There has been a lot of hyperventilating over this Bloomberg story about the transfer of derivatives positions from Merrill Lynch to Bank of America (NYSE:BAC). Much of the commentary, most notably by Felix Salmon, has expressed outrage at dumping risk on the deposit insurance fund.
The Bloomberg story focuses on the fact that FDIC and the Fed are at odds over the transfer. This tells you a lot, and what it should tell you is not comforting. Both sides are talking their book, and what the Fed is saying reveals its concerns about stresses in the market, and particularly on dealer firms.
The FDIC is obviously and justifiably concerned about the contingent liability it assumes as a result of the transfer. Presumably the Fed is not oblivious to this. So why would it favor the transfer?
I think it speaks volumes about the Fed’s concerns over the condition of dealer firms. In the current environment, the most worrisome ones would be Merrill, Morgan Stanley (NYSE:MS), and perhaps to a lesser degree Goldman Sachs (NYSE:GS). All of these have seen their credit spreads widen recently. Concerns about creditworthiness of these firms can lead to runs.
I don’t think that runs on derivatives per se are the issue. Yes, counterparties can seek to novate, or find other ways to get cash out of their dealers with whom they have in-the-money positions (although that’s not as much of an issue with standard interdealer CSAs in which no credit is extended.) But counterparties, customers, and lenders of/to dealer firms who are concerned about the derivatives exposure of a dealer of questionable creditworthiness have an incentive to reduce their exposure to the dodgy firm.
This, ironically, illustrates the systemic danger associated bankruptcy rules that give derivatives trades priority: It gives ostensibly junior claimants who can pull their money an incentive to get out first. You can’t evaluate the systemic risks of derivatives without considering capital structure more generally.
And there are reports that big non-dealer counterparties are getting nervous about dealer creditworthiness. Novation inquiries are increasing as dealer credit spreads have gapped.
[Black humor moment in linked article:
“We’ve not experienced clients moving away from us. On the contrary, we’ve seen more clients come to us as a result of our strong positioning in the equity derivatives markets,” said a source close to one French bank.
Sure. Remember that the French have claimed their banks have "no toxic assets." Which presumably explains why Sarkozy is running around like his head is on fire and his a** is catching it (h/t Charlie Daniels) trying to get the Germans to recapitalize French banks.]
Thus, my interpretation of the Fed’s action is this. It sees the conditions are ripe for a customer and funder run on Merrill. It wants to reduce the risk that customers and lenders perceive. The less risk in ML, the lower the likelihood that customers and lenders will get the urge to go for a jog–or a sprint. Reducing ML’s derivative exposure reduces its risk, and makes a destabilizing run less likely. Not that BofA is in great shape, but it is less vulnerable to what the Fed fears than Merrill is, and less vulnerable to a depositor run precisely because of deposit insurance.
So that’s the real story here, in my opinion: The Fed’s encouragement of the move of ML’s derivatives to BofA reveals its nervousness about the vulnerability of ML, and some dealer firms generally, to a run. From its perspective, moving the derivatives risk to BofA is the least bad option. If you believe that runs are an inefficient equilibrium outcome–and that is a reasonable belief–doing something to reduce the likelihood of a jump to that equilibrium makes sense. And that’s what the Fed appears to be doing.
And no, that shouldn’t give you the warm and fuzzies.