How BofA's Depositors Funded The Bank's "Fugazi P&L"

When we first exposed in February how yet another bank - Bank of America - has been quietly preserving the post Glass-Steagall world in which cash depositing taxpayers are on the hook for a bank's stupidity, some shrugged it off and looked to stress test to solve all the problems. However, it appears - for once - the SEC is not willing to just ignore the bank's actions. Just as JPMorgan's CIO Office, aka the London Whale, took advantage of fungible, taxpayer-insured funding in the form of excess US deposits over loans, to corner the US credit market (in what was clearly a directional prop trade); so, as WSJ reports, The SEC is investigating whether BofA broke rules designed to safeguard client accounts, potentially putting retail-brokerage funds at risk in order to generate more profits using large complex trades.
 

For at least three years, the bank used large, complex trades and loans to save tens of millions of dollars a year in funding costs and to free up billions of dollars in cash and securities for trading that Bank of America otherwise would have needed to keep off-limits, and now, as The Wall Street Journal reports,

The SEC is investigating whether the bank’s unusual strategy violated customer-protection rules and whether the bank misled regulators about what it was doing, these people said.

 

Bank of America, the second-largest U.S. lender by assets, stopped the strategy in mid-2012, amid internal debate about its potential regulatory and other risks, they said. The trades took place in Bank of America’s Merrill Lynch unit, which it bought in 2009.

The previously unreported SEC inquiry is being conducted by a specialized unit of the agency’s enforcement staff focused on complex financial instruments, people familiar with the inquiry said. It is the latest regulatory headache for Bank of America and, in particular, for an obscure corner of the company’s investment bank that pushed financial arrangements now under scrutiny from U.S. and European authorities. Among those are controversial trades crafted to help clients avoid taxes on dividends, at times funded by Bank of America’s federally-insured banking arm. The bank says it no longer uses that banking unit to fund tax-minimization trades.

Known in industry circles as Rule 15c3-3, a reference to the section where it is tucked within the Securities Exchange Act of 1934, the policy requires banks and other financial firms that handle customer trades to calculate at least once a week their net liabilities to clients—in other words, how much more banks owe to clients, in the form of deposits and other funds, than they are owed from clients, in the form of assets such as loans.

 

The greater the overall—or net—amount that the banks owe to their clients, the more money the banks need to set aside in reserve funds, known as “lockup” accounts, to pay their customers in an emergency. Funds in those lockup accounts must be segregated from other accounts, including the banks’ own.

Having billions of dollars idling in lockup is expensive for banks, partly because the money generally can’t be put to other profitable but potentially risky uses such as trading.

New York-based executives in Bank of America’s Merrill Lynch brokerage arm devised an array of complex trades and loans to reduce the amount of money trapped in lockup, according to people familiar with the trades.

 

One result of the trades was to dramatically increase the amounts of money that customers owed to the bank, thereby reducing the net amount that the bank owed its clients. That in turn reduced how much Bank of America had to stash in the 15c3-3 lockup.

 

Another benefit: Bank of America was able to curtail its use of more expensive funding from alternate sources such as the debt markets or other parts of the bank.

 

From 2009 to 2012, Bank of America completed billions of dollars’ worth of such trades, the people said. At times, the trades reduced the amount the bank had in lockup accounts by as much as $5 billion out of a total of up to about $20 billion in lockup, they said.

 

The SEC inquiry is focused on Bank of America’s compliance with a 1972 rule designed to ensure that investment banks and trading firms set aside enough cash and easy-to-sell securities that, in the event of failure, they can readily repay whatever they owe their customers.

Questions arose inside the bank’s New York office about regulatory and other risks involved in the strategy, the people said.

Some traders dubbed it “fugazi P&L,” slang for phony profit-and-loss math, the people said. Clients earned a slice of what the bank saved, they said.

The risk is more than theoretical.

The collapse of Lehman Brothers in 2008 and of MF Global Inc. in 2011 left some brokerage customers waiting for the return of billions of dollars, leading regulators to strengthen the long-standing customer-protection rule.

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As we concluded previously, one can argue the BofA trade was even worse than JPM's - at least there the circle of involvement was rather small. BofA's only saving grace: the trade was smaller: "At one point, in May 2012, internal bank documents showed $5.6 billion of outstanding BANA loans to European asset-management clients, with several top recipients involved in dividend-arbitrage trades. Three such clients were earmarked to receive up to $1 billion each in BANA funding, the documents show. People familiar with the financing say the amounts of BANA funding used for dividend-arbitrage trades fluctuated broadly." With JPM the total notional reached into the hundreds of billions.

But the absolute punchline: none other than the Bank's regulator, the Richmond Fed, knew all about it:

As part of an inspection last spring by the Federal Reserve Bank of Richmond, which is one of Bank of America’s main supervisors, regulators raised concerns about how BANA was financing risky parts of the bank, including dividend arbitrage and other trading activities, according to documents and people familiar with the matter. Bank officials are still in talks with the Fed about the issues, the people said.

 

On June 2, 2014, Fabrizio Gallo, Bank of America’s global head of equities, wrote a letter to the Richmond Fed, according to a copy of the letter reviewed by the Journal. “Our intention,” Mr Gallo wrote, “is to phase out the use of BANA in parts of the business and to transition without delay to a more operationally sound foundation.”

In conclusion: "The practice has ended, according to a bank spokesman."

What happens next? Why nothing of course....