The OTC derivatives market generates understandable confusion when it comes to grasping the overall concept. In fact, a global derivatives market with a notional value in excess of nine times 2011 Gross World Product causes an emotional roller coaster in most people that begins with disbelief, escalates to fear, and ends with anger. In a previous article, "America's Big Bank $244 Trillion Derivatives Market Exposed," I explained the domestic derivatives market, notional value, netting arrangements, VaR, and what and how specific derivatives are used. If you are unfamiliar with any of the terms mentioned above, I would highly recommend reading my previous article before continuing with this one.
Due to Bank of America's $67 trillion notional value in derivatives (about 10% of the global derivatives market), it is pertinent to get the facts about its activities in the derivatives market before investing in America's second largest bank. Its huge amount of derivative holdings make it the ideal candidate for demonstrating how big banks account for and value derivatives, and what banks gain from participating in the derivatives market.
This article will focus solely on Bank of America's (NYSE:BAC) derivative activities in its most recent quarter. I will be using information from the most recent 10-Q in order to shed some light on this often misunderstood issue.
How does Bank of America account for its derivatives, and are they included on the balance sheet?
To answer this question I went to Bank of America's most recent 10-K (pg. 159). Emphasis is mine.
Derivatives and Hedging Activities
Derivatives are entered into on behalf of customers, for trading, as economic hedges or as qualifying accounting hedges. Derivatives utilized by the Corporation include swaps, financial futures and forward settlement contracts, and option contracts ... All derivatives are recorded on the Consolidated Balance Sheet at fair value, taking into consideration the effects of legally enforceable master netting agreements that allow the Corporation to settle positive and negative positions and offset cash collateral held with the same counterparty on a net basis.
Derivatives Used For Hedge Accounting Purposes (Accounting Hedges)
For accounting hedges, the Corporation formally documents at inception all relationships between hedging instruments and hedged items, as well as the risk management objectives and strategies for undertaking various accounting hedges...The Corporation uses its accounting hedges as either fair value hedges, cash flow hedges or hedges of net investments in foreign operations ... Changes in the fair value of derivatives designated as fair value hedges are recorded in earnings, together and in the same income statement line item with changes in the fair value of the related hedged item. Changes in the fair value of derivatives designated as cash flow hedges are recorded in accumulated other comprehensive income (OCI) and are reclassified into the line item in the income statement in which the hedged item is recorded and in the same period the hedged item affects earnings. Hedge ineffectiveness and gains and losses on the excluded component of a derivative in assessing hedge effectiveness are recorded in earnings in the same income statement line item. The Corporation records changes in the fair value of derivatives used as hedges of the net investment in foreign operations, to the extent effective, as a component of accumulated OCI...
As can be seen from this very long (but informative) excerpt, derivatives can be classified into three groups: trading, economic hedges, and accounting hedges. Also, note that derivatives are recorded at fair value on the balance sheet net of collateral held and legally enforceable netting agreements.
Trading and economic hedges are treated as trading securities and gains/losses are always recorded in the income statement. Accounting hedges are given a little more leeway since they are used by the bank to protect cash flows, asset values, etc. The majority of accounting hedges gains/losses can be recorded in AOCI (a component of equity), but will not be recorded as a part of earnings. If the accounting hedge ever loses its status as an accounting hedge, all gains/losses in AOCI have to be reported in earnings in the same quarter.
Bank of America's Derivative Positions
Now let's take a look at pg. 128 of Bank of America's most recent 10-Q.
In the screenshot above, all of Bank of America's current derivative positions are outlined in detail. Swaps make up the vast majority of all derivative positions, with 78.7% of total derivative assets. Some key takeaways from the image above:
- Total notional value of Bank of America's derivative contracts is around $67 trillion. The actual market value of all derivative contracts is $1.5 trillion.
- The notional values are much higher than the actual fair value of the derivative assets and liabilities. This is due to the fact that the notional value is the gross amount of the contracts involved. The actual derivatives are valued mainly by using cash flows, option pricing models, and current market data. Again, I would highly recommend reading my article linked above for a more detailed explanation of derivatives and notional value.
- The last two rows subtract total netting agreements and cash from the derivative valuation. The end number is what is reported on the consolidated balance sheet.
- The majority of derivatives are used for trading and economic hedging, which means that most of the gains and losses associated with derivatives are reported through the income statement.
Why does Bank of America enter into all of these derivatives contracts, and what, exactly, do all of these contracts accomplish?
- In order to manage interest rate risk, Bank of America uses "generic" interest rate swaps, options, futures, options, and forward contracts to decrease earnings volatility caused by interest rate fluctuations. These derivatives help protect against adverse conditions in the commercial banking and mortgage markets.
- Bank of America uses foreign exchange contracts to protect the value of assets and liabilities denominated in foreign currencies.
- Derivative commodity contracts (futures, swaps, forward contracts, and options) are entered into on behalf of Bank of America's clients looking to manage price risk associated with commodities.
- Credit Default Swaps are purchased to lower credit risk, and minimize losses associated with a potential counterparty bankruptcy.
Next, let's take a look at the derivative gains and losses reported on Bank of America's income statement:
- A $134 million loss was recorded due to an ineffective hedging associated with interest rate risk management.
- A $1.2 billion gain was recorded due to profitable economic hedges for price risk, interest rate risk, and foreign exchange risk.
- An $852 million loss was recorded in AOCI due to poor hedge effectiveness. Bank of America also expects to recognize $822 million in losses through its income statement over the next 12 months. This is due to certain accounting hedges being reclassified as economic hedges, and the losses in AOCI associated with these derivatives are recorded through the P&L statement.
Credit Default Swaps
Bank of America has a current CDS (credit default swap) notional amount of $1.724 trillion, and by its own admission this notional amount is "the maximum amount payable by the Corporation for most credit derivatives." However, in order to offset this exposure, Bank of America purchases CDS with the same underlying referenced names as the written CDS. Bank of America has currently purchased $1.1 trillion (notional value) of these types of CDS in order to manage risk. I must admit that I was perplexed by this number, as this would still leave $624 billion in potential payouts on the table. I am assuming that other arrangements were made in order to offset this exposure, such as collateral posted, more offsetting derivatives contracts not mentioned, and netting agreements.
Credit-Related Contingent Features and Collateral
The vast majority of derivatives contracts contain credit related contingent features. In the event of a credit downgrade or a covenant breach, these contingencies would require additional posting of collateral (by counterparties), or allow Bank of America to terminate the trade immediately. Obviously, these types of contingencies can hurt as well as help Bank of America since they could very well (and have been) be on the receiving end of a "collateral call." Here are some key points related to derivative credit related contingent features and collateral:
- As of March 31, 2012, Bank of America held $87.1 billion of collateral, and had posted $74.5 billion in collateral.
- Bank of America has calculated that it could be required to post collateral of $2.5 billion within the coming year.
- If rating agencies downgrade Bank of America's long-term debt by one notch, Bank of America would be required to post $2.7 billion in additional collateral.
- If the rating agencies downgrade Bank of America's long-term debt by two notches, Bank of America would be required to post an additional $2.4 billion in collateral.
This is a lot of information to digest, but it sheds some light on a very opaque and misunderstood segment of the financial sector. There are a few main points that I would like to stress:
- Even when factoring in collateral held and netting agreements, the size of the overall derivatives market is alarming. As stated by the most recent OCC report, the domestic market alone has a value of $250 billion after factoring in netting agreements and collateral held.
- Due to the fact that the vast majority of derivatives contracts have counterparties, there is a very real possibility that a financial crisis in Europe could lead to a domino effect across the industrial and financial sectors. A mass wave of bankruptcies in the private and/or public sector could render the netting agreements and credit default swap protection bought on credit default swaps written irrelevant.
Netting agreements would be rendered irrelevant due to the fact that if a counterparty in certain derivative contracts default, its payments to Bank of America would cease to offset payments that Bank of America has to pay out to the other counterparty. For example: Assume that two companies agree to an interest rate swap, and Bank of America brokers the agreement. The interest payments being paid to (and paid out) by Bank of America by each party offset each other (this is the netting agreement). If one of the parties defaults, Bank of America no longer receives that payment used to offset the associated payout. This could cause Bank of America to potentially be paying out more than it is receiving to the other party, thus rendering the netting agreement irrelevant. (For a more detailed explanation, please read my article linked above).
Remember that Bank of America wrote $1.7 trillion in CDS protection, and purchased only $1.1 trillion in identical underlying CDS. If businesses and governments start defaulting on their debt, and Bank of America is forced to start making good on CDS sold, the bank could very well come to find out that the institutions that sold it CDS protection (as a hedge against writing so many CDS) have gone bankrupt themselves. In this situation, Bank of America could be forced to pay out more cash than it has on hand, go bankrupt itself, and cause CDS on Bank of America's debt to be triggered. Then banks that sold CDS on Bank of America debt would have to pay out, and they themselves could go bankrupt, causing more CDS and more payouts to be triggered. Are you getting the picture yet?
In all, I think that the derivatives market is not as nefarious and evil as most believe. The economic benefits are real, but the risks are exacerbated by lax regulation and no formal derivatives exchange. In order to restore trust in our banking system, these contracts should be sold on an organized exchange and the parties that buy and sell these products should be heavily regulated. Without a derivatives exchange to accurately value these products with current market data, we can never truly know what these products are worth. Without more regulation of selling and buying of derivatives, especially Credit Default Swaps (parties should have an insurable interest), we could be in for a financial fallout that would make the AIG debacle and financial crisis in 2008 look like a walk in the park.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I have all big banks on my watch list. I strongly believe they will all be cheaper in the coming months.