Also, this post explains why the FDIC is pissed at The Federal Reserve for allowing Bank of America (BOA or BofA) to transfer into BofA’s banking unit all the junk derivatives BOA acquired when they bought Merrill Lynch. As you may recall, the FDIC insures BOA’s depositors against losses as the result of any potential insolvency of bankruptcy.
Under the Bankruptcy Reform Act of 2005, Derivatives’ Counter-parties were given a preference over all other creditors and customers of a Financial Institution (including FDIC insured depositors). Bank of America recently moved all of their Merill Lynch Derivatives to their Banking Unit, causing the FDIC to object that this move subjects them to potential risk that they would become insolvent should BofA file for Bankruptcy. Yet supposedly, the provisions in the Bankruptcy Reform Act of 2005 that gave Counter-parties these special priorities over regular depositors was overridden by Dodd-Frank’s financial reforms. Some people have argued that the FDIC can step in under Dodd-Frank and place the Bank of America into a receivership outside of the Bankruptcy Court’s jurisdiction, thus protecting American taxpayers from bailing out BOA and its derivatives counter-parties again.
So what’s FDIC’s beef with what Bank of America did in transferring likely trillions of dollars of junk derivatives from Merill Lynch to their banking unit? Can’t they just ride Dodds-Frank to the rescue of BOA’s depositors (and the FDIC’s own reserves) in the event BOA files for Chapter 11? Well, as with most issues, the devil is in the details, and the details of an FDIC receivership under the rules established by the Dodd-Frank reform legislation are devilish indeed.
For starters, the FDIC does not have the sole right to prevent BOA or any other Too Big To Fail Bank from using the Bankruptcy Code to prefer payment to derivatives’ counter-parties before making FDIC insured depositors whole. Here’s what must happen before the FDIC can place any large financial institution such as BOA in receivership:
Before a Title II liquidation [i.e., an FDIC receivership under Dodd-Franks rules] can begin there are both substantive and procedural hurdles. Section 203(b) provides that, before the liquidation can begin, the Secretary of the Treasury, in consultation with the President, must first find that a financial company is “in default or is in danger of default.”
Got that? First the Secretary of the Treasury (currently Tim Geithner) must consult with the President and determine that BOA or any other too Big To Fail Institution (TBTF) holding trillions of dollars of crap derivatives is “in default or is in danger of default.” So that is hurdle No 1. The President and the Secretary of the Treasury must agree that they have a problem with a large TBTF bank about to go bust. Furthermore …
It requires the Secretary to find that a case is likely to be commenced under the Bankruptcy Code, that the company has or is likely to incur losses that will deplete its assets and it will be unable to protect them, that its assets are less than its obligations to creditors, or that it is unable or likely to be unable to pay its obligations in the ordinary course of business. […]
[M]ore important is the requirement that, before the receivership begins, the Secretary find that alternative ways of re-solving the financial distress “would have serious adverse effects on the financial stability of the United States.”
So things not only have to be really effed-up, but the Secretary has to determine that a bankruptcy would be worse for “the financial stability of the United States” than an FDIC receivership. That leave a lot of wiggle room for any Secretary of the Treasury to decide that letting counter-parties of junk derivatives get paid first before bank depositors and other creditors would be better for the “financial stability of the US” than letting the FDIC ride in to resolve the crisis.
But let’s assume that Tim Geithner or whomever is the Secretary of the Treasury at the time BOA goes bust decides that allowing the FDIC to go insolvent would be worse than paying off big corporate counter-parties on these crap derivatives. It’s possible, I suppose. Unfortunately, under Dodd-Frank, there are two more big hurdles to jump over before the FDIC can act as BOA’s receiver and protect the bank’s depositors without running the FDIC reserves down to zero:
In addition to the substantive criteria for taking action, there are also significant procedural hurdles. Before the Secretary of the Treasure can act, a “recommendation” must be obtained from both the Federal Reserve Board and the FDIC.
… Two-thirds of the Board of Governors of the Federal Reserve and, separately, two-thirds of the members of the FDIC’s Board of Directors must issue a recommendation regarding the proposed receivership
Starting to get the picture? If two-thirds of the members of the Board of the Federal Reserve do not agree to an FDIC receivership, it doesn’t happen. Period. End of story. A 2/3 super-majority of the Fed’s Board holds veto power over whether the FDIC and American taxpayers get whacked by a BOA bankruptcy or the counter-parties to all those allegedly AAA rated derivatives take it in the shorts. Doesn’t matter what the President wants, or the Treasury Department wants or the FDIC wants if the Fed says “HELL NO.”
And that my friends is why the FDIC is upset with the Fed over the transfer of these toxic waste derivatives to BofA’s banking unit. If they had stayed at Merrill Lynch the FDIC would not be at risk should those derivatives turn out to be worthless (as most people with any understanding of the assets on which they are based believes). If they had not been transferred, the FDIC wouldn’t be so upset with the Fed, which seems far more concerned about the financial stability of the counter-parties of those Merrill Lynch derivatives, and the financial rating of Bank of America, than it is regarding the financial stability of the US government.
The Federal Reserve and Federal Deposit Insurance Corp. disagree over the transfers, which are being requested by counterparties, said the people, who asked to remain anonymous because they weren’t authorized to speak publicly. The Fed has signaled that it favors moving the derivatives to give relief to the bank holding company, while the FDIC, which would have to pay off depositors in the event of a bank failure, is objecting, said the people. The bank doesn’t believe regulatory approval is needed, said people with knowledge of its position.
So if anyone tells you that the Dodd-Frank reforms makes the BofA derivatives transfer a non-issue, now you know why they are seriously misinforming you. You also know why the FDIC and many Democratic members of Congress are very upset that the Fed let this highly dubious transfer occur. It might be good news for BofA shareholders and the counter-parties to all those crap derivatives, but its far from good news for the rest of us.
Because when push comes to shove, who do you think 1/3 + 1 of the Federal Reserve Board Members are going to support in the event of a major financial institution’s insolvency?
