Is Bank of America Playing a "Shell Game" With Its Derivatives?

by Investment U Research Team

Is Bank of America Playing a "Shell Game" With Its Derivatives?

by Chris Matthai, Investment U Research

Wednesday, November 30, 2011

According to Bloomberg, Bank of America (NYSE: BAC) is currently shifting derivative contracts between its retail deposit bank, Bank of America NA, and its wholly owned brokerage arm, Merrill Lynch.

At first glimpse, no big deal right?

Wrong... Not when we're talking about $75 trillion in derivatives contracts that B of A is backing. And regulators may soon be putting an end to these transfers.

derivative activity banking system chart

Problems for Bank of America

What's at issue is that derivatives contracts usually require counterparties to post collateral in amounts that can increase if their creditworthiness deteriorates. And Bank of America's September downgrade from Moody's Investor Service is causing problems for B of A.

At stake for Bank of America is the continuing ability to shift derivative obligations between its operating units - thereby reducing billions of dollars in collateral payments to counterparties.

Due to the Moody's downgrade, Bank of America Corporation has designated the retail-deposit unit, Bank of America NA, as the new counterparty on certain Merrill Lynch contracts. The transfers lower collateral obligations because the retail unit still has a higher rating than the Merrill Lynch subsidiary after the downgrades.

However, the FDIC is not too keen on the idea of shifting derivatives contracts into the books of a deposit-taking bank (that's covered by FDIC insurance) and putting depositors at risk of failure.

On the other hand, the Federal Reserve, operating under the "Too Big to Fail" policy, has signaled that it favors moving the derivatives to give relief to the bank holding company.

Stay Tuned

The other two major ratings firms - Standard & Poor's and Fitch Ratings - are re-evaluating Bank of America and may also cut its credit ratings. If that happens, expect the tempo of B of A's shell game to accelerate.

While federal regulators remain at odds over B of A's derivatives strategy, there should be no doubt in your mind about investing in Bank of America... Don't do it. There's still way too much uncertainty surrounding these shares.

Good investing,

Chris Matthai

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