Streetwise Professor

October 21, 2011

Merrill-BAC: The Fed Sees Money Lacing Up Its Running Shoes

Filed under: Derivatives,Economics,Financial Crisis II,Regulation — The Professor @ 10:54 am

There has been a lot of hyperventilating over this Bloomberg story about the transfer of derivatives positions from Merrill Lynch to Bank of America.  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.

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, and perhaps to a lesser degree Goldman.  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 BAC 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, IMO: the Fed’s encouragement of the move of ML’s derivatives to BAC reveals its nervousness about the vulnerability of ML, and some dealer firms generally, to a run.  From its perspective, moving the derivatives risk to BAC 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.

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7 Comments »

  1. […] Thoughts on BofA’s attempt to relocate its Merrill derivatives […]

    Pingback by FT Alphaville » Further further reading — October 21, 2011 @ 2:01 pm

  2. Of course, Obama’s actions to increase investor uncertainty will contribute to a customer and funder run on these fine institutions, which will prolong and deepen the present recession, just as FDR’s attacks against “malefactors of great wealth” contributed to the regime uncertainty that retarded recovery in the Great Depression.

    The duration of the Great Depression had nothing to do with the fact that the US GNP had declined from $103.6 billion to $56.4 billion between 1929 and 1933. Nothing at all.

    Comment by a — October 21, 2011 @ 6:13 pm

  3. Hey I know, let’s send the perfectly tanned one aka Speaker ‘Bo-ner’ as they call him on the Government Electric channel, to a Heritage Foundation event about how bad the ‘Reset’ is. Because y’know, it’s not as if there’s any other more pressing foreign policy problems to talk about, like the Mexican journalists entrails spread across a highway bridge right in front of our border by Zetas armed with ATF-issued guns. No siree.

    Me thinks, to paraphrase the old Barry Goldwater slogan, in his heart SWP knows Ron Paul is right about the Fed. But he’s afraid to say it. Nothing good about them backstopping all those BOA derivatives, but y’know, it’s not like we’re gonna do anything about it or anything.

    Comment by Mr. X — October 21, 2011 @ 7:14 pm

  4. Any prof who quotes Charlie Daniels is ok by me.

    But if derivatives “priority” is such a systemic factor, why are firms trying to novate their way away from ML?

    Comment by Supine Bolivian — October 21, 2011 @ 7:29 pm

  5. @Supine Bolivian. Even with priority there is no guarantee that you’ll get paid 100 pct of what you are owed if things go pear shaped, or that you will get paid right away.

    The ProfessorComment by The Professor — October 21, 2011 @ 7:50 pm

  6. The bigger point re assignment & novation is that any counterparty with a higher credit rating than their dealer’s credit rating is, in effect, subsidizing that dealer’s credit rating, if that cp has a positive mark with the dealer and does not present-value it (i.e., take the NPV of the positive m2m immediately). The NPV of the positive mark should be discounted, at a minimum, at the rate the cp earns by lending in the overnight funding markets; at max, it would be the rate at which the cp can invest that positive mark given the term over which the positive mark will be realized. At a minimum the dealer should be paying an overnight charge on those funds to the cp with the higher credit rating, since by not NPVing the positive m2m the cp is effectively giving the dealer the use of those funds.

    What the Fed’s action suggests is that, in addition to all its other ills, Merrill’s m2m with cps with higher credit ratings is a big negative. If all these cps wised up at once and decided to PV their m2m gains, Merrill would topple. Hence the move to FDIC-insured BofA’s account. Another instance of Merrill’s (and likely MS’s and GS’s) untenable business model: They all depend on the kindness of strangers, not unlike Blanche DuBois. (See http://www.imdb.com/character/ch0012161/quotes )

    Comment by markets.aurelius — October 26, 2011 @ 6:04 am

  7. @markets.aurelius–thanks for the interesting comment. Nice handle, btw. As a sorta-Stoic I find it particularly amusing.

    The ProfessorComment by The Professor — October 26, 2011 @ 9:27 am

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