What happens when Bank of America (BoA) fails? In my opinion BoA is a severely wounded giant with odds approaching 33% chance of the US government, in some shape of form will need to bail them out for the second time in three years. I will not go into any argument about why BoA has a good shot of failing. So much of that story has been covered. Martin Weiss did an excellent job detailing the issues that BoA faces. For more view http://www.moneyandmarkets.com/america%E2%80%99s-largest-candidate-for-bankruptcy-46993
The question I am raising tonight is who else might blow up or become weakened/crippled if and when BoA fails? I think most of that story is determined by the derivative market.
Using the latest Office of the Comptroller of the Currency (OCC) derivative report I will try estimate who is likely to be hit the hardest if BoA cannot pay their derivative bets.
According to the OCC the derivative market in the US has a notional value of approximately $244 trillion. That is “T” as in trillion dollars, not billions of dollars. BoA (as a holding company) is a very large player in this market, in fact it is the 2nd largest player with a notional value of $72.7T in derivative contracts outstanding ($52.5T for their commercial bank operations). The top 5 banks that trade derivatives in the US represent 96% of all notional amounts and 83% of industry net current credit exposure (OCC Q3 2011 report).
Who the banks trade with and their exposure to each other or any one party for derivative contracts is not disclosed. The reason they obfuscate that exposure is simple; it is so that you cannot see their true exposure. The banks use Value at Risk (VAR) to try and measure the statistical odds that they will lose a set amount on any given trading day. JP Morgan and Goldman Sachs use 95% confidence ratio and Bank of America and Citi use 99%. A 95% ratio states that on any given 5 of 100 trading days (99% is 1 in 100 trading days) they can expect to lose more than their VAR amount. This is a false assumption and does not really take into account extremely volatile trading days. Example is the day AIG was bailed out in 2008 or when Bear Stearns failed. At best it is a cute statistical representation guessing risk in normal or up markets, volatile bear markets where a key player could fail the VAR measurement will probably be way off. Given the large sums of money involved in derivatives there is a good chance that if one of the top 5 players fails it will take out a large portion of the market.
The banks will all claim this is another black swan event that should only happen once every billion or so years. History shows the financial markets have these events every 10 years or so. So who is right? I vote history and not some stupid model in a spreadsheet. The derivative market is a time bomb ticking.
How a large player failure might work through the system
Suppose that BoA gets so weak that the US Government decides to step in and break up the bank to help protect depositors. Who will be affected by this change?
BoA depositors will be made whole on their FDIC insured accounts up to the maximum allowed by law. Large depositors and money market holders will be in line waiting with the bond holders hoping to be made whole either by a government program or by money received from selling the remaining assets of the bank.
BoA Shareholders (regular and preferred) will likely be wiped out with just a token amount refunded to them sometime in the future (many months or possibly years)
BoA Bond holders will probably take a large haircut in the value of their bonds. The amount is debatable but it could be anywhere from 40% to 100% depending on what an acquiring firm pays for the pieces they purchase. When Bear Stearns was forced taken over by JP Morgan they made the bond holders whole with the help of the US Government. I am not 100% convinced the US Government will step in again and do the same thing.
BoA derivatives bets made by the company will need to be worked out. Contracts where BoA has a positive value will be attempted to be collected. “Attempted” is the key word because the counter party that owes the money to BoA might also be owed money from BoA on other derivative trades, and may seek to have it netted out to minimize what they need to pay or to get paid in general. The administrator that is brought in to run BoA during the transition from failed bank to whatever their new form will seek to minimize paying out on these contracts just so that they can control the cash outflow and potentially maximize the amount of cash large depositors and bond holders receive. If BoA actually files bankruptcy or FDIC takes them over they can tie up any payments on the trades for a long time. The counter party to BoA might have won the battle but ultimately lose the war because they might not get paid or if they are paid, they might not be paid in full and it might be years before they get any cash. For large investors this is where the main risks lie. BoA is a large counter party risk.
Given that BoA represent approximately 21.5% of the entire market their failure might also severally impair other derivative traders. This is the theory why Bear Stearns was bailed out. Some people contend that if JP Morgan did not take over Bear Stearns and the US Government did not bailout AIG, Goldman Sachs and Citigroup would have been mortally wounded and might have started a chain reaction of failure in more derivative players. Remember the top 5 traders of Derivatives control 96% of the derivative market and all received government money in 2008 to help them through the financial crisis (though it was rumored that the US Government forced JP Morgan to take the cash).
This is 2011 and not 2008. A lot of the banks have truly cleaned up their balance sheets (i.e. Wells Fargo). So who is at risk if BoA should happen to fail?
To be fair to the top 5 derivative traders, they have all increased their cash and most have lowered their overall debt levels from 2008. The two that I feel are most at risk is Goldman Sachs and JP Morgan.
Goldman Sachs clearly punches way above their weight class. With the lowest amount of equity of the top 5 traders they take some of the biggest risks as measured with Notional Value to Equity or Notional Value to Risk-Based Capital. They are the fastest grower of derivatives. They have grown faster than any other derivative trader in notional value. Their balance sheet is getting worse as they add more and more leverage.
Most of the same can be said about JP Morgan.
Most of the same can be said about JP Morgan.
If BoA falls over and we assume that 21.5% of the trades that either Goldman Sachs or JP Morgan have placed were with BoA as a counter party, and looking only at the one that are in favor of Goldman or JP – measured by Gross Positive Fair Value- , they would easily overwhelm their equity if they had to recognize the loss as uncollectable.
The domino of Goldman Sachs falling over would not have that big of an impact outside of Wall Street. If BoA happened to bring down JP Morgan we would see the financial markets freeze up on Wall Street and every day markets freeze up on Main Street. As bad as that may sound we would eventually get over this and our markets would be much stronger without the dangers of derivatives hanging over them.
Full Disclosure
As of September 7, 2011 I do not own any positions in any companies mentioned. I do use some of these companies for banking and my mortgage.
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