published Wednesday, October 26th, 2011

Personal Finance: FDIC, Fed squabble over bank's moves

By Travis Flenniken

Last week Bloomberg broke a story about Bank of America's decision to move derivatives out of its Merrill Lynch subsidiary and into its retail bank.

The controversy with the bank's action stems from the fact that these derivatives, which few people fully understand, are now on the books of an institution that holds deposits guaranteed by the FDIC.

Interestingly, sources in the article cite that the FDIC objected to the move, but was trumped by the Federal Reserve, which supported the transfer.

Bank of America was one of the recipients of the Troubled Asset Relief Program in 2008 and 2009, receiving about $45 billion in taxpayer assistance. The funds were used to provide capital to the bank and to acquire Merrill Lynch. Since TARP was enacted, Bank of America has paid back every penny with interest.

News of the actions made by Bank of America has sent financial blogs ablaze with scathing accusations that the bank is positioning for another government bail-out, or perhaps about to file Chapter 11 bankruptcy.

Large news organizations such as the New York Post and The San Francisco Chronicle have used suggestive language such as "sleight of hand" and "dodgy," and even referred to Bloomberg's unnamed sources as "whistleblowers."

Bank of America's actions were spurred by Moody's September downgrade of the credit ratings for the bank's holding company and for the Merrill Lynch unit, giving the deposit-holding retail bank the highest credit rating in the organization.

The company estimated that the downgrades would be costly and would require it to post additional collateral for its derivative positions. In addition, counterparties (the entities on the other side of the derivatives position) have requested that Bank of America transfer the positions to the better-capitalized retail bank. Shifting the derivatives to the retail bank subsidiary would likely allow the company to avoid the extra costs.

Suspicions of the controversial transfer are warranted, since the composition of these Merrill Lynch derivatives is largely unknown and may be more exotic than the plain-vanilla interest rate swaps that even small community banks use to mitigate their risk.

Retail banks are typically better capitalized than their affiliates in the same holding company because of their deposit base, a very cheap source of capital, only made possible because of FDIC insurance.

If Merrill Lynch's derivative portfolio is composed of the same kind of positions that brought down AIG, among others, moving it to the retail bank side exposes that risk to the FDIC. Although the FDIC is capitalized by its member banks, it is also back-stopped by the full faith and credit of the United States -- i.e. taxpayers.

After the transaction, the company's retail bank will hold $75 trillion (that's right, trillion) of derivatives.

That's a crazy number when you consider that the GDP of planet Earth is $58 trillion.

Perhaps the reason many are shocked and bewildered is an apparent misunderstanding of this number. Notional value of a derivative position is not the value of capital at risk. The exact amount at risk is unknown, but significantly less.

In addition, if the bank failed, the FDIC would only be responsible for covering depositors within the maximum coverage limit. Bank of America has approximately $1trillion in deposits.

Bank of America's actions are hardly unprecedented. JPMorgan's deposit-taking entity, JP Morgan Chase Bank NA, holds $79 trillion of notional derivatives according to the Comptroller of the Currency.

While many pundits are proclaiming something is awry, a spokesperson from Bank of America said that these moves were a part of the "normal course of dealings with counterparties ... since the acquisition of Merrill Lynch."

Perhaps what's most interesting about the situation is the apparent conflict of interest between the Federal Reserve and the FDIC.

According to sources from the Bloomberg article, the Federal Reserve has signaled that it supports Bank of America's actions in order to improve the health of the holding company, and the FDIC is against it because of the additional risk to depositors. According to Bank of America, their actions do not necessitate regulatory approval from either side.

Moving risky assets from one unit of a bank holding company to another unit that holds FDIC-insured deposits is technically illegal according to Section 23A of the Federal Reserve Act. However, Bank of America, like many other major financial institutions, was granted "temporary" exemption from this rule during the credit crises and apparently continues to enjoy the benefit.

Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Travis Flenniken, CFA, is vice president of investments with DeMoss Capital -- demosscapital.com. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by emailing him at dflessner@timesfreepress.com.

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