Bob Ivry, Hugh Son and Christine Harper have written an article that needs to be read by everyone interested in the financial crisis. The article (available here) is entitled: BofA Said to Split Regulators Over Moving Merrill Derivatives to Bank Unit.
The thrust of their story is that Bank of America's holding company, BAC, has directed the transfer of a large number of troubled financial derivatives from its Merrill Lynch subsidiary to the federally insured bank Bank of America (BofA). The story reports that the Federal Reserve supported the transfer and the Federal Deposit Insurance Corporation (FDIC) opposed it. Yves Smith of Naked Capitalism has written an appropriately blistering attack on this outrageous action, which puts the public at substantially increased risk of loss.
During this crisis, Ken Lewis went on a buying spree designed to allow him to brag that his was not simply bigger, but the biggest. Bank of America's holding company – BAC – became the acquirer of last resort. Lewis began his war on BAC's shareholders by ordering an artillery salvo on BAC's own position. What better way was there to destroy shareholder value than purchasing the most notorious lender in the world – Countrywide. Countrywide was in the midst of a death spiral. The FDIC would soon have been forced to pay an acquirer tens of billions of dollars to induce it to take on Countrywide's nearly limitless contingent liabilities and toxic assets. Even an FDIC-assisted acquisition would have been a grave mistake. Acquiring thousands of Countrywide employees whose primary mission was to make fraudulent and toxic loans was an inelegant form of financial suicide. It also revealed the negligible value Lewis placed on ethics and reputation.
But Lewis did not wait to acquire Countrywide with FDIC assistance. He feared that a rival would acquire it first and win the CEO bragging contest about who had the biggest, baddest bank. His acquisition of Countrywide destroyed hundreds of billions of dollars of shareholder value and led to massive foreclosure fraud by what were now B of A employees.
Given this context, only the Fed, and BAC, could favor the derivatives deal
Lewis and his successor, Brian Moynihan, have destroyed nearly one-half trillion dollars in BAC shareholder value. (See my prior post on the "Divine Right of Bank Profits…") BAC continues to deteriorate and the credit rating agencies have been downgrading it because of its bad assets, particularly its derivatives. BAC's answer is to "transfer" the bad derivatives to the insured bank – transforming (ala Ireland) a private debt into a public debt. Banking regulators have known for well over a century about the acute dangers of conflicts of interest. Two related conflicts have generated special rules designed to protect the bank and the insurance fund. One restricts transactions with senior insiders and the other restricts transactions with affiliates. The scam is always the same when it comes to abusive deals with affiliates – they transfer bad (or overpriced) assets or liabilities to the insured institution.
As S&L regulators, we recurrently faced this problem. For example, Ford Motor Company attempted to structure an affiliate transaction that was harmful to the insured S&L (First Nationwide). The bank, because of federal deposit insurance, typically has a higher credit rating than its affiliate corporations. BAC's request to transfer the problem derivatives to B of A was a no brainer – unfortunately, it was apparently addressed to officials at the Fed who meet that description. Any competent regulator would have said: "No, Hell NO!" Indeed, any competent regulator would have developed two related, acute concerns immediately upon receiving the request.
First, the holding company's controlling managers are a severe problem because they are seeking to exploit the insured institution. Second, the senior managers of B of A acceded to the transfer, apparently without protest, even though the transfer poses a severe threat to B of A's survival. Their failure to act to prevent the transfer contravenes both their fiduciary duties of loyalty and care and should lead to their resignations. Now here's the really bad news. First, this transfer is a superb "natural experiment" that tests one of the most important questions central to the health of our financial system. Does the Fed represent and vigorously protect the interests of the people or the systemically dangerous institutions (SDIs) – the largest 20 banks? We have run a real world test. The sad fact is that very few Americans will be surprised that the Fed represented the interests of the SDIs even though they were directly contrary to the interests of the nation. The Fed's constant demands for (and celebration of) "independence" from democratic government, combined with slavish dependence on and service to the CEOs of the SDIs has gone beyond scandal to the point of farce. I suggest organized "laugh ins" whenever Fed spokespersons prate about their "independence."
Second, I would bet large amounts of money that I do not have that neither B of A's CEO nor the Fed even thought about whether the transfer was consistent with the CEO's fiduciary duties to B of A (v. BAC).
Third, reread the Bloomberg column and wrap your mind around the size of Merrill Lynch's derivatives positions. Next, consider that Merrill is only one, shrinking player in derivatives.
Finally, reread Yves' column in Naked Capitalism where she explains (correctly) that many derivatives cannot be used safely. Add to that my point about how they can be used to create a "sure thing" of record fictional profits, record compensation, and catastrophic losses. This is particularly true about credit default swaps (CDS) because of the grotesque accounting treatment that typically involves no allowances for future losses. (FASB: you must fix this urgently or you will allow a "perfect crime."). It is insane that we did not pass a one sentence law repealing the Commodities Futures Modernization Act of 2000. Between the SDIs, the massive, sometimes inherently unsafe and largely opaque financial derivatives, the appointment, retention, and promotion of failed anti-regulators, and the continuing ability of elite control frauds to loot with impunity we are inviting recurrent, intensifying crises. I'll close with a suggestion and request to reporters. Please find out who within the Fed approved this deal and the exact composition of the assets and liabilities that were transferred.