BAC-WT - Bank of America Warrants

[racemize]

Racemize,

Kyle Bass likes to ask his audiences, how many people think Greece will default. Most hands tend to go up. He then asks them a very specific question like what is Greece's outstanding debt or what is Greece's annual interest payments. Usually nobody has the answer.

 

The same seems to be true for derivatives. Few people bother to look at the facts. Very few people tend to read the Comptroller of the Currency's report, so get ahead of 99% of people that opine on derivatives.

 

So derivatives must read: http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq211.pdf

When reading don't confuse your billions and trillions.

Note Table 1

 

I don't buy into the benefits of netting, because 96% of derivatives are "held" by 5 banks and the problem is potentially bigger than the 5 of them.

 

Also, how will netting actually work? Legally it will be a nightmare http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1811164_code524668.pdf?abstractid=1476478&mirid=1 The paper is a bit of a slog, but worth the read.

 

Forgive me for doing this, but read pages 7-10 of this http://www.baobabglobalfund.com/Files/2010.pdf

 

In case it sounds like I am pontificating; I have spent many years looking at this issue and my conclusion is; "I know I don't know"

 

Mr. B, thanks for all the links--I've gone through the BIS and clearing house reports and read similar articles as above and, similar to you, realized I just didn't know.  I was hoping I was just ignorant (which is probably still true anyway), but I guess it's comforting to come here and have you folks say the same thing.

 

However, one thing I had not realized, per Kevin's response, is that 86% of the derivatives are interest rate swaps.  Am I correct in assuming the notional values pretty much do not come into play during a default for those contracts (e.g., since they appear to be only interesting in the interest rate difference)?  Chopping the total CDS notional amounts down to only two trillion (did not think I'd ever write that phrase) certainly seems to help the situation some.

[Junto]

Here is a discussion on derivatives and netting which I found quite interesting: http://epicureandealmaker.blogspot.com/2011/11/known-unknowns.html

 

Let’s look at the example of Bank A hedging some exposure by trading with Bank B. Let’s say

 

(1) Bank A has bought $100mm of CDS from Bank B,

(2) The CDS is currently worth 65 points (i.e. the $100mm notional contract is worth $65mm),

(3) Bank B has posted $60mm of collateral to Bank A.

 

What is Bank A’s direct exposure to Bank B? I would argue that the correct number is $5mm. If Bank B were to default and have 0 recovery, Bank A would post an immediate loss of $5mm, since Bank A already has the $60mm in collateral.

 

The point is that direct counterparty risk only exists on the uncollateralized portion of any exposure. One term for this is “gap risk.” This is relevant because in your example, Bank A would not try to hedge out its exposure to Bank B by buying protection on Bank B from Bank C. Almost all of Bank A’s exposure to Bank B is already covered by collateral. As for the remaining part, generally the amount of uncollateralized exposure that Bank A has to Bank B is not correlated to Bank B’s credit rating, especially if there are a large number of trades in multiple asset classes between the two banks. Bank A can’t know a priori what the uncollateralized amount will be if Bank B defaults; it’s just as likely that the CDS in the above example has moved from 60 points to 55 points and Bank A actually owes Bank B collateral. Also note that since this is essentially portfolio risk, doubling the number of trades with Bank B doesn’t actually double the exposure, especially if (as is common) many of the new trades are offsetting in risk. There’s no gross buildup of residual risk; this just boils down to net risk against the counterparty.

 

Why was AIG different? The above is a fairly accurate stylized approximation of what happens for relatively liquid CDS (which do increasingly go through central clearinghouses anyway). Something like a corporate or sovereign CDS is a distinct product that trades and has an observable market price. In the AIG case, most of AIG’s CDS exposure came from much more bespoke deals on structured products. A typical AIG CDS contract might be on some particular complex mortgage product, for which the only CDS trade was the one in which AIG wrote the protection. It has no observable market price and has to be priced using model assumptions on the underlying. This contrasts with e.g. sovereign CDS, where a price can be observed in the market and multiple trades happen on the same CDS; i.e. where there does in fact exist an observable market price.

 

Why is this relevant? In the above example, we assume that banks A and B agree on the contract’s valuation. If instead Bank A believes the contract is worth $65mm but Bank B only believes the contract is worth $30mm and has only posted that much collateral, then Bank A has $35mm of exposure to Bank B, which it will need to hedge accordingly. But the point is that this is a valuation issue; if the two banks actually agreed on the value of the contract, but Bank B simply refused to post collateral, then Bank B would be defaulting outright on its obligations, and would have its positions closed out accordingly, rather than have the counterparty risk just continue to exist.

 

The above discusses direct counterparty exposure in the sense of “losing money if my counterparty defaults.” There is of course further risk; if Bank B defaults, Bank A is left with that $100mm of risk that it previously didn’t have. But the risk here is actually a function of Bank B’s net exposure, not Bank A’s gross exposure. If, for example, Bank B had an offsetting contract for $90mm notional with Bank C, then after a default by Bank B, you would expect that Bank A and Bank C would offset their newly acquired risk against each other, such that e.g. Bank A only ends up with a $10mm change in risk, and Bank C ends up with no change in risk. This is pretty much what happened after Lehman defaulted. In fact there was a special trading session arranged for just that purpose, though most of the risk rebalancing actually happened in normal trading after the default.

 

I believe points (2) and (3) in your blog post boil down to concerns regarding net risk. I agree that large concentrations of net exposure would be a cause for concern, more so in illiquid positions but even to some extent in liquid ones. One way to get more comfortable with this in CDS space is just to look at the DTCC net notional numbers. By definition no entity’s net position can exceed the total net position. This ends up giving you a cap on how bad things can be; of course not ideal, but maybe less bad than you would initially think.

 

 

* *

One more thing—and you can share this too as long as it’s not attributed.

 

The “margin call contagion” scenario you propose is not representative of how banks operate. Just about everything in a bank’s portfolio will already be contributing to its funding. Bonds will be repoed out (i.e. for cash equal to the bond’s value, less a haircut), stock will be lent out, and collateral posted on derivative contracts will be rehypothecated.

 

It’s possible that e.g. repo haircuts will exceed the bid-offer on some instruments and selling a security might give me slightly more cash than repoing it, but the extra amount is small. In general the notion of “liquidating a valuable position for cash” doesn’t make sense for a bank. Of course this may be different for a buy-side firm, but it doesn’t make sense for a bank to sell a security for liquidity purposes when it’s already used to secure some cash. This is also less true for illiquid things that can’t be financed; it is however true for any collateralized derivative position due to rehypothecation.

 

The link also refers back to this post: http://epicureandealmaker.blogspot.com/2011/11/methinks-thou-dost-protest-too-much.html

 

[racemize]

Thanks Junto, that was great.

[ERICOPOLY]

The situation that scares me is the counterparty default.

 

Same scare I had with Fairfax in 2008.

 

Large reinsurance recoverable hedged with CDS.

 

AIG goes down and no bailout.  Barclays, Citigroup, DeutcheBank, BofA go down.  The Fairfax CDS portfolio is kaput.

 

AIG's reinsurance is worthless ->  most reinsurers go down in daisy chain style.

 

Fun isn't it?

 

Junto's post does help me feel better.

 

[MrB]

weird the entire financial system nearly went down in 2008/2009 yet the derivative book of JPM, the bank with the most derivative exposure per the bears who monitor such things, did not have any problems with it's derivative book. That is it did not blow up. It also looks like it will "survive" this crisis.----------

I SUSPECT that it was because problems were mostly related to credit derivatives (20% of total if I remember correctly). As per previous poster, interest/currency derivatives are the ones to watch, because it makes up the bulk of the total book.

Also, I have been unable to establish how much has been netted off outside the US banking system, so there is an important and potentially big piece of the puzzle missing. The BIS data I've looked at only shows that the US picture resembles the global one; the other very big player is Barclays; a very leverage entity to start off with.

 

Uccmal--If you invert the issue by asking, where will I be safe if any of the big banks blow up due to derivatives, then it gets interesting. What seems conclusive is that if one of those big 5 blow up the rest are all in trouble and all the resources that can be mustered will be brought to bear on the situation. So I get comfortable somewhere between the fact that there is really no place to hide, but say for gold under the bed and that the cavalry will be out in force. Many will disagree, but for me it provides enough comfort to invest in things like BAC. However, I will not invest in a non-TBTF

 

Lastly, a word on the notional. I find a lot of the derivative stuff goes straight over my head. I sometimes will count things on my fingers to make sure I get it right ;-) Point is I think the credit v notional talk is a bit like when companies were valued on revenues back in the Dotcom days. So I took it back to basics. Where does a derivative contract come from? From some farmer that wanted to hedge his harvest. So if his harvest was worth $100,000 then how much did he hedge? Well, $100k and that was the notional of his contract. Today we blew straight past that and many now maintain notional can be ignored. I am highly skeptical and think the fact that we have now reached 10x notional/GDP on a US and global basis might prove to be some kind of a barrier. We can only leverage up the global trade so much, right?

 

It is quite scary to think that as little as two years ago the average paperwork on the trading of derivatives were more than 6 months behind and that Buffett found it almost impossible to run down Gen Re's D-book.

[Smazz]

The rationale for the rating downgrades seems kind of perverse.  In effect we dont see the government stepping in to support them because they are strong enough to stand on their own now, so we downgraded them.  I just dont understand it.

 

As an aside, can anyone reflect on this for me:  Am I correct that the ratings agencies can only use publicly available information or are they privy to things that only insiders have access to?

 

After 2007-2008 no sane, rational human being should take the "ratings agencies" seriously.

 

Ive been saying this all along as well.

 

Just curious, with all these great documentaries we've seen over the last few years of how things have blown up - has anyone ever done an investigative of the rating agencies absolute incompetence over that time period?  I'd really love to sit down with some popcorn over that. :P

 

And I actually did well over that time period, I can just imagine those who got slaughtered.

[ERICOPOLY]

Buffett has also stated that he intends to exercise the Goldman Sachs warrants that Berkshire holds.  So the derivatives risk is within his risk tolerance at least. 

 

[MrB]

On Reuters today. Sorry no Link

 

WELLS FARGO & CO CEO SAYS BANK "LOOKS FORWARD" TO RETURNING MORE CAPITAL TO SHAREHOLDERS NEXT YEAR   

 

Are the warrants adjusted for dividends only or return of capital to?

[MrB]

  BofA Merrill unit in $315 mln mortgage settlement   

Dec 6 (Reuters) - Bank of America Corp (BAC.N) agreed

to pay $315 million to settle claims by investors who said they

were misled about mortgage securities offerings by its Merrill

Lynch unit, a court filing shows.

    The settlement requires court approval.

 

(Reporting by Jonathan Stempel in New York; Editing by Derek

Caney)

((jon.stempel@thomsonreuters.com +1 646 223 6317; Reuters

Messaging: jon.stempel.reuters.com@reuters.net))

 

 

[mals]

Now there is talk of Baupost being short BAC.

That reminded me that I should read again a well researched piece on the option that BAC takes Countrywide to bankruptcy and limit its liabilities.

I remember stumbling on one such researched document in the recent past but could not find it in my searches just now.

 

In general with

- the discount to its tangible book value already being placed on BAC, to the tune of $50-60B

- american economy not doing as badly as per most of the economic indicators

- BAC having loads of deposits and not having to access the market for funding needs too much

- and its franchise generating large pre-provision pre-tax surplus

I believe that it is possible that shorts win in the short term and longs win in the long term. BAC will be able to dig itself out of the hole and yet in the short term there may be further panic.

 

Panics can however ruin financial institutions and therefore I am concerned.

 

And that is why it is important to understand whether BAC has the option to limit Countrywide related losses.

So if somebody has seen the piece that I remember seeing, please do point me to it.

[lessthaniv]

http://www.bloomberg.com/news/2011-09-16/bofa-said-to-keep-bankruptcy-as-option-for-countrywide-unit.html

 

 

[mals]

I did not mean this news piece @lessthaniv.

 

I had seen a report from somebody who had read all the detailed legal documents and had prepared some sort of considered and detailed assessment of the situation. The kinds that news wires do not carry :)

I read the headline of the article and then decided to come back to it. But now I cannot find it...

 

---

 

In the meantime, I found these articles. Not the same thing as what I was looking for -

http://blogs.wsj.com/deals/2011/11/08/why-bofa-decided-against-a-countrywide-bankruptcy-for-now/

http://blogs.wsj.com/deals/2010/11/02/could-bofa-push-countrywide-into-bankruptcy/

http://www.subprimeshakeout.com/2011/04/pfaelzer-dismissal-of-bank-of-america-from-countrywide-suit-throws-investors-for-a-loop.html

 

Substance over form is the argument made here - did Countrywide become one entity (substance wise) or is it a separate entity (form wire - i.e. based on how the corporate entity was structured). Question is whether Countrywide is really separate or one entity with BoA.

 

Time will tell. On balance, it appears to be a situation where a long time frame investor will do quite well.

But I am no expert on legal wranglings. All I hope is that they have not created new mess since 2008 and it does appear that the franchise is doing ok and can do better and can afford to pay-off reasonably large liabilities.

 

[beerbaron]

Now there is talk of Baupost being short BAC.

 

I think Klarman once said he never shorts unless it's to hedge something else.

 

 

[MrB]

Mals,

This might be of some help

See links in first few lines. Challenging to read around the biases, but does make some valid points.

http://www.zerohedge.com/article/pimco-and-new-york-fed-said-seek-bank-america-repurchase-mortgages

 

The legal side of it. In this case foreclosures, but it gives you a sense of the legal challenges. Main point for me; It will take time. With investment time is your enemy, with debt it is your friend. $50Bn over 5 years is not $50Bn today; discounted at 5% it is $39Bn, plus lawyers fees.

(see page 13 and importantly 2nd para of page 16)

http://digital.library.unt.edu/ark:/67531/metadc29633/m1/1/high_res_d/R41491_2010Nov15.pdf

 

http://www.scribd.com/fullscreen/39593695

See Exhibit 9 for BAC

[racemize]

I'm sure most of you have already done this analysis, but here's a pretty good article on BAC's level 3 assets:

 

http://seekingalpha.com/article/312845-bank-of-america-piercing-its-opaque-balance-sheet

[Aberhound]

As soon as any bank in Europe fails to pay its depositors because derivatives take priority and the government refuses or is unable to bail out "the rich" depositors why would anyone keep their deposits in BoA instead of WFC or some smaller bank without the opaque derivative exposure? What will BoA's cost of capital be compared to its competitors when the risk becomes more apparent? How will BoA compete with deposit terms with those who have lower cost of capital? How will BoA compete with WFC who is in a far better position to take advantage of the flood of cheap bank owned assets that will be available over the next 5 years?

 

When you deposit monies at BoA you take a risk that the derivatives take priority. Less than 2% of the population choose to avoid the risk now but what happens when there is a cross-over of awareness? BoA's challenge is to get out from the vicious circle to the virtuous circle before there is a bank problem in Europe. Maybe BoA can make the transition, but their task is much more challenging than for their competitors and the amount of time they have is not in their control. Note the European banks all face the same problem but worse because they cannot expect support from the US and their sovereigns are weaker. This will create the derivative problem because Europe has as many derivatives as the US and European derivative problems will become US derivative problems. There is a lack of good counterparties so all derivative holders are exposed to weak counterparties.

 

Buffett prefers businesses that can be run by mediocre talent in a business that doesn't face such headwinds. It will be interesting to see if he doubles down if BoA weakens.

 

 

[alertmeipp]

how derivatives become such an evil ... options, equity, forex, interest swaps are used by financials as long as I can remember... the fact that the notion amount is huge or it's not straight forward really bother so many of u...

[ERICOPOLY]

Buffett prefers businesses that can be run by mediocre talent in a business that doesn't face such headwinds.

 

Imagine Goldman Sachs with mediocre talent though.

[mals]

 

Main point for me; It will take time. With investment time is your enemy, with debt it is your friend. $50Bn over 5 years is not $50Bn today; discounted at 5% it is $39Bn, plus lawyers fees.

 

http://www.scribd.com/fullscreen/39593695

See Exhibit 9 for BAC

 

Thanks for sharing the links. Going through them now.

 

A question:: I did not understand your comments about "time is your enemy...". As I view it, it is good for equity holders that BoA will likely need to meet its liability over several years. It would be better if there were no liability, but given that there is liability spreading it out is better for equity holders. Is that what you meant?

 

On the JP Morgan report, if one assumes that it is directionally right, then BoA put-back claims were only about $11B by around Aug 2010. Perhaps the claims have gone up, but by how much is the question. I am guessing there exist more updated estimate of how much the claims stand at around now?

 

BoA's valuation appears to be penalized to the tune of $50-60B (if one takes discount to tangible equity as one representative of the level of discount). With BoA's cash flows and the fact that they will need to pay these claims over the years, I believe that BoA will be fine.  It  does not have a liquidity problem - at least not that I can see. I also believe that regulators would also prefer to have it that way - who wants another problem to deal with when there is Europe to deal with at the same time.

 

I will review the documents some more, but on balance it appears to me that BoA exposure is a risk worth taking. Low but finite risk of wipe-out in return for a decent possibility of a large return over a few years.

[berkshiremystery]

Now there is talk of Baupost being short BAC.

 

I think Klarman once said he never shorts unless it's to hedge something else.

 

<snip>... The hedge-fund blog Zero Hedge speculated Thursday night that Baupost, as Walnut Place, may be fighting the proposed BofA MBS settlement because it has shorted Bank of America stock and taken a long position on MBIA, which is also engaged in do-or-die MBS litigation with BofA. The Baupost client memo -- without naming the Zero Hedge blog -- firmly rejected that assertion as "unfounded and completely false."

 

"We have on occasion owned a small amount of default protection on Bank of America debt as part of our overall portfolio hedging strategy through which we hold credit default swaps on a diverse group of financial institutions and other corporate issuers," the memo said. "We currently have no long or short position in equity, corporate debt, or credit default swaps of Bank of America or MBIA."  ... </snip>

 

Source: http://newsandinsight.thomsonreuters.com/Legal/News/ViewNews.aspx?id=34462&terms=%40ReutersTopicCodes+CONTAINS+'ANV'

[ERICOPOLY]

I'm surprised that BAC is only paying 0.27% on deposits.  WFC pays 0.25% on deposits.

 

What's driving the sudden drop in cost of deposits for BAC? 

[twacowfca]

Now there is talk of Baupost being short BAC.

 

I think Klarman once said he never shorts unless it's to hedge something else.

 

<snip>... The hedge-fund blog Zero Hedge speculated Thursday night that Baupost, as Walnut Place, may be fighting the proposed BofA MBS settlement because it has shorted Bank of America stock and taken a long position on MBIA, which is also engaged in do-or-die MBS litigation with BofA. The Baupost client memo -- without naming the Zero Hedge blog -- firmly rejected that assertion as "unfounded and completely false."

 

"We have on occasion owned a small amount of default protection on Bank of America debt as part of our overall portfolio hedging strategy through which we hold credit default swaps on a diverse group of financial institutions and other corporate issuers," the memo said. "We currently have no long or short position in equity, corporate debt, or credit default swaps of Bank of America or MBIA."  ... </snip>

 

Source: http://newsandinsight.thomsonreuters.com/Legal/News/ViewNews.aspx?id=34462&terms=%40ReutersTopicCodes+CONTAINS+'ANV'

 

Yup.  They're good guys trying to make a buck, not part of the Evil Empire of those despicable short sellers.  :)

[onyx1]

On the JP Morgan report, if one assumes that it is directionally right, then BoA put-back claims were only about $11B by around Aug 2010. Perhaps the claims have gone up, but by how much is the question. I am guessing there exist more updated estimate of how much the claims stand at around now?

 

Yes, the claims have gone up and may go even higher.  Just look at one line of JPMs $11b estimate which included almost no private label MBS liability (33m).  The BOY-Mellon settlement for private label MBS (of which Klarman claims should be "many times" higher) grew that liability from $33m to $8.5bln + another $5bln for range of possible losses. 

[Packer16]

The put back liability is what may put Countrywide into BK as it appears that not everyone is one baord with the settlement.

 

Packer

[ERICOPOLY]

On the JP Morgan report, if one assumes that it is directionally right, then BoA put-back claims were only about $11B by around Aug 2010. Perhaps the claims have gone up, but by how much is the question. I am guessing there exist more updated estimate of how much the claims stand at around now?

 

Current (Q3 2011) representations and warranties outstanding claims are $11.672b.

 

See page 31 of BofA's 3rd quarter earnings presentation:

 

http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9MTExMTY3fENoaWxkSUQ9LTF8VHlwZT0z&t=1