BofA said to shift derivatives from Merrill to bank — putting FDIC on the hook

Regulator unhappy with move, sources say; 'enormous temptation to dump the losers on the insured institution'

Oct 18, 2011 @ 7:10 am

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.

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.

Three years after taxpayers rescued some of the biggest U.S. lenders, regulators are grappling with how to protect FDIC- insured bank accounts from risks generated by investment-banking operations. Bank of America, which got a $45 billion bailout during the financial crisis, had $1.04 trillion in deposits as of midyear, ranking it second among U.S. firms.

“The concern is that there is always an enormous temptation to dump the losers on the insured institution,” said William Black, professor of economics and law at the University of Missouri-Kansas City and a former bank regulator. “We should have fairly tight restrictions on that.”

Accommodating Clients

Jerry Dubrowski, a spokesman for Charlotte, North Carolina- based Bank of America, declined to comment on the transfers or the firm's discussions with regulators. The company “continues to accommodate the needs of our clients through each of our multiple trading entities, including Bank of America NA,” he said in an e-mailed statement, referring to the company's deposit-taking unit.

The lender is scheduled to report third-quarter results today at 7 a.m. New York time. For the prior three-month period, the bank posted an $8.8 billion loss on costs tied to soured mortgages, its biggest ever.

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Barbara Hagenbaugh, a Fed spokeswoman, said she couldn't discuss supervision of specific institutions. Greg Hernandez, an FDIC spokesman, declined to comment.

Derivatives are financial instruments used to hedge risks or for speculation. They're derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in the weather or interest rates.

Keeping such deals separate from FDIC-insured savings has been a cornerstone of U.S. regulation for decades, including last year's Dodd-Frank overhaul of Wall Street regulation.

Bailouts

The legislation gave the FDIC, which liquidates failing banks, expanded powers to dismantle large financial institutions in danger of failing. The agency can borrow from the Treasury Department to finance the biggest lenders' operations to stem bank runs. It's required to recoup taxpayer money used during the resolution process through fees on the largest firms.

Bank of America benefited from two injections of U.S. bailout funds during the financial crisis. The first, in 2008, included $15 billion for the bank and $10 billion for Merrill, which the bank had agreed to buy. The second round of $20 billion came in January 2009 after Merrill's losses in its final quarter as an independent firm surpassed $15 billion, raising doubts about the bank's stability if the takeover proceeded. The U.S. also offered to guarantee $118 billion of assets held by the combined company, mostly at Merrill.

Moody's Downgrade

Moody's Investors Service downgraded Bank of America's long-term credit ratings Sept. 21, cutting both the holding company and the retail bank two notches apiece. The holding company fell to Baa1, the third-lowest investment-grade rank, from A2, while the retail bank declined to A2 from Aa3.

Bank of America's rating is now four grades below the one Moody's assigned to JPMorgan Chase & Co. (JPM), the biggest U.S. bank by deposits at midyear, and a level below the rating given to Citigroup Inc. (C), the third-biggest. Bank of America is the only U.S. lender that lacks a rating of A3 or higher among the five firms listed by the Office of the Comptroller of the Currency as having the biggest derivatives books.

The Moody's downgrade spurred some of Merrill's partners to ask that contracts be moved to the retail unit, which has a higher credit rating, according to people familiar with the transactions. Transferring derivatives also can help the parent company minimize the collateral it must post on contracts and the potential costs to terminate trades after Moody's decision, said a person familiar with the matter.

$75 Trillion

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.

Moving derivatives contracts between units of a bank holding company is limited under Section 23A of the Federal Reserve Act, which is designed to prevent a lender's affiliates from benefiting from its federal subsidy and to protect the bank from excessive risk originating at the non-bank affiliate, said Saule T. Omarova, a law professor at the University of North Carolina at Chapel Hill School of Law.

‘Created a Firewall'

“Congress doesn't want a bank's FDIC insurance and access to the Fed discount window to somehow benefit an affiliate, so they created a firewall,” Omarova said. The discount window has been open to banks as the lender of last resort since 1914.

As a general rule, as long as transactions involve high-quality assets and don't exceed certain quantitative limitations, they should be allowed under the Federal Reserve Act, Omarova said.

In 2009, the Fed granted Section 23A exemptions to the banking arms of Ally Financial Inc., HSBC Holdings Plc, Fifth Third Bancorp, ING Groep NV, General Electric Co., Northern Trust Corp., CIT Group Inc., Morgan Stanley and Goldman Sachs Group Inc., among others, according to letters posted on the Fed's website.

The central bank terminated exemptions last year for retail-banking units of JPMorgan, Citigroup, Barclays Plc, Royal Bank of Scotland Plc and Deutsche Bank AG. The Fed also ended an exemption for Bank of America in March 2010 and in September of that year approved a new one.

Section 23A “is among the most important tools that U.S. bank regulators have to protect the safety and soundness of U.S. banks,” Scott Alvarez, the Fed's general counsel, told Congress in March 2008.

--Bloomberg News--

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