Derivatives Trader Sees ‘Danger and Immorality’ in Bank of America Move

Derivatives Trader Sees ‘Danger and Immorality’ in Bank of America Move
November 11, 2011

Is Bank of America shifting trillions of dollars of potential losses onto the backs of taxpayers?

Ratings agency Moody’s downgraded the bank’s debt in September, and BoA began moving risky derivatives from its Merrill Lynch investment bank arm to its retail banking unit.

Derivatives are financial instruments whose value is derived from underlying assets, such as mortgages. Retail banks have government protections that investment banks lack.

Some economists say Bank of America appears to be setting up another taxpayer bailout if the derivatives go bad. Bloomberg News first reported the move but did not put a dollar figure on it. The New York Post estimated it at more than $55 trillion—yes, trillion.

Heartland Institute Fellow Ross Kaminsky, a professional derivatives trader, offers his thoughts:

Socializing Losses, Keeping Gains

Even most professional derivatives traders would find the financial engineering behind many investment banks' portfolios incomprehensible. Therefore, even for a professional derivatives trader like me, it's pointless to think about what might or might not happen to the value of Bank of America's portfolio—or, more precisely, Merrill Lynch's portfolio, about to be transferred to BoA—in any given economic situation.

Being unable to answer such a question focuses the mind, then, on questions we can answer, such as "Why do we have a situation in which banks can try to force the socialization of future potential losses, while they privatize [keep] their gains?"

‘Dangerous, Immoral’

This situation is not just economically dangerous; it is immoral.

That the transfer is being requested by the derivates' counterparties is no surprise. Of course they want something as close as possible to government backing of their transactions with BoA. Who wouldn't want that? But it is not government's job to guarantee such things. And when they do, we get Fannie Mae.

This is a perfect example of the Fed acting as if it still believes some banks are "too big to fail," which people from the leftists in the Occupy Wall Street movement to Tea Party conservatives and libertarians all object to.

Government Creating Perverse Incentives

If we must have a situation where the government insures deposits, that insurance must not be allowed to cover the risk of an investment bank's proprietary trading portfolio. (Yes, banks pay premiums to the Federal Deposit Insurance Corporation, but when those premiums aren't enough, taxpayers are on the hook.)

The risk of forcing taxpayers to cover potential derivatives losses is worse, both ethically and in terms of the moral hazard it creates, than the risk of forcing a bank to deal with the risks it voluntarily took.

I understand the "systemic risks" argument and am not swayed. At some point the system must right itself. It will do so only when perverse incentives created by government are eliminated. Preventing an investment bank from being able to transfer trading positions to a commercial bank is a good place to start.

Ross Kaminsky (rossputin@aol.com) is a derivatives trader and blogs at Rossputin.com.