Re: Today in Bailout News

Kevin: This part from the Bloomberg piece, in particular, is unsurprising but disturbing:

Bank of America estimated in an August regulatory filing that a two-level downgrade by all ratings companies would have required that it post $3.3 billion in additional collateral and termination payments, based on over-the-counter derivatives and other trading agreements as of June 30. The figure doesn’t include possible collateral payments due to “variable interest entities,” which the firm is evaluating, it said in the filing.

Back in September 2008, one of the reasons that AIG got sucked into a death bailout spiral of its own making was that it had managed to take itself hostage via these type of agreements with derivatives counter-parties. Under these deals, AIG had to pony up significant cash to these counterparties — including Goldman — in the event that it suffered a downgrade.

Of course, the day that you’re being downgraded is probably not the day you’ve got billions — maybe tens of billions — in cash lying around with which to make such a payout. (You can read a funny anecdote about this on pp 243–4 of The Financial Crisis Inquiry Report.)

Three years after AIG, the fact that B of A is still able to rely on its credit rating to avoid putting an adequate cash cushion behind its derivatives is breathtaking.

Capital requirements for derivatives should be clear and consistent across companies, no matter what a company’s rating. Derivatives should be cleared via third parties — even if that means (gasp!) more transparency and competition and thus lower bank profits — to remove the risk from too-big-to-fail (TBTF) bank balance sheets (really the U.S. taxpayer).

The report that regulators are squabbling over where B of A should house this derivatives risk would be amusing if it weren’t so scary. It does not matter whether B of A puts this risk in Merrill Lynch or in its insured banking unit. In a crisis that hits a financial system made up of trillions of dollars of undercapitalized derivatives that feature embedded hair-trigger cash calls, a bailout — or a severe depression — is inevitable no matter where the derivatives lie. 

At this point, the only question about bailouts is whether the U.S. government can continue to use its credit to bring banks up — or whether the banks will start bringing the U.S. credit down. In fact, that’s a rhetorical question. 

Jon Huntsman has an okay op-ed on this topic today. He skirts the derivatives part, yes. But even raising the TBTF issue, as Huntsman does, passes for bravery (in either party) when it comes to the financial industry these days. Mitt Romney still would rather not talk about “what happened three years ago and what the cause was of our collapse.”

— Nicole Gelinas is a contributing editor to the Manhattan Institute’s City Journal and author of After the Fall, now in paperback and on e-book. 

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