There has been a lot of hyperventilating over
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
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.
The 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
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 Sachs (
). All of these have seen their credit spreads widen recently.
Concerns about creditworthiness of these firms can lead to
I don't think that runs on derivatives
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
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
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 BofA 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
So that's the real story here, in my opinion: The Fed's
encouragement of the move of ML's derivatives to BofA reveals its
nervousness about the vulnerability of ML, and some dealer firms
generally, to a run. From its perspective, moving the derivatives
risk to BofA 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
And no, that shouldn't give you the warm and fuzzies.
Nu Skin: What's Not To Like?