I have posted this warning of Bank of America's naked swap writing to my subscribers a few weeks ago. Since BAC is reporting this week, I have decided to make my suspicions public.
As many of my subscribers and readers know, I have caught many companies on the short side as they imploded. One company that I did not get was American International Group. The reason it escaped me? I was too close to it. I have met Frank Tizzio (then president), Maurice Greenberg (then CEO and Chairman), and a several of their upper management to collaborate on deals, and was impressed with the way they ran their shop. Because of this, I didn't apply the same critical, skeptical eye that I used with the other prospects. Alas, because of such, I overlooked the inevitable, and in retrospect, the blatantly obvious. Well, I have learned my lesson. The lesson learned from AIG was not wasted on me, but does seem to have been wasted on many others. With this thought in mind, let's review the net, unhedged swap exposure of a few of our analysis subjects. I think a few of my readers may have their eyebrows raised. Some things are actually hiding in plain sight. I have made this short description of what I see as Bank of America, the naked swap dealer, available for free download, but you must register (I made the process very quick) to get it. I know it is a pain in the ass, but I want to be sure that the disclaimer is acknowledged by all who access the document. Thank our litigious society. See BAC Swap exposure_011009 I need for all to know that, in my opinion, bank reporting is quite opaque, so it is not very easy to get granular information out of it. The conclusions drawn from this post and the accompanying downloads are derived from BAC's publicly available documents and are the result of me and my team's best efforts to piece the information together. For those who do not know of me, you can reference the "who am I"section below to see how well this process has worked in the past.
For the sake of nostalgia, here is an old post of Bank of America's estimated ABS inventory: ABS Inventory
I will be releasing similar analysis of other banks and insurers to subscribers over the next day or two, and then to the public a day or two before their respective earnings announcement.
Chronology of September 2008 liquidity crisis
On September 16, 2008, AIG suffered a liquidity crisis following the downgrade of its credit rating. Industry practice permits firms with the highest credit ratings to enter swaps without depositing collateral with its trading counter-parties. When its credit rating was downgraded, the company was required to post additional collateral with its trading counter-parties, and this led to an AIG liquidity crisis. [Here's a quick glance at Bank of America's current rating as compared to AIG's, both before and after their "incident". Be aware that this is not my proprietary rating (which would be substantially lower), but that of the oh so accurate major rating agencies. I doubt if they have taken this naked and unhedged exposure into consideration!]
Click graphics to enlarge
AIG's London unit sold credit protection in the form of credit default swaps (CDSs) on collateralized debt obligations (CDOs) that had by that time declined in value. [The lower quality assets are the most likely to decrease in value dramatically. One should keep this in mind, for BAC has written $116 billion on non-investment grade (junk) credit derivatives and $3 billion in junk total return swaps. They have hedged, but not completely. My calculations and estimates have BAC with a carrying value of unhedged exposure of around $32 billion and a notional unhdeged expousre of $348 billion]. The United States Federal Reserve Bank announced the creation of a secured credit facility of up to US$85 billion, to prevent the company's collapse by enabling AIG to meet its obligations to deliver additional collateral to its credit default swap trading partners. [Keep in mind that BAC just gave up its government guarantee on the JUNKY assets acquired with the Merrill Lynch acquisition. Merrill Lynch was one of the, if not the LARGEST writer of CDS on Wall Street! BAC also bought Countrywide, arguably the most wretched pool of subprime and underperforming mortgage assets in this country.] The credit facility provided a structure to loan as much as US$85 billion, secured by the stock in AIG-owned subsidiaries, in exchange for warrants for a 79.9% equity stake, and the right to suspend dividends to previously issued common and preferred stock. AIG announced the same day that its board accepted the terms of the Federal Reserve Bank's rescue package and secured credit facility. This was the largest government bailout of a private company in U.S. history, though smaller than the bailout of Fannie Mae and Freddie Mac a week earlier. [Well, we shall see, since Bank of America is currently the largest bank in America. We still have time to set a new record.]
AIG's share prices had fallen over 95% to just $1.25 by September 16, 2008, from a 52-week high of $70.13. The company reported over $13.2 billion in losses in the first six months of the year. [Well, green shoots is a sproutin'! AIG is currently trading at $44.33. I am at a loss as to how anyone can justify such, but hey, people are still buying Bank of America stock as well...] The AIG Financial Products division headed by Joseph Cassano, in London, had entered into credit default swaps to insure $441 billion worth of securities originally rated AAA. [Hmmm!!! BAC has written protection $2.6 trillion notional, with $348 billion unhedged (at least according to my calculations). For those "not to use notional nitwits", that translates to $198 billion carrying value with $32 billion apparently unhedged or written naked - just like AIG, with one big exception. It appears as if BAC has one the machismo contest of "mine is bigger than yours" with AIG - congrats fellas!] Of those securities, $57.8 billion were structured debt securities backed by subprime loans.CNN named Cassano as one of the "Ten Most Wanted: Culprits" of the 2008 financial collapse in the United States.[Well, Ken Lewis, the BAC CEO, is not to popular around these parts either. I am sure the upcoming Cuomo/congress investigations will be juiced when they find out that BAC is doing the AIG thing, just on a much larger scale!!! Just remember who you heard it from first!]
As Lehman Brothers (the largest bankruptcy in U.S. history at that time) [Hey, I warned you guys about Lehman and Bear WAY in advance, just as I am doign ow with Bank of America - "Is Lehman really a lemming in disguise?" (Thursday, 21 February 2008) - Is this the Breaking of the Bear? January 2008 - Lehman rumors may be more founded than some may have us believe Tuesday, 01 April 2008 (be sure to read through the comments, its like deja vu, all over again!) - Lehman stock, rumors and anti-rumors that support the rumors Friday, 28 March 2008 - Funny CLO business at Lehman Friday, 04 April 2008] suffered a catastrophic decline in share price, investors began comparing the types of securities held by AIG and Lehman, and found that AIG had valued its Alt-A and sub-prime mortgage-backed securities at 1.7 to 2 times the values used by Lehman which weakened investors' confidence in AIG. [If BAC is not careful, the market may have similar misgivings on how BAC values its credit card recievables and mortgages held in off balance sheet trusts. See our my findings on what may lay off balance sheet - If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It?: Pt 3 - BAC (the bank] On September 14, 2008, AIG announced it was considering selling its aircraft leasing division, International Lease Finance Corporation, to raise cash. The Federal Reserve hired Morgan Stanley to determine if there are systemic risks to a financial failure of AIG, and asked private entities to supply short-term bridge loans to the company. In the meantime, New York regulators allowed AIG to borrow $20 billion from its subsidiaries. [Why ask Morgan Stanley? In 2008, they were "The Riskiest Bank on the Street". I guess it takes one to know one! I ask my readers, is one of the biggest banks in the country that then swallows the biggest brokerage and at the time the sickest brokerage in the country right after swallowing the biggest and sickest mortage lender in the country a systemic risk if it fails? I bet a lot of you guys and gals can answer that question for a whole lot more than the government paid Morgan Stanley. I wonder, why don't these guys ask me my opinion? NY bloggers don't get enough respect :-)]
At the stock market's opening on September 16, 2008, AIG's stock dropped 60 percent. The Federal Reserve continued to meet that day with major Wall Street investment firms, hoping to broker a deal for a non-governmental $75 billion line of credit to the company. Rating agencies Moody's and Standard and Poor downgraded AIG's credit ratings on concerns over likley continuing losses on mortgage-backed securities. [Now, this is just simply hilarious. With friends like the credit rating agencies, who needs enemies? Think about the fire alarm that starts to go off just when the smoldering embers of what use to be your house begin to cool... How much money has AIG paid the credit ratign agencies over the last 10 years or so?] The credit rating downgrade forced the company to deliver collateral of over $10 billion to certain creditors and CDS counter-parties. [Well, we shall see what will happen with that "other" bank] The New York Times later reported that talks on Wall Street had broken down and AIG may file for bankruptcy protection on Wednesday, September 17. Just before the bailout by the US Federal Reserve, AIG former CEO Maurice (Hank) Greenberg sent an impassioned letter to AIG CEO Robert B. Willumstad offering his assistance in any way possible, ccing the Board of Directors. His offer was rebuffed. [And why wasn't this man's assistance accepted???]
Federal Reserve bailout
On the evening of September 16, 2008, the Federal Reserve Bank's Board of Governors announced that the Federal Reserve Bank of New York had been authorized to create a 24-month credit-liquidity facility from which AIG could draw up to $85 billion. The loan was collateralized by the assets of AIG, including its non-regulated subsidiaries and the stock of "substantially all" of its regulated subsidiaries, and with an interest rate of 850 basis points over the three-month London Interbank Offered Rate (LIBOR) (i.e., LIBOR plus 8.5%). In exchange for the credit facility, the U.S. government received warrants for a 79.9 percent equity stake in AIG, with the right to suspend the payment of dividends to AIG common and preferred shareholders. The credit facility was created under the auspices of Section 13(3) of the Federal Reserve Act. AIG's board of directors announced approval of the loan transaction in a press release the same day. The announcement did not comment on the issuance of a warrant for 79.9% of AIG's equity, but the AIG 8-K filing of September 18, 2008, reporting the transaction to the Securities and Exchange Commission stated that a warrant for 79.9% of AIG shares had been issued to the Board of Governors of the Federal Reserve. AIG drew down US$ 28 billion of the credit-liquidity facility on September 17, 2008. On September 22, 2008, AIG was removed from the Dow Jones Industrial Average. An additional $37.8 billion credit facility was established in October. As of October 24, AIG had drawn a total of $90.3 billion from the emergency loan, of a total $122.8 billion.
Maurice Greenberg, former CEO of AIG, on September 17, 2008, characterized the bailout as a nationalization of AIG. He also stated that he was bewildered by the situation and was at a loss over how the entire situation got out of control as it did. On September 17, 2008, Federal Reserve Bank chair Ben Bernanke asked Treasury Secretary Henry Paulson join him, to call on members of Congress, to describe the need for a congressionally authorized bailout of the nation's banking system. Weeks later, Congress approved the Emergency Economic Stabilization Act of 2008. Bernanke said to Paulson on September 17:
[Oh, this soap opera gets worse. Bank of America's bailouts have totaled $168 billionos so thus far, and we haven't even addressed the naked swap writing issue as of yet. Then again, BAC did buyout the Merrill Lynch loss guarantee from the government after much wrangling. I don't think this was the wisest idea, for they very well may still need it. Again excerpted from Wikipedia]:
Bank of America received US $20 billion in federal bailout from the US government through the Troubled Asset Relief Program (TARP) on 16 January 2009 and also got guarantee of US $118 billion in potential losses at the company. This was in addition to the $25 billion given to them in the Fall of 2008 through TARP. The additional payment was part of a deal with the US government to preserve Bank of America's merger with the troubled investment firm Merrill Lynch. Since then, members of the US Congress have expressed considerable concern about how this money has been spent, especially since some of the recipients have been accused of mis-using the bailout money. The Bank's CEO, Ken Lewis, was quoted as claiming "We are still lending, and we are lending far more because of the TARP program." Members of the US House of Representatives, however, were skeptical and quoted many anecdotes about loan applicants (particularly small business owners) being denied loans and credit card holders facing stiffer terms on the debt in their card accounts.
According to a March 15, 2009 article in The New York Times, Bank of America received an additional $5.2 billion in government bailout money which was channeled through American International Group.
As a result of its federal bailout and management problems, The Wall Street Journal reported that the Bank of America is operating under a secret “memorandum of understanding” (MOU) from the US government that requires it to ”overhaul its board and address perceived problems with risk and liquidity management.” With the federal action, the institution has taken several steps, including arranging for six of its directors to resign and forming a Regulatory Impact Office. Bank of America faces several deadlines in July and August and if not met, could face harsher penalties by federal regulators. Bank of America did not respond to The Wall Street Journal story.
This is exactly what I am talking about when I say these institutions CANNOT hedge their large risks. The number 2 derivative holder in the country (Bank of America) and the number 3 derivative holder in the country (Goldman Sachs) had to be bailed out by the government through AIG (another large derivative holder) when AIG had just $10 billion dollars in collateral calls that it could not pay. AIG was the largest insurer in the world!!! The number 1 derivative holder int eh country (JP Morgan) needed $90 billion or so in bailout monies when its major counterparty failed - Bear Stearns. See Is this the Breaking of the Bear? January 2008 for how easy that was to see coming at least 3 momths in advance! That circle of concentrated risk is even smaller now then it was back then. Now 5 institutions hold 97% of the notional vale and 88% of the market value in derivatives, and they are all basically in the same business and all basically hedge with each other. It is not a true hedge when the other side can't pay, and history has clearly proven how easy it is for the other side not to be able to pay. See a sampling of my many posts on this topic:
Additional Bailouts of 2008
On October 9, 2008, the company borrowed an additional $37.8 billion via a second secured asset credit facility created by the Federal Reserve Bank of New York (FRBNY). From mid September till early November, AIG's credit-default spreads were steadily rising, implying the company was heading for default. On November 10, 2008, the U.S. Treasury announced it would purchase $40 billion in newly issued AIG senior preferred stock, under the authority of the Emergency Economic Stabilization Act's Troubled Asset Relief Program. The FRBNY announced that it would modify the September 16th secured credit facility; the Treasury investment would permit a reduction in its size from $85 billion to $60 billion, and that the FRBNY would extend the life of the facility from three to five years, and change the interest rate from 8.5% plus the three-month London interbank offered rate (LIBOR) for the total credit facility, to 3% plus LIBOR for funds drawn down, and 0.75% plus LIBOR for funds not drawn, and that AIG would create two off- balance-sheet Limited Liability Companies (LLC) to hold AIG assets: one will act as an AIG Residential Mortgage-Backed Securities Facility and the second to act as an AIG Collateralized Debt Obligations Facility. Federal officials said the $40 billion investment would ultimately permit the government to reduce the total exposure to AIG to $112 billion from $152 billion. On December 15, 2008, the Thomas More Law Center filed suit to challenge the Emergency Economic Stabilization Act of 2008, alleging that it unconstitutionally promotes Islamic law (Sharia) and religion. The lawsuit was filed because AIG provides Takaful Insurance Plans, which, according to the company, avoid investments and transactions that are"un-Islamic".
AIG was required to post additional collateral with many creditors and counter-parties, touching off controversy when over $100 billion was paid out to major global financial institutions that had previously received TARP money. While this money was legally owed to the banks by AIG (under agreements made via credit default swaps purchased from AIG by the institutions), a number of Congressmen and media members expressed outrage that taxpayer money was going to these banks through AIG.
Had AIG been allowed to fail in a controlled manner through bankruptcy, bondholders and derivative counterparties (major banks) would have suffered significant losses, limiting the amount of taxpayer funds directly used. Fed Chairman Ben Bernanke argued: "If a federal agency had [appropriate authority] on September 16 , they could have been used to put AIG into conservatorship or receivership, unwind it slowly, protect policyholders, and impose haircuts on creditors and counterparties as appropriate. That outcome would have been far preferable to the situation we find ourselves in now." The "situation" to which he is referring is that the claims of bondholders and counterparties were paid at 100 cents on the dollar by taxpayers, without giving taxpayers the rights to the future profits of these institutions. In other words, the benefits went to the banks while the taxpayers suffered the costs.
Well, Bank of America may very well give Ben Bernanke and the American taxpayer an opportunity to find out if we have learned our collective lessons. With the S&P pushing 1100 while practically all of the problems from the period illustrated above remain extant, and if anything exacerbated (ex. counterparty and concentration risk, credit risk and asset quality concerns, and above all, government sanctioned opacity in reporting), I doubt so very seriously.
Who is this guy, Reggie Middleton?
When I have sounded the alarm in the past, it made sense to take notice. Look at who has failed over the last two years, and what I have said publicly, months before each failure.
i. Is this the Breaking of the Bear?: On Sunday, 27 January 2008 I made it very clear that Bear Stearns was in a fight for its life and was in explicit risk of failure. Most sell side firms had a buy on this stock at $185, and it had an investment grade rating from all of the big ratings agencies. We all know what happened two months later.
ii. "Is Lehman really a lemming in disguise?": On February 20th, 2008, I made the proclamation that Lehman was hiding significant losses on its balance sheet. We all know what happened 7 months later. It had an investment grade rating from all of the big ratings agencies.
iii. At the inception of this blog, I warned about nearly all of the homebuilders as well as issuing explicit insolvency proclamations on the monoline insurers when they had AAA rating and were trading in the $60 dollar range. We all know how that story ended...
iv. I also warned about the more generalized life/P&C insurers when they had AAA ratings and were thought to be healthy. They have since converted into a bank to run to the government for TARP funds and aid. See In case you haven't forgotten, I'm still bearish on the life insurance industry and scroll down for the relevant links.
v. The current regional bank failures were called out in the spring of 2008 with the advent of the Doo Doo 32 list. They shortly started dropping like flies, with investment grade ratings. See As I see it, these 32 banks and thrifts are in deep doo-doo! and "The Doo Doo 32, revisited". Prior to this, in 2007, I made it clear that Washington Mutual and Countrywide were probably done for (while they had investment grade ratings), see Yeah, Countrywide is pretty bad, but it ain't the only one at the subprime party... Comparing Countrywide to its peer.
vi. The list of timely and relevant warnings can actually go on for some time. As a matter of fact, after sounding the alarm on commercial real estate exactly two years ago, and singling out the granddaddy of all commercial real estate failures a full year in advance (General Growth Properties was called out and shorted on this blog in November of 2007 as a general foreclosure case while it was the 2nd largest commercial mall owner in the country trading above $60 - with and investment grade rating, it filed for bankruptcy a year and a half later - see If only more rich heiresses read my blog for a full chronology).
I am not hard to reach, and can be found via the contact form at BoomBustBlog.