During the last several weeks I have had many of my clients ask me about the big banks, like Bank of America, and what is going to happen to them. Although on the surface it seems like a simple question, there are many aspects to the answer.
The era of the big independent bank is a thing of the past. In the last few years we have learned the phrase “too big to fail,” when the reality is that these banks were simply too big to succeed.
We are letting these banks take all different kinds of risks, create all kinds of financial derivatives and invest in all kinds of worldwide credit and the taxpayer takes all of the downside cost while the bankers reward themselves on the volume of the actions. This type of business doesn’t exist anywhere else in the world. Banks are in the business of hiding risk.
Just last week, Bank of America transferred up to $53 trillion of derivatives from its Merrill Lynch unit, which are likely to become worthless, into an FDIC insured holding company. The FDIC was not very happy about this because it doesn’t have the money to insure the risk. The sad thing about this is that it would not have been allowed without the sanction of the Federal Reserve. Under Rule 23A of the Federal Reserve Act, the Fed gave permission for Bank of America to transfer these toxic assets to the American taxpayer.
Keeping these types of deals separate from FDIC insured savings has been a cornerstone of U.S. regulation for a long time. The division was reinforced through the Dodd-Frank legislation of last year.
Bank of America has benefited greatly from the American taxpayer. In 2008 it received $15 billion for the bank and $10 billion for Merrill, which the bank agreed to purchase. It then received a second round of cash in the amount of $2 billion in January 2009. Additionally, the U.S. also offered to guarantee $118 billion of assets held mostly by Merrill Lynch. This move amounts to a direct transfer from derivatives counterparties of Merrill Lynch to the American taxpayer, by way of the FDIC. The Federal Reserve granted Section 29A exemptions to the banking arms of Ally Financial Inc., HSBC Holdings Plc, Fifth Third Bancorp, General Electric (big surprise), Northern Trust Corp., Morgan Stanley and Goldman Sachs, among others.
So far by my count the Bank of America has received more than $168 billion of taxpayers’ money. The Wall Street Journal reported that the Bank of America is operating under a secret “memorandum of understanding” from the U.S. government that will require the bank to “overhaul its board of directors and address perceived problems with risk and liquidity management.”
Sadly, Bank of America is No. 2 in the amount of derivatives that it holds. JP Morgan is No. 1. To put it in perspective, the amount of derivatives JP Morgan holds is greater than the GDP of the entire world as of 2008 and nearly six times the GDP of the United States.
Capitalism is about incentives, but also about disincentives. There must be a downside to the risk. If you make money you should be able to keep it, but if you lose money society should not back you up. That is not a normal economic system. That is some hybrid between capitalism and socialism.
The executives and the rest of the employees will be government employees, with government employees pay scales. Think the post office of banking. The derivative market, at this level, will unwind eventually and the days of Las Vegas-style financial instrument creation will be history.
The future of real banking will be in the community-banking sector, small regional banks that take in deposits and make local loans, charge interest and know their clientele.
Gary L. Rathbun is president and CEO of Private Wealth Consultants Ltd., 6591 W. Central Ave., Suite 108. Email him at GaryRathbun@PrivateWealth Consultants.com.