this difficult and that it was reported incompletely and often hysterically.
In September, Moodys downgraded several big banks, including BofA. The downgrade was specifically on projections that these big banks would not be rescued by the federal government even if they were so exposed they posed a risk of failure.
Why no bailout? Because Dodd-Frank set procedures in place for failing banks -- particularly failing banks that might pose systemic risk to the economy -- to be unwound on an orderly basis and liquidated. Quoting Moodys:
The government is "more likely now than during the financial crisis to allow a large bank to fail should it become financially troubled, as the risks of contagion become less acute," the ratings agency said.
Because some derivatives contracts carry a requirement that they be liquidated if ratings drop, there was a very real concern that a demand for liquidation could stress the investment banking side. So falling into line alongside Merrill Lynch, Citibank and others, BofA moved their remaining derivatives over to their retail banking subsidiary where deposits are, in fact, insured by the FDIC.
The astronomical number stated in headlines -- $75 trillion -- was tossed all over the Internet as the mind-boggling amount the FDIC and Fed would cover in the event of a run or other wobble in BofA's stability. Only, that number means less than nothing, particularly in the world of bank "rescues". The $75 trillion number is a statement of "notional value." Notional value does not represent the exposure a bank might have, nor does it even represent the value of the derivatives contracts. It is a number which represents the total amount of money a small amount of money might control. Via DesertBeacon:
Notional value is: “The total value of a leveraged position’s assets. This term is used commonly in the options, futures, and currency markets to describe how a very small amount of invested money can control a large position (and have a large consequence for the trader).” [FinDict] Here’s where the going got sticky — “a small amount of money controlling a large position.”
In the case of derivatives which have been carved up and sold to many parties, each party has a stake in the notional value of all parties.
Investopedia offers an example: “As an example, one S&P 500 Index futures contract obligates the buyer for 250 units of the S&P 500 Index. If the index is trading at $1,000, the futures contract is the equivalent to investing $250,000 (250 × $1,000). Therefore, $250,000 is the notional value underlying the futures contract.” [FinDict] I think we can all figure out where this is going. If the notional value can be calculated like the S&P Index, since we can all look at the television set or check online to see the price of S&P Index trading, then life is good, the transaction has a predictable value. If, however, the swap is being made on something-anything-everything for which a notional value cannot be readily determined — oh, say something like the value of securitized asset vehicles sliced diced and tranched out of home mortgage paper — then what we have is not managed risk but layered risk.
To get to $75 trillion, add up all the numbers on the far left. In terms of actual exposures at the time that the report was filed, we’re talking $66.6bn on the asset side and $54.4bn on the liability, once netting and collateral has been accounted for.
Ok, back to Dodd-Frank and the FDIC. First, a clarification on the FDIC. Taxpayers do not pay for it. Banks do, and only banks. We can have a discussion about whether it is adequately funded, but it's wrong to say taxpayers pay for FDIC rescues and unwinds of failed banks, because we don't. Dodd-Frank laid out very specific ways that an investment bank or holding company like BofA would be isolated and unwound in the event that they were teetering on the edge.
EconomicsofContempt has an excellent explanation. Here's an excerpt:
Now we get to the actual resolution. What would the resolution of a large financial holding company look like under the OLA? First, the FDIC would be appointed as receiver of the holding company, all its US primary entities (except for any insurance companies, which are still resolved by the states), and all its US booking entities. Technically, the FDIC would be appointed as receiver of the US commercial bank under the Federal Deposit Insurance Act rather than the OLA, but this is a distinction without a difference for our purposes, as the statutes are substantially similar. As receiver, the FDIC would succeed to all the rights, titles, powers, and privileges of these companies and their assets — in other words, the FDIC would be in complete control.
The FDIC resolves the vast majority of failed commercial banks through what’s known as “purchase and assumption” agreements (called “P&As”), in which a healthy bank purchases some or all of the assets of a failed bank and assumes some or all of the liabilities, including all insured deposits. For example, the FDIC resolved WaMu — which had over $300bn in assets — through a P&A with JPMorgan, in which JPM acquired all of the assets ($296bn), and almost all of the liabilities ($265bn) of WaMu’s depository instutition. Crucially, JPM left behind some $28bn of WaMu’s senior unsecured debt, subordinated debt, and preferred stock — and those creditors took huge haircuts. The particular structure of the P&A, and of the resolution, depends on the situation the FDIC is facing.
In the case of a large financial holding company, there are essentially four types of situations that the OLA needs to be able to handle:
- A buyer for the entire FHC can be identified prior to triggering the OLA;
- A buyer for only some of the FHC’s assets can be identified prior to triggering the OLA (most likely);
- Potential buyers have been identified, but no agreement has been reached by the time the OLA is triggered;
- No buyer can be or will ever be identified (least likely).
I highlighted the part about creditors taking haircuts to amplify what would actually be at risk if the consumer bank (which now has the derivatives on their books) were to be taken over by the FDIC. Instead of a bank run on those contracts and shaking the entire economy here and abroad (because of the notional value and idea that those assets are spread across many entities, all of whom are at risk), the bank is effectively isolated and the FDIC has the authority to write down the value of the assets and dispose of them as they see fit.
This is why bankers hate Dodd-Frank. They have to stay within the parameters or risk takeover and unwinding. It forces them to limit their casino stake and potential profits (and losses, of course). It also protects taxpayers from having to fork up a bunch of money once again to keep them from failing while they still pay out ginormous bonuses.
The headlines were scary. They fit really, really well with the Occupy Wall Street protests. The problem is, they just weren't true. Dodd-Frank does have teeth, and especially in these situations. The bottom line here? BofA is still evil, but taxpayers will not bear the brunt of their gambling ways as they would have before Dodd-Frank.
Extra credit reading:
Note: This post came about as the result of discussions on Twitter over posts on C&L and elsewhere reporting that $75 trillion in risk was being shifted to the FDIC and constituted a bailout. A belated h/t to @rootless_e for several links and the discussion of the underlying issues that led me to the conclusion that notional values are not an accurate statement of risk and helped clarify the role of Dodd-Frank.