Bloomberg reports that Bank of America (BAC) has shifted about $22 trillion worth of derivative obligations from Merrill Lynch and the BAC holding company to the FDIC insured retail deposit division. Along with this information came the revelation that the FDIC insured unit was already stuffed with $53 trillion worth of these potentially toxic obligations, making a total of $75 trillion.
Derivatives are highly volatile financial instruments that are occasionally used to hedge risk, but mostly used for speculation. They are bets upon the value of stocks, bonds, mortgages, other loans, currencies, commodities, volatility of financial indexes, and even weather changes. Many big banks, including Bank of America, issue derivatives because, if they are not triggered, they are highly profitable to the issuer, and result in big bonus payments to the executives who administer them. If they are triggered, of course, the obligations fall upon the corporate entity, not the executives involved. Ultimately, by allowing existing gambling bets to remain in insured retail banks, and endorsing the shift of additional bets into the insured retail division, the obligation falls upon the U.S. taxpayers and dollar-denominated savers.
Even if we net out the notional value of the derivatives involved, down to the net potential obligation, the amount is so large that the United States could not hope to pay it off without a major dollar devaluation, if a major contingency actually occurred and a large part of the derivatives were triggered. But, if such an event ever occurs, Bank of America's derivatives counter-parties will, as usual, be made whole, while the American people suffer. This all has the blessing of the Federal Reserve, which approved the transfer of derivatives from Merrill Lynch to the insured retail unit of BAC before it was done.
Contrary to popular belief, which blames the global financial crisis on subprime borrowers, it was the derivatives, based upon the likelihood that those borrowers would pay their debts, that were the primary catalyst triggering the global economic crisis of 2008. Back then, the derivative obligations of AIG (AIG) imploded the insurer. Under the pressure of fear-mongering from the Federal Reserve and the financial industry, the U.S. government committed hundreds of billions of dollars to bail out AIG's counter-parties, including the biggest banks of Europe and America. Had the government not stepped in, virtually all the banks on Wall Street would have gone bankrupt. A host of European and Asian banks would have followed.
AIG was not FDIC insured. It could have been allowed to fail, and should have been allowed to fail. All the banks on Wall Street that would have failed should have failed. Their speculator counter-parties should have been bankrupted, and their retail depositors should have been made whole. The retail divisions could have been temporarily nationalized and sold off as soon as possible to more prudent management. Had this occurred, America would have experienced a deep but very temporary economic downturn, and, by now, the downturn would be over. But, with derivatives obligations tied intimately with FDIC insured depositary units, the debt will need to be paid by the government, as a matter of law. We will have no legal choice except to default, or pay them off.
In 2008, politicians in Washington D.C., and Trojan horse operatives within the financial organs of our government, bailed out imprudent managements of big casino-banks. Bank executives not only didn't need to go bankrupt, as they should have, but collected huge bonuses. Later, in response to the abuse, Congress passed the Dodd-Frank legislation and the Volcker rule. These were supposed to insure that such bailouts were not needed in the future. Supposedly, this would prevent further abuse of the American taxpayer.
The most recent abuse-event, involving BAC, illustrates the uselessness of such laws. Bank of America NA is FDIC insured, and has the blessing of the Federal Reserve, in spite of such a transaction being prohibited by Section 23A of the Federal Reserve Act. Specifically, the section reads in relevant part:
"A member bank and its subsidiaries may engage in a covered transaction with an affiliate only if--
1. in the case of any affiliate, the aggregate amount of covered transactions of the member bank and its subsidiaries will not exceed 10 per centum of the capital stock and surplus of the member bank; and
2. in the case of all affiliates, the aggregate amount of covered transactions of the member bank and its subsidiaries will not exceed 20 per centum of the capital stock and surplus of the member bank ..."
The Federal Reserve is an institution largely controlled by those who are probably the counter-parties to the Merrill Lynch derivatives. No doubt, its approval of the transaction, in spite of the prohibitions of section 23A arise out of a claim that Merrill is not a "bank" as defined under the Act, and, therefore, not an affiliate.
But, the Act also provides that:
For purposes of applying this section and section 23B, and notwithstanding subsection (b)(2) of this section or section 23B(d)(1), a financial subsidiary of a bank--
1. shall be deemed to be an affiliate of the bank; and
2. shall not be deemed to be a subsidiary of the bank.
So, Merrill Lynch is clearly an affiliate of Bank of America, and the Federal Reserve is clearly violating the law by approving this particular transaction. But, here is the kicker. Congress has given ultimate power to the Federal Reserve to ignore its own enabling Act legislation. The law also reads:
The Board may, at its discretion, by regulation or order exempt transactions or relationships from the requirements of this section if it finds such exemptions to be in the public interest
The FDIC opposed the move, but there is nothing the FDIC can do, except file a petition for a writ of mandamus in court, against the Federal Reserve, seeking a declaration that the approval was illegal. But, the FDIC would lose, because Congress has given the Federal Reserve Board ultimate power to do whatever it wishes.
So, the bottom line is this: When something bad happens, and the derivative obligations are triggered, the FDIC will be on the hook, thanks to the Federal Reserve. The counter-parties of Bank of America, both inside America and elsewhere around the world, will be safely bailed out by the full faith and credit of the USA. Meanwhile, the taxpayers and dollar denominated savers will be fleeced again. This latest example of misconduct illustrates the error of allowing a bank-controlled entity, like the Federal Reserve, complete power over the nation's monetary system. The so-called "reforms" enacted by Congress, in the wake of the 2008 crash, have vested more, and not less, power in the Federal Reserve, and supplied us with more, rather than less instability and problems.
This is not an isolated instance. JP Morgan Chase (JPM) is being allowed to house its unstable derivative obligations within its FDIC insured retail banking unit. Other big banks do the same. So long as the Federal Reserve exists and/or other financial regulatory agencies continue to be run by a revolving door staff that moves in and out of industry and government, crony capitalism will be alive and well in America. No amount of Dodd-Frank or Volcker rule legislation will ever protect savers, taxpayers or the American people. Profits will continue to be privatized and losses socialized.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.