Wednesday, July 27, 2011

BofA, Merrill Lynch & Counterparty Risk

I saw an unbelievable story on Monday's CNBC noontime program.

Merrill Lynch is offering a 4-year bond which pays, if I remember correctly, according to the following conditions:

S&P500 down 16% or more:  99% of principal

S&P500 down 0-16% : 100% of principal

S&P500 up 0-15% : 100% of principal plus 15%

S&P500 up 16%+ : 100% of principal plus S&P gain

A quick look at the structured payoffs reveals that an investor appears to get all the S&P upside and virtually no downside, thus competing with simply buying the S&P.

However, Gary Kaminski asked the correct question, which is, if a herd of investors bought this offering and the S&P rose, say, 50% in four years, how will Merrill Lynch, a unit of the too-big-to-fail BofA, hedge its exposure? What if it doesn't or can't?

Isn't an investor assuming a large amount of counterparty risk of the sort that counterparties to AIG effectively assumed? Yes, an investor is assuming an immense counterparty risk on the part of a firm which imploded in 2008 due to risk mismanagement.

How can our new, souped-up, fancy, so-called-smarter Dodd-Frank regulators be allowing this to occur at the subsidiary of one of the nation's four largest commercial banks? One currently viewed probably as third weakest, in front of Citi, but behind Chase and WellsFargo?

Isn't this the sort of risk-taking that isn't supposed to be funded or subsidized by taxpayers anymore?

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