Is Bank of America Gambling on Resurrection (or Is BoA Holding the U...

What would you do if you were running an insolvent company? The smart thing is to bet big:  go with a high-risk/high-return strategy.  If the gamble pays off, you're solvent, and if not, well, you're already insolvent.  You're playing with the creditors' money. (And without a tort of deepening insolvency, there really isn't a clear downside for management.)  This is gambling on resurrection.  

We've seen the disastrous results of banks gambling on resurrection.  That was the S&L crisis. Rising interest rates in the late '70s decapitalized the S&Ls as the S&Ls' assets were long-term, fixed rate mortgages that paid lower rates than the S&Ls had to pay depositors.  The S&Ls, however, got a pliant Congress to agree to massive deregulation that allowed them to expand into all sorts of new business lines, like commercial real estate and race horses and junk bonds. Insolvent S&Ls went chasing high risk/high return projects.  The result was that the tab for taxpayers to fix the S&L mess was significantly greater.

Today, it looks like Bank of America is repeating the S&Ls' gamble on resurrection and using this gamble to hold the US government hostage.  

It's hard to tell if Bank of America is really insolvent--lots of assets aren't marked-to-market.  But it's telling that the market cap is around $65 billion, while the book equity is at $220 billion. The market thinks that BoA has $155 billion of bogus assets or unrecognized liabilities. If BoA isn't a zombie, it's the next thing to it.  

The smart move for BoA, then, would be to gamble on resurrection. And it seems that is exactly what BoA is doing. What's the most obvious high risk/high rewards strategy available presently? Writing CDS on European sovereign debt. Going long on Greece (or all the PIIGS). This is exactly what BoA (and other US banks) have been doing. 

Here's what's really scarry.  BoA just moved its derivatives business (where it does its CDS) from Merrill into its insured depository. BoA's immediate motivation might have been to reduce collateral requirements following itsSeptember ratings downgrade. But there's also a huge political benefit to the move.  Remember that CDS are qualified financial contracts that will come before FDIC claims. So it looks like BoA is gambling on resurrection at the expense of the US taxpayer. If things work out in Europe, BoA makes a bundle. And if not, the US taxpayer picks up the tab. 

This means that BoA has the US government over a barrell. BoA can basically tell Treasury that it had better make everything good in Europe or it will be paying the bill. By strapping a financial bomb to itself, BoA is in a position to dictate terms to the US government regarding international financial policy. The difficulty for BoA, however, is that the Administration understands that intervening to help the Europeans will probably cost them the election (never mind that we already did this when we bailed out AIG and protected its regulatory capital arbitrage swap counterparties).  

But here we are, a year after Dodd-Frank and three years after the financial crisis, and a too-big-to-fail bank is in a position to hold the US government hostage. If this doesn't underscore that too-big-to-fail is a threat not just to the US economy, but to the US political system, I'm not sure what does.