The American taxpayer is still backing derivatives trading at our largest banks. JPMorgan Chase’s $2 billion loss on credit derivatives is just the tip of an iceberg. Congress would like us to believe that regulators are going to prevent future taxpayer bailouts of big financial institutions. But what if our regulators disagree with each other?

The Federal Reserve allowed Bank of America to move Merrill Lynch’s derivatives from a non-bank subsidiary into the FDIC-guaranteed bank, Bank of America, N.A. The FDIC guarantee is the federal guarantee of deposits, begun in 1934 to minimize runs on banks.

An October 18, 2011, Bloomberg News article stated that the FDIC did not support this move, but was overruled by the Fed. As described in our February post, this regulatory action violates the public intention of Congress to keep new risky trading isolated from the government’s deposit guarantee.

Front running in the securities business is about timing and advantage. It occurs, for example, when a trader purchases a few hundred shares in a stock for his own account knowing that his brokerage firm is going to recommend the stock to the public or that his firm is going to buy a big block of the stock for a client. When front running, the trader is profiting from his advance knowledge of client trading activities. He will have a gain, possibly at the expense of the client.

The Fed’s pure pragmatism– trying to keep the big behemoths afloat — is clashing with the FDIC’s defense of taxpayer interests here. The biggest banks are scrambling to find capital in the worst economic climate in decades. The Fed is trying to help them minimize the cash needed to back derivatives. (The Fed regulates bank holding companies, the corporate parents of FDIC-guaranteed and regulated banks. The FDIC regulates the banking subsidiaries.)

The Fed’s override of the FDIC is also about timing and financial advantage. It puts the interests of derivatives counterparties and the biggest banks which trade derivatives well ahead of the interests of the taxpayers who back the FDIC’s guarantee of bank deposits.

First, the timing advantage. Derivatives dealers gain access to the FDIC-guaranteed bank’s cash ahead of the FDIC. The FDIC doesn’t get to take over control of the bank’s assets until the bank is going under. Derivatives dealers get collateral, usually in the form of cash, as the bank’s credit profile declines. Until the crash the biggest banks had credit ratings at the upper end of the investment grade range. Their ratings are still within the investment grade range, nowhere near bankruptcy. (An explanation of the credit rating scale can be found at the end of this post.)

Like loans, derivatives trades are governed by a legal document, called a Master Agreement. Whereas a bank loan involves a borrower and a lender, a derivative transaction involves two parties called counterparties (to each other). Each big bank has a Master Agreement with each of its trading counterparties.

Among the many clauses in the Master Agreement is the requirement that a counterparty post collateral in the event of a downgrade of its credit rating. Collateral is typically cash or Treasury securities. Since derivatives contracts involve promises to make payments years out into the future, the collateral provides protection in support of these promises. The more one side of a derivatives contract owes the other and the more its credit rating declines, the more collateral it must post for the benefit of its counterparty.

Moody’s may downgrade some of the largest banks this year, possibly more than one notch. Their ratings are expected to remain within investment grade. But the amount of collateral that may be demanded isn’t an insignificant amount.

The Securities and Exchange Commission (SEC) requires the biggest banks to disclose in their annual reports the amount of collateral they estimate they would have to post in the event of a one- or two-notch downgrade. These amounts may involve several billion dollars, particularly in the event of a two-notch downgrade. According to an estimate provided by the American Bankers Association to our top federal regulatory officials in September 2008, each $1 of bank capital supports $7.6 of lending. (Here is a link to the Bloomberg article linking to the letter.) The redirection of each $1 billion in cash from bank capital to posted collateral dramatically affects credit available to make loans.

Derivatives counterparties will have walked off with billions of dollars of the banks’ cash, and taxpayers will again be left holding the bill.

THE CREDIT RATING SCALE.  The credit rating scale starts at the highest, risk-free rating — AAA. Called “triple AAA.” Moody’s writes it “Aaa.” It means the same and is getting very rare, even among countries. Credit quality is high in the “investment grade” range, which continues through the letter grades AA, A and BBB (the latter called Baa at Moody’s). Ratings below BBB/Baa are deemed to be in the “non-investment grade” range, or “junk” for short. The junk letter grades are BB, then B. A “C” rating carries a high risk of default. For further refinement, each agency uses three “notching” categories within a letter grade — “+”, no sign and “-” at S&P, and the numbers 1, 2 and 3 at Moody’s.