U.S. Rep. Brad Miller (D-NC) and Sen. Sherrod Brown (D-OH), along with other members of the House and Senate, sent letters today to Treasury Secretary Timothy Geithner and to federal regulators on the Financial Stability Oversight Council (FSOC) expressing concern that Bank of America has moved trillions of dollars in derivatives from its subsidiary Merrill Lynch into a subsidiary insured by the Federal Deposit Insurance Corp (FDIC).
Three years after taxpayers rescued some of the biggest U.S. banks, lawmakers continue to question how to protect taxpayers from risks generated by investment-banking operations. The lawmakers are concerned with a reported increase in so-called 23A exemptions, referring to the section of the Federal Reserve Act that separates insured banking from investment activities.
In the letter sent today to regulators, lawmakers questioned the transfer of an undisclosed amount of derivatives from Merrill Lynch, a securities trading subsidiary, to Bank of America, a retail bank subsidiary. Bank of America's retail bank has $1.04 trillion in deposits, $548 billion of which are insured by the FDIC. The transfer reportedly happened following threats of further credit downgrades that would have forced Merrill Lynch to post an additional $3.3 billion in collateral.
"Regulators must stop treating transactions like this as a private matter," Rep. Miller said. "This kind of transaction raises many issues of obvious public concern. If the bank subsidiary failed, innocent taxpayers could end up paying off "exotic" derivatives."
"If banks are going to gamble, they should do it with their own money," Sen. Brown said. "Ending 'too big to fail' means that depositors and taxpayers are not asked to cover Wall Street's losses. It's time to put an end once and for all to taxpayer-funded bailouts of reckless banks."
Among the answers Miller and Brown and other Members seek include whether investigators determined if the transfer occurred to avoid the requirement to post additional collateral in light of the credit downgrade for the company. The lawmakers also want to know if the risk of the derivatives was determined and whether the newly-insured derivatives pose a risk to the financial system.
Three years ago, Bank of America received $45 billion in TARP funding to prevent its crash during the financial crisis.
The full text of the letters follow:
Members of the Financial Stability Oversight Council
c/o Secretary Geithner, Chairman FSOC
1500 Pennsylvania Avenue NW
Washington, DC 20220
October 27, 2011
Dear Secretary Geithner and Members of the FSOC,
We are writing concerning press reports last week that Bank of America Corp. (BAC) transferred an undisclosed amount of derivatives from Merrill Lynch, a securities trading subsidiary, to Bank of America NA, a retail bank subsidiary with $1.04 trillion in deposits, $548 billion of which are insured by the Federal Deposit Insurance Corporation (the FDIC).
Again according to the press reports, the transfer followed a credit downgrade of BAC and Merrill Lynch that might result in requirements by counterparties that Merrill Lynch post an additional $3.3 billion in collateral. The retail bank subsidiary has a higher credit rating and more in assets, and would thus be required to post less collateral. The counterparties reportedly requested the transfer to the retail bank subsidiary.
Bloomberg reported that the Federal Reserve favors the transfer to relieve BAC of the requirement of additional collateral, the FDIC opposes the transfer as increasing the risk to insured deposits, and BAC contends that regulatory approval is unnecessary.
The Bloomberg report was attributed to "people with direct knowledge of the situation." Regulators are apparently treating the transaction as a private matter, but the transaction raises issues of obvious public concern.
First, was the transfer reviewed under section 23A of the Federal Reserve Act, and if not, why not? The section limits transactions between non-bank and bank affiliates to protect the safety and soundness of banks and to avoid effectively subsidizing high-risk transactions with deposit insurance. Because of the favored treatment of derivative contracts in receivership, it appears highly likely that losses on derivatives would result in losses to insured deposits ultimately borne by taxpayers.
The transaction would avoid the reporting and review threshold of section 23A only if the transfer was of high-quality assets constituting less than ten percent of the retail bank's capital stock and retained earnings. The total capital stock and retained earnings of BAC and the retail bank subsidiary is $176 billion. The notional value of all derivatives held at BAC is $75 trillion, and as of second quarter of this year, $53 trillion of those were held in Bank of America NA. It is undoubtedly extremely difficult to translate the "notional value" of derivatives into actual risk, and we do not know how much of Merrill's derivatives portfolio was transferred to Bank of America NA. The reported demand by counterparties that Merrill Lynch transfer the derivatives to the retail bank to avoid a possible requirement to post additional collateral suggests that the derivatives pose substantial risk, however. Was the transfer treated as an asset purchase of the derivates by the retail bank from Merrill Lynch? If so, was the purchase price in what was obviously not an arm's-length transaction used to determine the applicability of section 23A?
Second, if regulators did review the transfer, either for purposes of approval under section 23A or to determine if such a review was required, how did regulators determine the risk posed by the derivatives? Did BAC or Merrill Lynch make their proprietary models available to regulators to assess that risk? Are any of the derivatives credit default swaps on European sovereign debt? If so, what effect would default on European sovereign debt have on potential liability under the swaps?
The derivatives are apparently complex, opaque, and not remotely standardized--at least one report called some of the derivatives "exotic." And according to another published report, even by the incautious standards of derivatives traders, Merrill Lynch was considered "the cowboy." And those calculations of risk assume that the counterparties will be able to pay any amount due on the derivative contracts, which AIG's counterparties learned three years ago to be a bad assumption.
Third, if BAC completed the transaction without reporting under section 23A, what measures are available to regulators if regulators disagree with BAC's contention that reporting and review under section 23A was not required? Can regulators require rescission of the transfer? If the transfer of the derivatives to the retail bank would put insured deposits at risk, would the transfer of the derivatives back to Merrill Lynch create a systemic risk to the financial system?
Finally, if the transfer was not reported and reviewed under section 23A based on BAC's own assessment of the transfer, will regulators allow reporting and review under section 23A to be an honor system in the future?
Rep. Brad Miller
Rep. Maxine Waters
Rep. Elijah E. Cummings
Rep. Michael E. Capuano
Rep. Stephen Lynch
Rep. Keith Ellison
Rep. Jan Schakowsky
Rep. Jackie Speier