BofA shifts derivative risk. Evil, good or neither? Discuss.

by Karoli on October 22, 2011 · 7 comments

This started on Twitter as a discussion1 between @rootless_e and myself over this post. Then this one by Mike Lux went up a few minutes ago. Rootless observed that the first post was not complete in how the scenario plays out. The second post leaves room to wonder.

DesertBeacon wrote on this a few days ago in the context of financialization, and how it’s stifling the economy, simply because we’re shifting from a market economy to a financial economy.

Perhaps now the average American victim of the credit meltdown, whose tax dollars were used to guarantee the solvency of the American bankers, are tired of being scapegoats?  Members of the financial sector, whose avarice engendered the over-heated housing bubble, cry “Irresponsible Borrowers, Mortgage Twins, Community Reinvestment Act” in a manner analogous to the practice of putting one’s fingers in one’s ears and repeating “La, La, La, La I Can’t Hear You.”  {stage directions: “door slams, sound of car leaving driveway}

“Mother said you were shiftless.”  There’s nothing a disreputable person loves more than to remain unsupervised.   Likewise, there is nothing an ethically challenged group loves more than deregulation.   Why else would banks revise their charters to place themselves under the eyes of those government agencies most willing to look the other way?  [DB] [NRP] [TBS] And yet the banking corporations and their supporters continue to prescribe deregulation as the way to protect American taxpayers, account holders, and consumers.

Before Congressional investigators the Wall Street barons proclaimed their patriotism and devotion to American “ethics and values,” back in their corporate offices they reinforced the notion that any “market” was ethical as long as there were two willing partners to the transaction — even if one was being sold a pig in a poke — even if the investment bank was betting against its own deal. [Bloomberg] [NYT]   Brooksley Born, former head of the CFTC tried to warn us about the deregulation of credit default swaps before most people had even heard the term, she was rewarded for her prescience by being replaced, and later labeled a Cassandra. [WaPo] [PBS] {stage directions:  two adversaries sit in tense silence across the room…}

“How can you keep running up these bills?”  Corollary to ” You promised you’d stop…“  If we were thinking that the popularity of credit default swaps might have declined in the wake of the housing bubble collapse, consider their use as European economies struggle.  [Bloomberg] As for the infamous CDO’s — some settlements have been agreed upon, but Morgan Stanley was exonerated from charges of defrauding a government pension fund (Libertas Case) because the offerers, not Morgan Stanley, prepared the statements. [Reuters] {stage directions: A throws pile of paperwork at B}

“You expect everyone else to clean up your messes.”  One such mess is “financialism.”

“Over the last 25 years American capitalism has become financialism, which is primarily transactional, unrestrained greed. Financialism embraces the view that the only purpose of business is to create shareholder value, measured primarily by short-term results. The dominance of short-termism is evidenced by the magnitude of institutional stock “renting” for terms of 12 months or less, the volume of high-speed, high-frequency algorithmic short-term trading, the short average tenures of chief executive officers and the dominance of executive compensation tied solely to short-term results.”  [Forbes]

And, this is a truly large mess, something Adam Smith never contemplated. Financialism distorts capitalism and creates middle class income stagnation, income disparity, off shoring jobs, diminished manufacturing capability, and equity market volatility.   It is the financial equivalent of being “excused” for leaving dirty clothing, empty pizza boxes, half-empty pop cans, and dirty tableware scattered about because “I’m busy.”  It is to trade short term profitability for long term stability.   If it’s messy, so be it, the “taxpayers” will clean up after us.   {stage directions: clothing, pizza boxes, pop cans hurled against wall to make a pile on the floor}

Rootless contends that by shifting the toxic securities into a FDIC-insured entity, the FDIC can simply shed them (toss in the trash) without harming taxpayers.

Here are my questions:

  1. Who are the depositors in this FDIC-insured institution? In other words, whose deposits are being insured?
  2. Is there a moral hazard issue here inasmuch as BofA was able to shift those liabilities off their books without penalty, enabling them to declare a $6 billion profit for the third quarter?
  3. How does any financial institution accrue risk of $75 trillion in imaginary money without some penalty?

For background on financialization, I recommend these posts and their contained links:
Oh, Brother Can You Spare A CDS? Financialism Erodes Free Market Capitalism

For The Love Of Money: Financialists vs. Capitalism

Hopefully some answers will emerge in the comments. Feel free to discuss. I’ll be there.

Also, this discussion of the term “notional” is a critical one to understand the underlying issues.

1 Chirpstory of our discussion:

  • http://twitter.com/rootless_e rootless

    First of all, neither Lux nor Madrak nor any of the other shrieking panickers seem to understand what “notional” means in that $79 Trillion of notional derivatives”. If BoA sells Buffet $1B insurance against GoldmanSachs going bankrupt, and then buys $1B insurance from JP Morgan against Goldman Sachs going bankrupt the NOTIONAL value of their two bets is $2B. Actually its a lot more complicated than that because one can have a derivative interest swap in which there is limited worst case payout but a big notional amount and so on. So I don’t know BoAs actual exposure on these things but mikey, suzie and black don’t know either. 

    Second, it takes 5 minutes research to learn that section 210 of Dodd Frank gives the FDIC resolution authority to create a “bad bank” and move derivatives or any other assets into that bank – with no appeal.  Maybe it won’t work that way in practice, maybe it’s flawed, I don’t know,but obviously  lux nor madrak nor their sources didn’t tell their readers about this – through sheer ignorance or because it cuts back on the indignation level of the story, I don’t know. But claiming that the derivatives owners will be at the head of the line is NOT TRUE. 

    Third, we have no idea whether BOA transferred assets to the bank as well – I certainly hope so.

    Finally, and this is really key, the shrieking misses and actually hides the really gross malfunction of the system. The credit rating agencies, which we know are more than a little crappy at their supposed jobs downgraded BOA. By law, this triggers a process in which certain owners of the derivatives might be forced to start cashing them in. To me, the role of incompetent private companies in this type of regulation is a huge scandal. 

  • http://www.drumsnwhistles.com/ Karoli

    ok, i’m starting to get some clarity around this issue. Clearly the key word is ‘notional’ and how that plays into the valuation of things. And whether or not we all know exactly what that means here, what we do know is that it’s not $75 trillion of real money that taxpayers would have to come up with. It’s something far less than that. Am I right?

    Follow me through the process for a minute. BofA has CDOs on the books that create a level of risk which credit ratings agencies consider unacceptable. BofA then transfers that risk to a FDIC-insured subsidiary which bolsters its foundation, at least, ratings-wise. 

    By making that transfer, BofA bows to FDIC control of that subsidiary and its assets, including the possibility that the FDIC can simply unwind these transactions and write off whatever needs to be written off in a walled garden? Do I have that right? And presumably, FDIC is only on the hook for whatever insured deposits also exist at that institution, too — a number we don’t know, but which represents depositors who weren’t out gambling with their money.

    And on to the ratings agencies, who I agree are terrible actors in all of this. Depending on the type of contract, though, the derivatives owners could simply take a haircut on what they receive back from the contract, right? It’s not necessarily a given that they’ll have to sell.

    Those are my questions. If I understand you correctly, you contend that the ratings agencies (malefactors that they are) downgraded BofA because of the risk in their CDO portfolio, causing BofA to shift that risk onto a government-insured entity. By handing control to that entity, the underlying assets may end up being worthless, but no run on the banks or financial system will occur. 

    Do I have that more or less right?

  • http://www.drumsnwhistles.com/ Karoli

    Adding DesertBeacon’s excellent post about options available when systemic risk is identified and assets shifted as BofA did. http://desertbeacon.wordpress.com/2011/10/22/a-good-reason-not-to-repeal-dodd-frank-ola/

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  • http://twitter.com/Art_Guy1 lloyd

    The $75 million figure in CDOs is probably not correct as it is impossible to properly price them using any current risk assessment model. The key is to find the trigger that will set them in motion. It very well could be the price of a BoA bond or its stock price. In other words, when a BoA bond hits a certain price the dominoes start to fall. Once they start to fall they can’t be stopped until they payer of last resort intervenes. History has demonstrated that the payer of last resort is the government. Passing toxic assets from A to B does not make them less toxic. Unfortunately, this mess will continue until all parties are paid or the legal payers go bankrupt.

  • http://www.drumsnwhistles.com/ Karoli

    agree. and my research says the trigger was the ratings agencies’ downgrade.

  • Anonymous

    This has ZERO to do with CDOs.   I’m sorry, but you really don’t get what’s going on at all. “Pricing” has nothing to do with it either.

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