BAC-WT - Bank of America Warrants

[xazp]

BAC's NIMs are depressed and expenses are still elevated because they are still dealing with legacy mortgage issues.  This continues to be an overhang from the Ken Lewis era.  I don't think it's an apples-to-apples comparison today. 

 

All of the metrics you usually compare are being shot because of their continuing legacy asset problems.  You have a business (much like Citi Holdings) that is earning a negative ROA, ROE, etc.  Like billions of dollars in losses each year.  It's also tying up a lot of capital.  Only time can really resolve these issues; but when you take equity or capital that is losing a few billion dollars a year, and either return it to shareholders or invest it in a real business - you see big swings in profits.  BAC's earnings will grow faster than JPM's for this reason - but the question is, where do they normalize out? 

 

I agree that JPM"s normalized earnings are better than BAC's, I don't think they're 30% better than BACs as reflected by their market cap.  And because BAC has more capital to return (this is a consequence of a lot of capital being tied up in non-performing-loans and tax assets) there's the intriguing possibility they can buy lots of shares before their earnings normalize and below book value. 

 

I really wish that BAC would do an investor day similar to JPM's where they talk about what the company looks like post-legacy-resolution.  We're getting close to that point, but, we only have vague targets for the future (whereas JPM and Citi both have been much clearer about where they see themselves in a  few years).  Right now we're debating a clear outlook from JPM with speculation what BAC might do. 

 

Also, I would not say JPM is taking deposit market share from BAC.  BAC is still growing deposits by $10Bn/quarter and it is selling off branches and deposits (here's a recent billion dollars in deposits sold - http://www.businessweek.com/news/2014-05-14/bank-of-america-will-sell-huntington-13-more-michigan-branches).  JPM's deposits are growing faster than BAC's, but they are both growing - they are both taking share from (I'm guessing) smaller banks.  It's hard to compare because BAC is trying to shrink their branches and deposits while JPM is trying to grow branches and deposits. 

 

 

Well the question is whether JPM's superior management is basically such a long-term advantage that it makes up for the 30% higher market cap. 

 

On the growth side, BAC's says its easier to grow internationally (taking share from sucky, under-capitalized European banks), than for JPM to grow domestically (through WFC, BAC, USB). 

 

The thesis for BAC is basically they can "return to mediocrity."  Their metric growth is mostly just by getting rid of legacy costs and getting the company in-line on its expenses will get BAC earning something close to JPM (but at a 30% discount).  The thesis for JPM is the better management means a permanent and widening gap with BAC.  I think both are plausible (and I also think both will be good investments).  Buffett seems to prefer BAC even though he agrees that Dimon is the best guy in the business.

 

I'm prefer BAC right now, but for example during the "whale" I preferred JPM.  So for me it is a question about price. 

 

 

For example, BAC has a huge deposit base (Buffett talks about this) is something that has little value now, but a lot of value when interest rates rise. 

 

But remember, xazp, JPM has Chase bank under its belt.  It can take market share from BAC and WFC and create a sticky deposit base that is equivalent to those guys' deposit base.  I myself have been a long time BofA customer, but I am seriously considering switching everything to Chase.  Because only JPM was smart enough to give me a mortgage when I needed it, and I also have a credit card with them.

 

Things I love about JPM:

 

-The upside of building a BAC- and WFC-like deposit base in the US

-Credit card franchise that is becoming a real rival to AXP's (though it's not close looped)

-Outstanding IB ops

-Best corporate banking biz?

-Payments system growth that can take away from C's franchise

-Global ops that are much better run than C's

-Strongly growing asset management biz that can rival BX, AZ, etc.

-Opportunity to remake/simplify biz portfolio and re-allocate to higher return ideas (e.g., selling commodities biz)

-Outstanding management

 

JPM is the banker's bank and the type of bank that I would go to if I ran a big multinational corporation.  It's just a fantastic company with outstanding management.

 

I think it is well worth paying up a little for better management. The neat thing about JPM and BAC are that they are very similar in terms if size, balance sheet etc. JPM is just a better bank. A few example's from the latest 10-q: - JPM's NIM is 2.66% and BAC is 2.33%. JPM 's compensation expense is 2B$ lower than BAC (~8B$ vs BC ~10B$ and has been falling faster). Both have now very similar credit card earnings, but JPM's has taken quite a bit if market share. JPM's deposits were 1.2T$ vs BAC's ~1.1T$ (there may be structural differences in the deposit base, I have not checked). At least in CA, Chase has taken huge market share in deposits from BAC via the Wamu takeover and organic growth, while BAC has been licking their wounds.

 

Morgan's bank is better than Merrill Lynch, imo. I also think that Chase wealth management is better and has grown stronger than BAC. I have been Credit card customer with both BAC and Chase and I can say that Chase is way better (offerings and customer service are better). All the above are structural advantages that have nothing to do with BAC legancy issues (which come on top of that). The 2B$ in compensation expense alone is 8B$/year in earnings power. Can BAC close that gap? They probably will close some of it, but it will take many years and most likely some of JPM's advantages will remain in place.

 

That said, I agree it's more of a case that both JPM and BAC (and C while we are at it) are cheap. I would be inclined to buy BAC at tangible book (~13.8$ if they accounting is correct ), but I think the relative bargain is JPM more so than BAC.

[xazp]

So as a quick back-of-the-envelope (I know, this is not very accurate - I'm just trying to get a very approximate number). 

 

BAC Q1:

1)  Assume that residential real-estate eventually gets to break-even (versus a profit center for some banks).  BAC lost $5Bn after-tax in this division in Q1. 

2)  Back-out 3/4 of their once-a-year retirement benefits of $1Bn.

 

You get earnings of about $5.25Bn

 

JPM Q1:

seemed pretty clean, and they reported $5.3Bn

 

C Q1:

Assume citi holdings (which is in run off) goes to break-even

Earnings of about $4.4Bn

 

IMO on a normalized basis BAC and JPM are not very different (assuming "normalized" for BAC means their residential real estate division goes to break even).  A few percent different perhaps but the market caps are off by > 30%.  I would venture to guess in the alternate universe where BAC threw Countrywide into bankruptcy in 2011, BAC would currently be earning about the same as JPM today. 

 

 

 

 

[no_free_lunch]

I own both BAC & JPM.  At these prices I would made JPM a huge position but their derivative positions scare the hell out of me.  Did you guys see the Buffet quotes about JPM and a discontinuity?  Now I don't mean to be a fear-mongerer, derivative fear was big back in 05 and nothing has happened yet.  However it's a big unknown that gets associated with JPM and perhaps worth in some way trying to weigh in when you compare the two banks.

 

 

Warren Buffett is well known for his famous warning about derivatives as “weapons of mass destruction.” Well, recently he went much further with Forbes Magazine, flatly prognosticating someday (he doesn’t known when) a massive financial “discontinuity,” which the dictionary refers to as an “ending, expiration, halt, lapse, a shutdown, a stoppage,”  that could very well be worse than 2008. What terribly worries him is that he simply doesn’t understand the massive derivatives position on the balance sheet of J.P. Morgan Chase .” Like many other financial experts Buffett can’t really figure out the financial health of JPM’s derivatives. It is impossible for anyone to divine the extent that JPM is profiting or losing money or the risks entailed in the identity of counterparties, the quality of the collateral used, and the amount of leverage employed.

 

“Someday,” he tells Forbes, “it won’t matter how large the level of assets on J.P. Morgan’s balance sheet. There is no risk control system that is effective if the numbers get big enough. I don’t believe the reserves they set up against loss in their derivatives. All that netting stuff doesn’t mean anything. I don’t want to be intertwined with any bank as to significant amounts of receivables. I can’t get that intertwined.” One of  the fears he has is of a major cyber warfare attack on the major Too Big to Fail banks that disrupts the financial markets.

http://www.forbes.com/sites/robertlenzner/2014/04/30/seking-shelter-warren-buffett-limits-receivables-from-major-banks/

 

According to the Office of the Comptroller of the Currency, the four largest derivatives participants in the United States are JPMorgan Chase, Citibank, Bank of America and Goldman Sachs, which together represent more than 30 percent of the total global derivatives market. Since the crisis, JPMorgan’s derivatives portfolio has been declining slowly every year and as of the end of 2013 was about $70 trillion. It is still the largest derivatives portfolio in the United States. Bank of America’s portfolio has risen significantly every year since the crisis, mostly because of the enormous portfolio that came with the purchase of Merrill Lynch. Last year, however, was the first time that the bank’s portfolio declined significantly. And its portfolio at the end of the year was $39 trillion.

 

http://dealbook.nytimes.com/2014/05/13/derivatives-markets-growing-again-with-few-new-protections/?_php=true&_type=blogs&_r=0

[xazp]

Well Buffett and/or Berkshire have positions in BAC, GS and JPM - three of the big four - so he can't worry about it too much. 

 

One thing about derivatives, look into their accounting.  Here's my brief summary. 

 

If you want to exit a stock position, you sell the stock.  If you want to exit a derivative position of size $X, you enter into an offsetting derivative position of -$X.  With a stock, you would then say your exposure to stocks was $0, but with derivatives you'd say your gross exposure to derivatives is now $2X.  So when you read about a "trillion dollars of derivatives" this is a meaningless number.  To make an analogy to stocks, if you day-traded $100,000 of stocks per day for a month, and ended up completely in cash - derivatives accounting would call this $30,000,000 in exposure. 

 

It's a little more complicated than that: there are rules about when netting is appropriate and when it is not; but that you'll have to look up on your own. 

 

 

I own both BAC & JPM.  At these prices I would made JPM a huge position but their derivative positions scare the hell out of me.  Did you guys see the Buffet quotes about JPM and a discontinuity?  Now I don't mean to be a fear-mongerer, derivative fear was big back in 05 and nothing has happened yet.  However it's a big unknown that gets associated with JPM and perhaps worth in some way trying to weigh in when you compare the two banks.

 

 

Warren Buffett is well known for his famous warning about derivatives as “weapons of mass destruction.” Well, recently he went much further with Forbes Magazine, flatly prognosticating someday (he doesn’t known when) a massive financial “discontinuity,” which the dictionary refers to as an “ending, expiration, halt, lapse, a shutdown, a stoppage,”  that could very well be worse than 2008. What terribly worries him is that he simply doesn’t understand the massive derivatives position on the balance sheet of J.P. Morgan Chase .” Like many other financial experts Buffett can’t really figure out the financial health of JPM’s derivatives. It is impossible for anyone to divine the extent that JPM is profiting or losing money or the risks entailed in the identity of counterparties, the quality of the collateral used, and the amount of leverage employed.

 

“Someday,” he tells Forbes, “it won’t matter how large the level of assets on J.P. Morgan’s balance sheet. There is no risk control system that is effective if the numbers get big enough. I don’t believe the reserves they set up against loss in their derivatives. All that netting stuff doesn’t mean anything. I don’t want to be intertwined with any bank as to significant amounts of receivables. I can’t get that intertwined.” One of  the fears he has is of a major cyber warfare attack on the major Too Big to Fail banks that disrupts the financial markets.

http://www.forbes.com/sites/robertlenzner/2014/04/30/seking-shelter-warren-buffett-limits-receivables-from-major-banks/

 

According to the Office of the Comptroller of the Currency, the four largest derivatives participants in the United States are JPMorgan Chase, Citibank, Bank of America and Goldman Sachs, which together represent more than 30 percent of the total global derivatives market. Since the crisis, JPMorgan’s derivatives portfolio has been declining slowly every year and as of the end of 2013 was about $70 trillion. It is still the largest derivatives portfolio in the United States. Bank of America’s portfolio has risen significantly every year since the crisis, mostly because of the enormous portfolio that came with the purchase of Merrill Lynch. Last year, however, was the first time that the bank’s portfolio declined significantly. And its portfolio at the end of the year was $39 trillion.

 

http://dealbook.nytimes.com/2014/05/13/derivatives-markets-growing-again-with-few-new-protections/?_php=true&_type=blogs&_r=0

[sswan11]

No liability for BofA for allegedly concealing $10 billion AIG case

http://finance.yahoo.com/news/no-liability-bofa-allegedly-concealing-151659045.html

[TwoCitiesCapital]

Well Buffett and/or Berkshire have positions in BAC, GS and JPM - three of the big four - so he can't worry about it too much. 

 

One thing about derivatives, look into their accounting.  Here's my brief summary. 

 

If you want to exit a stock position, you sell the stock.  If you want to exit a derivative position of size $X, you enter into an offsetting derivative position of -$X.  With a stock, you would then say your exposure to stocks was $0, but with derivatives you'd say your gross exposure to derivatives is now $2X.  So when you read about a "trillion dollars of derivatives" this is a meaningless number.  To make an analogy to stocks, if you day-traded $100,000 of stocks per day for a month, and ended up completely in cash - derivatives accounting would call this $30,000,000 in exposure. 

 

It's a little more complicated than that: there are rules about when netting is appropriate and when it is not; but that you'll have to look up on your own. 

 

 

I own both BAC & JPM.  At these prices I would made JPM a huge position but their derivative positions scare the hell out of me.  Did you guys see the Buffet quotes about JPM and a discontinuity?  Now I don't mean to be a fear-mongerer, derivative fear was big back in 05 and nothing has happened yet.  However it's a big unknown that gets associated with JPM and perhaps worth in some way trying to weigh in when you compare the two banks.

 

 

Warren Buffett is well known for his famous warning about derivatives as “weapons of mass destruction.” Well, recently he went much further with Forbes Magazine, flatly prognosticating someday (he doesn’t known when) a massive financial “discontinuity,” which the dictionary refers to as an “ending, expiration, halt, lapse, a shutdown, a stoppage,”  that could very well be worse than 2008. What terribly worries him is that he simply doesn’t understand the massive derivatives position on the balance sheet of J.P. Morgan Chase .” Like many other financial experts Buffett can’t really figure out the financial health of JPM’s derivatives. It is impossible for anyone to divine the extent that JPM is profiting or losing money or the risks entailed in the identity of counterparties, the quality of the collateral used, and the amount of leverage employed.

 

“Someday,” he tells Forbes, “it won’t matter how large the level of assets on J.P. Morgan’s balance sheet. There is no risk control system that is effective if the numbers get big enough. I don’t believe the reserves they set up against loss in their derivatives. All that netting stuff doesn’t mean anything. I don’t want to be intertwined with any bank as to significant amounts of receivables. I can’t get that intertwined.” One of  the fears he has is of a major cyber warfare attack on the major Too Big to Fail banks that disrupts the financial markets.

http://www.forbes.com/sites/robertlenzner/2014/04/30/seking-shelter-warren-buffett-limits-receivables-from-major-banks/

 

According to the Office of the Comptroller of the Currency, the four largest derivatives participants in the United States are JPMorgan Chase, Citibank, Bank of America and Goldman Sachs, which together represent more than 30 percent of the total global derivatives market. Since the crisis, JPMorgan’s derivatives portfolio has been declining slowly every year and as of the end of 2013 was about $70 trillion. It is still the largest derivatives portfolio in the United States. Bank of America’s portfolio has risen significantly every year since the crisis, mostly because of the enormous portfolio that came with the purchase of Merrill Lynch. Last year, however, was the first time that the bank’s portfolio declined significantly. And its portfolio at the end of the year was $39 trillion.

 

http://dealbook.nytimes.com/2014/05/13/derivatives-markets-growing-again-with-few-new-protections/?_php=true&_type=blogs&_r=0

 

Sure, netting is great....until it's 2008 and your counterparty for tens of billions of dollars in offsetting positions is AIG and they don't have the money to pay you the billions that offset losses on positions held at other counterparties.

 

In a crisis, there is a chance for your net exposure to approach your gross exposure as counterparties like Lehman, Bear Stearns, and AIG fail. The total gross number is a better indicator of systemic risk.

[xazp]

This is a popular narrative which fortunately has little grounding in reality.  Your examples are exactly right.  So these are all trillion dollar+ gross derivative exposure companies, right?

 

Lehman did go bankrupt.  Did the other investment banks cumulatively take a trillion dollars of losses?  (No). 

Bear Sterns WAS taken over by JPM prior to bankruptcy.  Did JPM then take a trillion dollar of losses?  (No).

Merrill WAS taken over by BAC prior to bankruptcy.  Did BAC then take a trillion dollar of losses?  (No).

AIG WAS bailed out by the US government.  AIG it should be noted is not a bank, and, the real problem was they did not hedge their book.  They issued CDS without hedging the other side.  Even here, the government bailout was $185Bn, and the government exited with a $25Bn gain. 

 

Today, Bear, Merrill and AIG are all profitable. 

 

In the last few years we've had an actual financial crisis, actual financial institution bankruptcies, wild swings in interest rates, commodity prices, stock prices - everything.  You actually have NOT seen any of these guys take large losses on their derivatives through any of this.  Certainly not on the scale of a trillion dollars or the $100 trillion in gross exposure that you claim is the real risk. 

 

Actually the problems are much simpler and not related to derivatives. 

 

For investment banks: problem is they rely on short-term funding, which dried up.  This is why good old fashioned banks with deposit funding bought them up.  Short-term funding is clearly a problem (not only for financial companies) and that's why there are now liquidity rules which require banks to be able to operate without any external funding for an extended period of time.  (For BAC this is nearly 3 years). 

For banks: the problem was really crappy loans!  Countrywide has been the real headache here.  BAC would be worth at least $50Bn more if they never acquired Countrywide.

For AIG: the problem is, they were not sufficiently regulated and allowed to take un-netted, un-hedged derivatives positions. 

 

Back to netting rules: for banks, the netting rules are clear, and you only get to net when you are A) netting against the same counter-party; with B) an agreement to net out the exposure.  To the extent they were trading with AIG which was not hedging, that amount would *not* have been netted out - you only net when you've got opposing positions with the same counter party. 

 

Anyway, I think your examples show that netting works, the losses on derivatives have been much closer to net exposure than gross exposure.

 

Sure, netting is great....until it's 2008 and your counterparty for tens of billions of dollars in offsetting positions is AIG and they don't have the money to pay you the billions that offset losses on positions held at other counterparties.

 

In a crisis, there is a chance for your net exposure to approach your gross exposure as counterparties like Lehman, Bear Stearns, and AIG fail. The total gross number is a better indicator of systemic risk.

[MYDemaray]

Short-term funding is clearly a problem (not only for financial companies)

 

As an aside, was watching "Hank: 5 Years from the brink" this weekend. Was interesting to hear him talk about the breaking of the buck and the fear they had over money market redemptions and what that would mean for all of corporate America. I don't think I fully appreciated how that could ripple through the commercial paper market at the time...

[Liberty]

Thanks xazp, very interesting explanation on derivatives.

[TwoCitiesCapital]

This is a popular narrative which fortunately has little grounding in reality.  Your examples are exactly right.  So these are all trillion dollar+ gross derivative exposure companies, right?

 

Lehman did go bankrupt.  Did the other investment banks cumulatively take a trillion dollars of losses?  (No). 

Bear Sterns WAS taken over by JPM prior to bankruptcy.  Did JPM then take a trillion dollar of losses?  (No).

Merrill WAS taken over by BAC prior to bankruptcy.  Did BAC then take a trillion dollar of losses?  (No).

AIG WAS bailed out by the US government.  AIG it should be noted is not a bank, and, the real problem was they did not hedge their book.  They issued CDS without hedging the other side.  Even here, the government bailout was $185Bn, and the government exited with a $25Bn gain. 

 

Today, Bear, Merrill and AIG are all profitable. 

 

In the last few years we've had an actual financial crisis, actual financial institution bankruptcies, wild swings in interest rates, commodity prices, stock prices - everything.  You actually have NOT seen any of these guys take large losses on their derivatives through any of this.  Certainly not on the scale of a trillion dollars or the $100 trillion in gross exposure that you claim is the real risk. 

 

Actually the problems are much simpler and not related to derivatives. 

 

For investment banks: problem is they rely on short-term funding, which dried up.  This is why good old fashioned banks with deposit funding bought them up.  Short-term funding is clearly a problem (not only for financial companies) and that's why there are now liquidity rules which require banks to be able to operate without any external funding for an extended period of time.  (For BAC this is nearly 3 years). 

For banks: the problem was really crappy loans!  Countrywide has been the real headache here.  BAC would be worth at least $50Bn more if they never acquired Countrywide.

For AIG: the problem is, they were not sufficiently regulated and allowed to take un-netted, un-hedged derivatives positions. 

 

Back to netting rules: for banks, the netting rules are clear, and you only get to net when you are A) netting against the same counter-party; with B) an agreement to net out the exposure.  To the extent they were trading with AIG which was not hedging, that amount would *not* have been netted out - you only net when you've got opposing positions with the same counter party. 

 

Anyway, I think your examples show that netting works, the losses on derivatives have been much closer to net exposure than gross exposure.

 

Sure, netting is great....until it's 2008 and your counterparty for tens of billions of dollars in offsetting positions is AIG and they don't have the money to pay you the billions that offset losses on positions held at other counterparties.

 

In a crisis, there is a chance for your net exposure to approach your gross exposure as counterparties like Lehman, Bear Stearns, and AIG fail. The total gross number is a better indicator of systemic risk.

 

I'm not talking about "bank netting" and the rules surrounding it for collateral purposes. I'm talking about this idea that having hundreds of trillions of dollars in notional exposure to derivatives is ok because they offset in aggregate.

 

When AIG failed, the government made good on its counterparty claims. Goldman got $6B alone. That would've been a pretty big hit for them and other banks would've suffered as well had there been no backstop.

 

JPM bought Bear for firesale prices and only with a government back stop on the losses.

 

B of A required 45B in government bailouts for the losses it sustained and to fund the whole from consolidated losses from ML.

 

Even beyond all of the explicit benefits of bank bail outs and low rates, there were hundreds of billions of dollars in guarantees covering potential losses.

 

I'm sorry that I'm not inspired or comforted by a system that requires both the willingness and solvency of the central government to put up hundreds of billions, if not trillions, of dollars to ensure it continues to operate after just a 50% loss in housing prices. Many of these derivatives are written in assets a lot more volatile then housing, mortgages, etc. The system looks a lot more precarious when you remove bailouts. It wouldn't be so bad if the risk was spread across dozens of institutions and not just on the dozen that are the largest.

 

Also, as the derivative liability grows larger, even central government ability to handle it becomes limited.

 

 

[xazp]

Aren't you making my point again?  You talk about the real risk being hundreds of trillions of dollars in gross derivatives.  I said, no, the risk is related to the netted number, and the "hundreds of trillions of dollars" of exposure is just alarmism. 

 

You point out GS got $6Bn from AIG.  This is not within a few orders of magnitude of either GS or AIG's gross derivatives book.  But it is similar to their net derivatives book. 

 

BAC needed (and still needs) money for *countrywide*.  BAC's problem was not derivatives, it was for acquiring countrywide, which in turn made a series of extremely stupid loans.

 

JPM bought bear, correct?  And bear had a trillion dollars of gross derivatives.  What were JPM's losses on derivatives?  Something close to their gross exposure or something close to their net exposure?  I'm not even aware of JPM's losses on derivatives, if you find them, let me know - but I'm pretty sure I would have noticed if they lost or made a trillion dollars.

 

I will repeat the problems in order are A) reliance on short-term lending; B) really stupid lending; C) unhedged derivatives book, which AIG got away with but banks didn't (different regulators - Buffett also gets away with unhedged derivatives). 

 

The result of this, which was good, was:  A) rules requiring that banks carry higher liquidity and be able to fund themselves without access to short-term markets for a long period of time; B) higher capital rules which place higher risk weights on sub-prime and no-doc loans;  C)  even tighter regulation on derivatives. 

 

 

Again, I think you are confusing the popular narrative with reality.  Where are the trillions of dollars of losses that represent the gross derivatives market??  I mean, I make or lose 1% on my stocks each day: how come in a $100 trillion market, no one has lost even 1% of their gross derivatives exposure?  It's because they're hedged and netted and/or trading on behalf of customers. 

 

 

I'm not talking about "bank netting" and the rules surrounding it for collateral purposes. I'm talking about this idea that having hundreds of trillions of dollars in notional exposure to derivatives is ok because they offset in aggregate.

 

When AIG failed, the government made good on its counterparty claims. Goldman got $6B alone. That would've been a pretty big hit for them and other banks would've suffered as well had there been no backstop.

 

JPM bought Bear for firesale prices and only with a government back stop on the losses.

 

B of A required 45B in government bailouts for the losses it sustained and to fund the whole from consolidated losses from ML.

 

Even beyond all of the explicit benefits of bank bail outs and low rates, there were hundreds of billions of dollars in guarantees covering potential losses.

 

I'm sorry that I'm not inspired or comforted by a system that requires both the willingness and solvency of the central government to put up hundreds of billions, if not trillions, of dollars to ensure it continues to operate after just a 50% loss in housing prices. Many of these derivatives are written in assets a lot more volatile then housing, mortgages, etc. The system looks a lot more precarious when you remove bailouts. It wouldn't be so bad if the risk was spread across dozens of institutions and not just on the dozen that are the largest.

 

Also, as the derivative liability grows larger, even central government ability to handle it becomes limited.

[onyx1]

Again, I think you are confusing the popular narrative with reality.  Where are the trillions of dollars of losses that represent the gross derivatives market??  I mean, I make or lose 1% on my stocks each day: how come in a $100 trillion market, no one has lost even 1% of their gross derivatives exposure?  It's because they're hedged and netted and/or trading on behalf of customers. 

 

 

Yes, hedged, netted, and finally marked-to-market on a daily basis with an agreement to exchange cash to limit counterparty exposure.  This is rarely explained or understood by the "OMG $100s of Trillions!" crowd.

[Uccmal]

The bulk of the derivatives written are interest rate swaps. 

 

The client, Seaspan, as a real life example, needs to smooth out its floating rate debt, or protect itself from a sudden rise in interest rates pays JPM or BAC to insure their interest rates to a collared level. 

 

Virtually every large company uses some version of these instruments. 

 

it is not as if JPM, and BAC have sold trillions in unprotected Credit Default Swaps.

 

As XAzp alludes, we saw the worst and it was 2008/09. 

 

Zackmansell, you can choose to avoid investing in instruments that use these derivatives but that is going to leave you with a handful of small caps to invest in. 

[TwoCitiesCapital]

Aren't you making my point again?  You talk about the real risk being hundreds of trillions of dollars in gross derivatives.  I said, no, the risk is related to the netted number, and the "hundreds of trillions of dollars" of exposure is just alarmism. 

 

You point out GS got $6Bn from AIG.  This is not within a few orders of magnitude of either GS or AIG's gross derivatives book.  But it is similar to their net derivatives book. 

 

BAC needed (and still needs) money for *countrywide*.  BAC's problem was not derivatives, it was for acquiring countrywide, which in turn made a series of extremely stupid loans.

 

JPM bought bear, correct?  And bear had a trillion dollars of gross derivatives.  What were JPM's losses on derivatives?  Something close to their gross exposure or something close to their net exposure?  I'm not even aware of JPM's losses on derivatives, if you find them, let me know - but I'm pretty sure I would have noticed if they lost or made a trillion dollars.

 

I will repeat the problems in order are A) reliance on short-term lending; B) really stupid lending; C) unhedged derivatives book, which AIG got away with but banks didn't (different regulators - Buffett also gets away with unhedged derivatives). 

 

The result of this, which was good, was:  A) rules requiring that banks carry higher liquidity and be able to fund themselves without access to short-term markets for a long period of time; B) higher capital rules which place higher risk weights on sub-prime and no-doc loans;  C)  even tighter regulation on derivatives. 

 

 

Again, I think you are confusing the popular narrative with reality.  Where are the trillions of dollars of losses that represent the gross derivatives market??  I mean, I make or lose 1% on my stocks each day: how come in a $100 trillion market, no one has lost even 1% of their gross derivatives exposure?  It's because they're hedged and netted and/or trading on behalf of customers. 

 

 

I'm not talking about "bank netting" and the rules surrounding it for collateral purposes. I'm talking about this idea that having hundreds of trillions of dollars in notional exposure to derivatives is ok because they offset in aggregate.

 

When AIG failed, the government made good on its counterparty claims. Goldman got $6B alone. That would've been a pretty big hit for them and other banks would've suffered as well had there been no backstop.

 

JPM bought Bear for firesale prices and only with a government back stop on the losses.

 

B of A required 45B in government bailouts for the losses it sustained and to fund the whole from consolidated losses from ML.

 

Even beyond all of the explicit benefits of bank bail outs and low rates, there were hundreds of billions of dollars in guarantees covering potential losses.

 

I'm sorry that I'm not inspired or comforted by a system that requires both the willingness and solvency of the central government to put up hundreds of billions, if not trillions, of dollars to ensure it continues to operate after just a 50% loss in housing prices. Many of these derivatives are written in assets a lot more volatile then housing, mortgages, etc. The system looks a lot more precarious when you remove bailouts. It wouldn't be so bad if the risk was spread across dozens of institutions and not just on the dozen that are the largest.

 

Also, as the derivative liability grows larger, even central government ability to handle it becomes limited.

 

I don't think i am making your point. The whole argument I just made was to say the reason that losses experienced were comparable to net exposure ONLY because of extraordinary government intervention to the tune of hundreds of billions of dollars.

 

JPM only bought Bear with backstop guarantess by the gov and paying pennies on the dollar. Had they not been provided guarantees Bear would've failed. Same with Merril Lynch and BofA.

 

You're really telling me that in a world where three major derivative counterparties fail that banks would've still been net hedged and not experienced extraordinary losses from positions that are no longer offset on the tens of billions in derivative exposure to those companies?

 

Also, the last crisis was largely due to mortgage CDX exposure that makes up a much smaller portion of the market then, say, interest rate swaps which are 70% of it. We're talking tens of billions in losses from a single company (AIG) concentrated in a handful of banks on a minority of the derivatives held. I think that's pretty significant and speaks more to the gross figure of mortgage CDX that were held between them then you are willing to admit.

 

I agree that derivatives aren't the problem. That doesn't mean we can dismiss them because they magnify the problem as witnessed in 2008.

 

I also agree MTM accounting and variation margin that occurs today (and not back then) helps.

 

My concern is if shit really hits the fan with interest rate derivatives. This is not a linear game. Each failing counterparty affects in a exponential fashion. If we experience an event where interest rate shock causes Morgan Stanley (for instance) to fail, this would be a much bigger deal and have much larger implications than the mortgage crisis and Lehman. And since notional amounts are much larger, I'm concerned that government wouldnt even have the resources to backstop losses to force firesales to shore up the system and prevent the next shoe dropping and making it that much worse.

 

Bottom line, derivatives are generally used for leveraged exposure. Does 600-700 trillion in leveraged exposure ever sound like a good idea even if it is hedged and offset by a handful of banks?

[Kraven]

Xazp, Onyx, etc are correct.  The "headline" number is way overblown.  Referring to the derivatives market by reference to the aggregate notional amount is flawed and intended to create a sense of panic.  As an example, an interest rate swap may reference a $500 mil notional amount, yet the amounts changing hands is bp.  It would be referred to however as a $500 mil derivative.  As far as I'm concerned it's all under control.  For if the dominoes were to fall in some crazy and unexpected way it wouldn't matter that you owned WFC instead of BAC or JPM instead of GS, we'd all be fighting over guns and canned goods. 

[blainehodder]

The following has some decent charts on bank purchases of treasuries offsetting QE.

 

http://www.bankregdata.com/lab/comm_052114.pdf

 

Ugly symptom of loan demand.  This should demonstrate how compressed NIMs are.  Ballooning deposits, but nothing better to do than buy 10 yr treasuries up to a sub 2.7% yield.  Pretty sad.

 

On the bright side, BAC is probably sitting on a pretty decent mark to market gain.  Lets hope they unwind this before Citi!

 

"Bank of America, the only U.S. bank among the five biggest to publicly release a breakdown of their available-for-sale assets in a supplement to their first-quarter earnings, tripled government debt to $29.6 billion in the first three months of the year from $8.95 billion at the end of 2013, the data show. "

 

http://www.bloomberg.com/news/2014-04-27/treasuries-irresistible-to-america-s-banks-awash-in-record-cash.html

[writser]

Xazp, Onyx, etc are correct.  The "headline" number is way overblown.  Referring to the derivatives market by reference to the aggregate notional amount is flawed and intended to create a sense of panic.  As an example, an interest rate swap may reference a $500 mil notional amount, yet the amounts changing hands is bp.  It would be referred to however as a $500 mil derivative.  As far as I'm concerned it's all under control.  For if the dominoes were to fall in some crazy and unexpected way it wouldn't matter that you owned WFC instead of BAC or JPM instead of GS, we'd all be fighting over guns and canned goods.

 

Yeah, especially the notional value of outstanding interest rate swaps is a nonsensical number. Also, governments worldwide are pushing OTC derivative trading towards Swap Execution Facilities in order to monitor and reduce the counterparty problem. Nevertheless every crisis this problem will pop up in the news again (justified or not) because nobody outside has a clue about what is going on. Occasionally some people will lose some money but I'm more scared of all the lawsuits.

[Liberty]

http://www.bloomberg.com/news/2014-05-21/bofa-said-to-end-market-making-unit-amid-trading-scrutiny.html

[rkbabang]

"Overall, according to an analysis prepared by a mortgage bond portfolio manager for Fortune, the group of bonds that BofA bought in the settlement from Fannie and Freddie are now worth $3,338,229,282.41, give or take. BofA has made $138 million on the bonds in nearly two months."

 

Bank of America is making money on its financial crisis settlement

[nikhil25]

Bank of America resubmits capital plan

http://www.marketwatch.com/story/bank-of-america-resubmits-capital-plan-2014-05-27-8103358?reflink=MW_news_stmp

[ourkid8]

It is a shame Berkshire's preferred stake will not be counted towards regulatory capital as it was approved in May.  My guess is that the dividend will be raised to $0.20/share and the repurchase program will be $2-3B.

 

Tks,

S

 

http://www.sec.gov/Archives/edgar/data/70858/000007085814000062/bac0527148kccarre-submissi.htm

 

On May 27, 2014, Bank of America Corporation (the “Corporation”) resubmitted its requested capital actions and certain 2014 Comprehensive Capital Analysis and Review (“CCAR”) schedules to the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The Corporation previously announced on April 28, 2014 that it would be resubmitting these 2014 CCAR items following discovery of an adjustment to regulatory capital. A third party was engaged to perform certain procedures related to the Corporation’s 2014 CCAR resubmission processes and controls regarding reporting and calculation of regulatory capital ratios, and focused on the periods ended September 30, 2013 and March 31, 2014. The third party review has been completed and resulted in additional adjustments that had a de minimis effect (less than one basis point reduction) on the Corporation’s reported regulatory capital ratios for the period ended September 30, 2013, and no effect on such ratios for the period ended March 31, 2014. As the Corporation announced on April 28, 2014, the requested capital actions contained in the resubmission are less than the 2014 capital actions to which the Federal Reserve previously did not object. Pursuant to CCAR capital plan rules, the Federal Reserve has up to 75 days to review the Corporation’s resubmitted 2014 CCAR items, including the requested capital actions.

 

 

There can be no assurance as to the timing or outcome of the Federal Reserve’s review of the resubmitted 2014 CCAR items, including the requested capital actions contained therein.

 

 

[xazp]

I think $4Bn mistake = $4Bn reduction in repurchase request from $5Bn to $1Bn.  Dividend to .20.  So about a $3Bn capital return.  [i'd prefer if they kept the div at .04 personally]. 

 

Even though the number is disappointing this still represents about a 2% shareholder return on market cap.  It's not far from the S&P average and it should be able to grow substantially over the years. 

 

 

It is a shame Berkshire's preferred stake will not be counted towards regulatory capital as it was approved in May.  My guess is that the dividend will be raised to $0.20/share and the repurchase program will be $2-3B.

 

Tks,

S

 

http://www.sec.gov/Archives/edgar/data/70858/000007085814000062/bac0527148kccarre-submissi.htm

 

On May 27, 2014, Bank of America Corporation (the “Corporation”) resubmitted its requested capital actions and certain 2014 Comprehensive Capital Analysis and Review (“CCAR”) schedules to the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The Corporation previously announced on April 28, 2014 that it would be resubmitting these 2014 CCAR items following discovery of an adjustment to regulatory capital. A third party was engaged to perform certain procedures related to the Corporation’s 2014 CCAR resubmission processes and controls regarding reporting and calculation of regulatory capital ratios, and focused on the periods ended September 30, 2013 and March 31, 2014. The third party review has been completed and resulted in additional adjustments that had a de minimis effect (less than one basis point reduction) on the Corporation’s reported regulatory capital ratios for the period ended September 30, 2013, and no effect on such ratios for the period ended March 31, 2014. As the Corporation announced on April 28, 2014, the requested capital actions contained in the resubmission are less than the 2014 capital actions to which the Federal Reserve previously did not object. Pursuant to CCAR capital plan rules, the Federal Reserve has up to 75 days to review the Corporation’s resubmitted 2014 CCAR items, including the requested capital actions.

 

 

There can be no assurance as to the timing or outcome of the Federal Reserve’s review of the resubmitted 2014 CCAR items, including the requested capital actions contained therein.

[Uccmal]

Well, that was quick.  It hadn't occurred to me that they might tell us what the results of their tests were.  Very good news.

 

Ourkid, They are using period end to count the numbers but part of the negotiations are on intangibles.  For the time being the change in the BRK stake status is a positive intangible.  This should at least firm up whatever their request is.  I agree with yours and XAzps assessment on the dividend/buyback amount. 

 

So, any excess cash goes into potential energy for the next review. 

[maxthetrade]

Allan Mecham on BAC:

 

http://www.beyondproxy.com/bank-america-bac-2/

 

[xazp]

It's a little weird that his second paragraph starts with capital returns that happened last year, in light of the currently-rejected capital plan for 2014. 

 

 

Allan Mecham on BAC:

 

http://www.beyondproxy.com/bank-america-bac-2/