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London Whale 2.0: BofA Used Government-Backed Funds For "Reckless, Extremely Levered" Tax-Avoidance Trades

When we recently described in detail the reason, or rather 70.3 trillion reasons, why Citigroup scrambled to make sure the swap push-out provision language remained in the Cronybus government funding bill, we made it clear that that primary reason why at least one (and certainly two) TBTF bank is desperate to keep taxpayers on the hook for its derivatives is that between JPM and Citi, there were over $135 trillion in total notional derivatives outstanding as of Q3.

 

Today we find why yet another bank, Bank of America, has been extremely incentivized to preserve the post Glass-Steagall world in which cash depositing taxpayers are on the hook for a bank's stupidity, and more impotantly, to make the uber-wealthy even uber-wealthier.

Recall that back in 2013, it was JPMorgan's CIO Office, aka the London Whale, which, taking advantage of fungible, taxpayer-insured funding in the form of excess US deposits over loans, proceeded to attempt and corner the IG9 market in what was clearly a directional prop trade and which launched what is now a quarterly tradition of billions of non one-time, recurring legal charges for Jamie Dimon. As everyone knows by now, the London Whale trade (and its employees) blew up spectactularly and it was only a forced intervention by management which prevented impairment to the company's depositors.

Now it is Bank of America's turn to disclose that it, too, was being ridiculous cavalier with taxpayer-insured deposits. Only instead of traying to make money directly by letting its prop traders trade with deposit proceeds, BofA decided it would be more prudent to use its government-backed subsidiary to "finance billions of dollars in controversial trades that helped hedge funds and other clients avoid taxes, according to internal documents and people familiar with the matter."

According to the WSJ which broke the story, BofA had been engaging in a "practice of using funds from its U.S. banking unit to finance transactions by its European investment-banking arm that, among other things" which helped hedge funds avoid taxes on stock dividends, according to the documents and people.

The practice dates back to at least 2011, when senior Bank of America investment-bank officials in London started pushing subordinates to adopt the policy in order to take advantage of the lower funding costs enjoyed by the U.S. unit called Bank of America National Association, according to internal emails and the people familiar with the matter. The goal was to attract more hedge-fund clients to Bank of America’s European investment-banking unit, including clients that were engaged in the so-called dividend-arbitrage tax trades.

 

Bank of America National Association, or BANA, is home to the company’s vast U.S. retail-banking network, including the majority of its federally insured deposits. BANA pays less to borrow money than business units that engage in riskier investment-banking activities.

Supposed advocates of the non-TBTF man, such as one time FDIC head Sheila Bair, and currently Director of Santander, aka the bank which is currently issuing the largest amount of subprime auto loans in the US, were unhappy to learn that yet again, banks have not learned their lack of lesson, and will gladly put trillions in excess deposits at risk if it means higher year end bonuses for bankers.

"I don’t think it’s an appropriate use,” said Sheila Bair , the former chairman of the Federal Deposit Insurance Corp. “Activities with a substantial reputational risk... should not be done inside a bank. You have explicit government backing inside a bank. There is taxpayer risk there.”

And why do you think Bank of America used this subsidiary? Precisely because of the government backing, which made the funding essentially costless, and allowed the bank to generate massive profits on all such activities. Activities, which, courtesy of Gramm-Leach-Bliley are perfectly legal. And somehow regulators wonder why banks continue to engage in legal, if frowned upon, means to generate profits in a NIRP world in which the legacy NIM trade no longer works.

So just what did BofA use this costless funding for? "Funds from the safeguarded banking entity financed a variety of strategies. At times, billions of dollars in question were earmarked to the dividend-arbitrage strategy, in which banks and brokerage firms help hedge funds and other sophisticated investors avoid or minimize the withholding taxes they pay on stock dividends."

Ironically, according to the WSJ, while one may debate the ethics of using government-backed funds to allow hedge funds avoid taxes, the practice itself is illegal!

Such trades tied to U.S. stock dividends were banned following U.S. government investigations starting in 2007 as well as tax-rule changes. Bank of America paid $63 million in a confidential 2011 settlement related to its past U.S. dividend-arbitrage trading, according to bank documents.

But what is most interesting is how the WSJ got this information:

 

A current Bank of America employee has made a number of
whistleblower submissions to the U.S. Securities and Exchange Commission
about the role played by the U.S. banking subsidiary in financing
dividend-arbitrage trade
s, according to copies of the submissions
reviewed by The Wall Street Journal.

Are bankers indeed growing a consciences? If so, the avalanche of dirt that is set to follow will be truly epic.

But while we wait, what is most shocking is that 2 years after the London Whale died with JPM, it has been reincarnated with Bank of America:

The employee’s submissions allege that Bank of America’s London-based Merrill Lynch International unit has extended “extreme levels of BANA leverage” to fund “increasingly aggressive and reckless” tax-avoidance trades. The submissions said the practices risked causing the bank “serious financial and reputational damage.”

 

The issue of banks putting federally insured funds at risk has been under increased scrutiny by regulators since J.P. Morgan Chase & Co. in 2012 suffered more than $6 billion in losses on bad trades in its Chief Investment Office. Those blunders, led by a trader whose large positions earned him the “London Whale” moniker, resulted in J.P. Morgan paying $1 billion in fines for securities-law violations. The bank has said customer deposits weren’t harmed.

Worse, unlike the JPM fiasco, this time upper management can not deny it knew all about the strategy:

One afternoon in February 2011, bankers, traders and others crowded into a Bank of America auditorium in London for a “town hall” meeting. Executives announced that they were changing the way they loaned money to certain clients, according to people who attended. The money for the loans now would come through BANA rather than Merrill Lynch International.

John Addis, an investment-banking executive, told attendees that increasing the use of lower-cost cash would give Bank of America a new edge over competitors. He and other executives said the funding would allow the bank to extend more loans to more hedge funds, including those with hard-to-sell investments, in turn generating more profits for the bank, according to internal documents and people involved in the discussions.

In 2011 and 2012, executives told employees to shift hedge-fund and trading clients into BANA-originated loans, according to emails.

“Given funding costs in [Merrill Lynch International] can we make sure all new clients, where possible, are loaded right on to bana? Where we can’t I’d like to understand why,” a senior investment-banking executive, Sylvan Chackman, wrote in an email to employees in January 2012.

Therefore, 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.

Remember: the banks are now in charge of both the regulators and government. Which means that just for the sake of appearance, BofA may in the worst possible case, be slapped with a +/- $1 billion penalty, as it neither admits nor denies that it broke any law, and the incident will be forgotten. Of course, nobody, anywhere, will go to prison over any of the above: the amounts involved are in the billions - far greater than what is considered a punishable offense under US "law", and courtesy of the hijacking of the US financial system by crony capitalism-cum-low cost socialism, those people have an unlimited "get out of jail" card. At least until the guillotines start falling.