Bank of America Corp. (BAC) may be prevented by regulators from shifting derivatives contracts into the books of a deposit-taking unit, potentially forcing the lender to hand over more collateral to counterparties.
The lender has designated the retail-deposit unit, Bank of America NA, as the new counterparty on some Merrill Lynch contracts after the company’s credit ratings were cut in September, it said last week in a filing. The Federal Reserve and Federal Deposit Insurance Corp. have disagreed over the moves, and they are now discussing whether to allow future transfers, according to people with knowledge of the matter.
“Our ability to substitute or make changes to these agreements to meet counterparties’ requests may be subject to certain limitations, including counterparty willingness, regulatory limitations on naming Bank of America NA as the new counterparty, and the type or amount of collateral required,” the lender wrote in the quarterly regulatory filing.
At stake for Bank of America is the power to curb billions of dollars in collateral payments to counterparties that could be required after a credit-rating downgrade. The company, which has lost more than half its market value this year amid rising expenses from soured mortgages, is vulnerable to further rating cuts, the bank said in the Nov. 3 regulatory filing.
Limits on moving contracts from Merrill Lynch to the deposit unit could “adversely affect” results, the Charlotte, North Carolina-based bank said in the filing. The transfers lower collateral obligations because the retail unit still has a higher rating than the Merrill Lynch subsidiary after the Sept. 21 downgrades from Moody’s Investors Service.
“It’s a game of ‘move the risk,’” said Mark Williams, a former Federal Reserve examiner who lectures on financial-risk management at Boston University. “It makes sense for Bank of America, but the broader implication is that it makes the retail operations potentially riskier. If there is another downgrade, you have the possibility of falling off a credit cliff.”
The Fed has signaled that it favors moving the derivatives to give relief to the bank holding company, people familiar with its position said Oct. 18. The FDIC, which would have to pay depositors in a failure, objected, the people said.
The other two major ratings firms, Standard & Poor’s and Fitch Ratings, are re-evaluating Bank of America and may also cut its credit grades, the lender said in the quarterly filing. The full scope of damage from a credit-rating downgrade is “inherently uncertain” because it depends upon the behavior of counterparties and customers, the bank said.
Derivatives are financial instruments used to hedge risks or for speculation. They’re derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in the weather or interest rates. The contracts often require counterparties to post collateral in amounts that can increase if their creditworthiness deteriorates.
Bank of America’s holding company -- the parent of both the retail bank and the Merrill Lynch unit -- held almost $75 trillion of the contracts at the end of June, according to data compiled by the Comptroller of the Currency. About $53 trillion, or 71 percent, were within Bank of America NA, according to the data, which represent the notional values of the trades. The company is the second-largest U.S. lender by assets.
In August, the bank said a two-level downgrade by all ratings companies would require it to post $3.3 billion in additional collateral and termination payments, based on agreements as of June 30. As of Sept. 30, counterparties were entitled to $4.9 billion beyond what the bank had posted, according to last week’s filing. Of that, $3.2 billion resulted from the Moody’s downgrade.
Bank of America also said the impact of further downgrades would be more severe than in previous projections. Another two- level cut could amount to $6.6 billion in collateral demands, based on Sept. 30 data, it said.
The firm held cash and securities collateral of $93 billion as of Sept. 30, and had posted $87.8 billion, about 30 percent more than the end of 2010.
Bank of America’s rating is now four grades below the one Moody’s assigned to JPMorgan Chase & Co. (JPM), which became the biggest U.S. bank by assets this year, and a level below the rating given to Citigroup Inc. (C), the No. 3 lender. JPMorgan’s deposit-taking entity, JPMorgan Chase Bank NA, contained 99 percent of the New York-based firm’s $79 trillion of notional derivatives, according to the OCC.
‘Not FDIC Insured’
Congressional Democrats including North Carolina Representative Brad Miller and Ohio Senator Sherrod Brown asked regulators last month whether they explored potential risks from the derivative moves. Eighteen lawmakers signed onto letters seeking information.
“These derivative trades are not FDIC insured,” said Jerry Dubrowski, a Bank of America spokesman. “Other financial institutions hold higher derivative balances in their banking entities.”
Bank of America Chief Financial Officer Bruce R. Thompson discussed the transfers on a conference call with analysts last month after Bloomberg News reported that federal regulators were at odds over the movements.
“We had worked very hard over the course of the last nine months to be prepared to the extent that we did receive a downgrade, and feel very good about the way that we’ve minimized the potential impact,” he said on the Oct. 18 call. The moves are part of “the normal course of dealings that we’ve had with counterparties since Merrill Lynch and BofA came together.”
To contact the reporter on this story: Hugh Son in New York at email@example.com