Bank of America dumps $75 Trillion in derivatives

According to Bloomberg reports, the Bank of America has transferred about $22 trillion worth of derivative obligations to the FDIC insured deposit division. Besides, the FDIC insured unit was already filled with $53 trillion of obligations, making a total derivative worth of $75trillion.

Derivatives are used to hedge financial risk from time to time, but mostly for speculation. The speculation is betting on stocks, bonds, mortgages, commodities and financial indices. Banks like Bank of America issue derivatives which are highly profitable to issuers and generate big bonus to executives who manage them when the derivatives are not triggered. And when the derivatives are trigged the obligation falls upon the issuer entity rather than executives. As for Bank of America, by putting the derivatives in insured retail banks and the insured retail division, the obligations falls upon taxpayers and savers. The value of derivatives is so large that the United States has to pay off the obligation by dollar depreciation if the derivatives are triggered.

The derivatives betting on the default of mortgages are the catalyst in the global financial crisis in 2008, rather than the subprime mortgages. It is the derivative obligations of AIG that implode the insurer. With the fear of contagion, US government issued billions of dollars to bailout AIG counterparties---the biggest banks of Europe and America. Without the bailout, banks on Wallstreet have gone to bankruptcy, followed with bunch of European and Asian banks.

Not like AIG and other banks on Wallstreet which could have been allowed bankruptcy, the derivatives closely tied with FDIC insured division make the obligations have to be paid by US government. There is no choice for except the default. Bank of America is insured by FDIC, with the protection of the Federal Reserve. When obligations are triggered, FDIC and counterparties of Bank of America will be bailed out as guaranteed by the US government credit. Therefore, the risks are directly transferred to taxpayers and dollar savers.

It is a good case in point that the bank-controlled entity poses power over nation’s credit system. After financial crisis in 2008 such power has become more rather than less and the instability problem still exists. Another example is JP Morgan is allowed to issue derivatives insured by FDIC retail banking Unit. With such power over the national monetary the taxpayers and savers will never be protected.

The Application of the Weighted Average Cost of Capital

With the gradual increase of the income approach used in our assessment practices, new issues are also gradually increasing. Income approach as before most of the appraisers as best placed to exploit the assets of Canadian and French historical cost as the basis, but needs more analysis and judgment, there is more change and uncertainty. What is the importance for the business is raising finance. Therefore, which choice for the Business; Equity Capital or debt Finance? With the increase of the risks, the cost of capital is also on the way of increasing. However, if we use the WACC, we could have the similar result as before.

Therefore, the Weighted Average Cost of Capital (WACC) is more applied at the present. WACC used to measure a company's cost of capital in financial activities. Because the cost of financing is seen as a logical price tag, it was used as a discount rate of financing projects. WACC reflecting the average cost of a company through equity and debt financing, project financing, the rate of return must be higher than the weighted average cost of capital investment value.

As an example, Eurozone seeks central banks' help in Greek bail-out. Eurozone governments are looking to the European Central Bank and national central banks to help pare back the cost of a second rescue package for Greece which would otherwise amount €170bn.

                                         

Figures seen by the Financial Times reveal Greece needs €136bn in fresh bail-out funding from the European Union and International Monetary Fund – in addition to the €34bn left over from Greece’s first bail-out. This is €6bn more than EU leaders agreed in October. Germany, the Netherlands and Finland have insisted on paying no more than €130bn.

All of these phenomenons tell us the information that the Eurozone have many crises needs to be solved moreover only seeking the help from the central bank. Firstly, they should take the necessary measures to stabilize the people's heart has been affected by the situation as soon as possible. Secondly, some unnecessary expenditure should reduce or avoid, which is a kind of measure to reduce the cost of margin. Thirdly, the relevant government should be prepared to investigate and develop some new projects, then can make it back on track and re-make a profit, which make the real sense of getting rid of the present situation and take a new lease of life.

In my opinion, although this news is refers to the European government; however, we could considered it as a larger version of evolution assistance and financing from the financial crisis. They play the roles for the Government National Banks instead of the companies. In another way, the Eurozone should show its profitability and the control the relevant.

From the above case, it could help us to find the application of the WACC in the real world more than understanding the definition in the book and explain the reason for the decision making and how to apply the WACC to evaluate the business. The application of the WACC is various and useful, it can decide that the project evaluation method of operation, which has a very important reference value and the actual role.

Sources: Global Economy, The Financial Times, BBC News.