Without getting extremely complicated, the bad bank could be funded/paid for from the original bank from an equity raise or debt sale with the equity in and supporting collateral being the good bank. The bad bank would then purchase the bad assets (for pennies on the dollar) from the good bank and look to unwind and/or sell them to the highest bidder. It's obviously a big process that would take place but that's the gist of it.

OK ... (thanks for playing) ... and why doesn't BAC do this on their own today? Why will it take the imminent collapse of a trillion dollar bank and the end of the world before change will occur?

Mike

Without getting extremely complicated, the bad bank could be funded/paid for from the original bank from an equity raise or debt sale with the equity in and supporting collateral being the good bank. The bad bank would then purchase the bad assets (for pennies on the dollar) from the good bank and look to unwind and/or sell them to the highest bidder. It's obviously a big process that would take place but that's the gist of it.

I would imagine there are a few things that could be done but like Lornz mentioned, following some sort of Scandinavian style work out makes sense. Sweden broke down the large banks via pre-packaged BK and created good banks/bad banks. Taking all the good assets and placing them with the good banks and the bad with the bad. The bad banks assets were auctioned off or just sat there while the good banks were able to recover and create a healthy base again. I believe Norway nationalized their banks while Sweden just sort of mandated what the banks were to do. Maybe Lornz can confirm that.

The thing is BAC will probably not have the option of saying yes or no. I would think they get to the point where they are on the verge of failure and that's when they should be broken up ASAP if not sooner. The issue is what are their underlying assets? There's been a huge uproar about the amount of derivatives they have. But I'm almost certain not all of the derivatives are just the CDO/CLN/CDS type. Don't get me wrong, I'm sure they have way more of that than they should have which will be their demise but a lot of bank's derivatives are also in FX Swaps which aren't the toxic type we're concerned with. Unfortunately, BAC has hid all of this from us so it's hard to decipher. But my point is, there should be a bad bank set up that can "swallow" the bad assets and attempt to unwind whatever they can and auction off whatever will get a bid which will be pennies on the dollar of course. The bad bank would be more or less a private fund vs a traditional bank. Then the good assets could be used to create a new bank that is far smaller and less complex as far as underlying assets and liabilities. Just a thought of course and Bernanke will inherently do the wrong thing but you'd think the guy learned by now.

I was able to locate BofA's 3rd quarter 10Q filing and as I mentioned earlier, a majority of the derivatives it holds are comprised of the lower levered FX and Interest Rate Swaps. But there is one big problem and that's the CDS holdings which accounts for $4,138,400,000,000 +/- a few bucks. That ought to be enough to take down the farm. Also, should there be a blow on the CDS side, look for the other derivatives to be in trouble as counter parties will want to collect or exit their positions with BofA or better put, one big margin call.

Thanks for your analysis Private Banker.

I just doubt this $4,138,400,000,000 exposure is a directional one: this should rather be the sum of various long and short positions that are aggregated. Very few people in a bank can take a directional bet, only prop desks can do that. 90% of an investment bank revenues are generated through fees and bid-ask spreads.

Futhermore if I had to short financials, I'd rather look to the good old europe that have tons of irresponsibly leveraged banks.

Have a look at this blog from a French economist, these are really interesting times !

Jean-Pierre CHEVALLIER Categorie : English

So your solution is basically wait for the next bubble to collapse and they will fix themselves? I am not so confident, I think BAC failing will lead to many other failures. I can't see a solution that doesn't involve some sort of bail out, even though I strongly oppose a bail out.

Mike

Bank of America Corp. (BAC), hit by a credit downgrade last month, has moved derivatives from its Merrill Lynch unit to a subsidiary flush with insured deposits, according to people with direct knowledge of the situation.

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.

Three years after taxpayers rescued some of the biggest U.S. lenders, regulators are grappling with how to protect FDIC- insured bank accounts from risks generated by investment-banking operations. Bank of America, which got a $45 billion bailout during the financial crisis, had $1.04 trillion in deposits as of midyear, ranking it second among U.S. firms.

“The concern is that there is always an enormous temptation to dump the losers on the insured institution,” said William Black, professor of economics and law at the University of Missouri-Kansas City and a former bank regulator. “We should have fairly tight restrictions on that.”

Moody’s Investors Service downgraded Bank of America’s long-term credit ratings Sept. 21, cutting both the holding company and the retail bank two notches apiece. The holding company fell to Baa1, the third-lowest investment-grade rank, from A2, while the retail bank declined to A2 from Aa3.

The Moody’s downgrade spurred some of Merrill’s partners to ask that contracts be moved to the retail unit, which has a higher credit rating, according to people familiar with the transactions. Transferring derivatives also can help the parent company minimize the collateral it must post on contracts and the potential costs to terminate trades after Moody’s decision, said a person familiar with the matter.

Bank of America’s holding company — the parent of both the retail bank and the Merrill Lynch securities unit — held almost $75 trillion of derivatives at the end of June, according to data compiled by the OCC. About $53 trillion, or 71 percent, were within Bank of America NA, according to the data, which represent the notional values of the trades.
That compares with JPMorgan’s deposit-taking entity, JPMorgan Chase Bank NA, which contained 99 percent of the New York-based firm’s $79 trillion of notional derivatives, the OCC data show.

Moving derivatives contracts between units of a bank holding company is limited under Section 23A of the Federal Reserve Act, which is designed to prevent a lender’s affiliates from benefiting from its federal subsidy and to protect the bank from excessive risk originating at the non-bank affiliate, said Saule T. Omarova, a law professor at the University of North Carolina at Chapel Hill School of Law.