Twitter has been buzzing this morning with people complaining that Bank of America's online system is down nationwide. It's too early to know for certain the cause, but it wouldn't be surprising to learn that their system is down due to another cyber attack.

Read more about these attacks here:
Major banks hit with biggest cyber attacks in history (CNN, Sept 28th)
Largest banks under constant cyber attack, feds say (CSO, Nov 2nd)
Major banks under renewed cyber attack targeting websites (Bloomberg, Dec 20th)

It's another reason to switch from Bank of America.

Need more reasons? Here are a few:

In addition to having stuttering servers, Bank of America has been fined an average of every other month for fraud and customer abuse.

They score the lowest on customer satisfaction surveys.



And they uniformly have bad customer reviews.



Time to switch to a local lender.

As we recounted in the preface to our derivatives timeline, though derivatives were not the sole cause of the financial crisis, they were a crucial factor.

What are derivatives?

Derivatives are financial instruments whose value is derived from an underlying asset (stocks, bonds, commodities, etc.). Traders can swap interest rates, take bets on whether a firm will go bankrupt, safeguard against future asset price increases, etc—all under the ugly umbrella term derivative. The concept of a derivative has been around for centuries, but their use has recently exploded, as demonstrated in our timeline and in the images below.

Derivatives are recorded in what's termed as notional value, which just equals the value of the underlying asset on which the derivative is based. So if the underlying asset equaled $500 million, the notional value would be $500 million even though the megabank doesn't actually trade $500 million. They just trade the derivative. It's complicated if you're totally unfamiliar with this market, but at least you can see why the global notional value for the derivative market can reach into the hundreds of trillions as shown above. It's because the megabanks are recording the notional value.

Some traders don't think people should worry about the notional value since it's not referencing what is actually being traded. But the notional value matters because if the underlying asset turns toxic, then the derivative itself does too.

We saw this in the 2007-08 crisis: when underlying mortgages went bad, then all the derivatives contracts on top of those mortgages also went bad, and this worsened the crisis tremendously. So the notional value of derivatives matters, and you can see from the charts above that Wall Street in 2012 is a completely different world compared to Wall Street in 2000 (when the total notional amount was less than $100 trillion). In other words, the dangers of the derivatives market are still very much with us. 

So, why are derivatives dangerous?

1. Derivatives allow for phony accounting

Charlie Munger once asserted that "to say that derivative accounting is a sewer is an insult to sewage." Well said, Munger. Derivatives allow firms the option to record profits today that will supposedly come tomorrow. This way a firm can put on a good pony show today and get a better stock price. All is well—unless tomorrow's profits don't arrive as expected (because of an unforeseen fiasco). If this happens a seemingly healthy firm can suddenly implode, all because of phony accounting—as happened with Barings Bank, Enron, and Lehman Brothers.

2. Derivatives obscure the market

Several derivative contracts can be written on a single underlying asset, a feature which adds enormous complexity to financial markets. A derivative contract on one asset might be traded in Asia and the US, while another contract on the same asset might be traded in Europe. What's more, the majority of derivatives are over-the-counter, meaning they aren't standardized or traded on public exchanges. So the terms of each contract can vary greatly and so the implications and interconnectedness of this market can be impossible for regulators and traders to see clearly. When markets melted during the 2007-08 crisis trading halted in part because market players couldn't readily discern which firms were on the brink of collapse and which firms were safe. This was partly because of all the derivatives contracts on top of the crumbling mortgage market.

3. Derivatives concentrate risk

Four US megabanks—JPMorgan, Bank of America, Citi, and Goldman Sachs—have a notional amount of $214 trillion in derivatives exposure. That's more than 30% of the worldwide amount just in four US banks. When firms have such concentrated derivatives exposure, they leave themselves open to surprise losses like last year's $6 billion London Whale loss at JPMorgan Chase.   

4. Derivatives allow megabanks to take on more debt

Megabanks trade risk via derivatives contracts to another firm while keeping the underlying asset on their books. This way they can bypass capital requirements and take on more debt. This in turn allows them to make more trades, but it also means that if a sudden downturn surfaces in the markets, the firm which borrowed way beyond their means may quickly go bankrupt. Lehman Brothers experienced this after they'd borrowed 30 times more money than they had in reserve. In that case a relatively small loss of 3% meant that Lehman no longer had reserves (i.e. capital), and they therefore collapsed.

5. Derivatives deceive smart people into thinking they've eliminated risk

It keeps happening, over and over. "The smartest men in the room" think that they've figured out some way to eliminate risk completely through the use of derivatives. One amazing example of this is the tragedy of Long-Term Capital Management. A group of highly intelligent economists and traders created a hedge fund in the late 1990s centered around a formula which supposedly hedged risk completely. For the first few years, the fund made enormous returns and the creators of the formula even won the Nobel Prize for economics. But then they borrowed more and more money thinking they were safe in doing so (similar to Lehman), and when a series of unpredictable events occurred in world markets, they lost billions of dollars and put US markets in danger. Their downfall should have been a warning sign about the dangers of derivatives-related risk, but several other firms suffered similar fates in the following decade. If things remain the same, we'll see the same results.

Interested in learning more? See our derivatives timeline.

This chart from CNN Money shows a sharp rise in computer automated trades, from about 25% of total trades in 2004 to about 65% in 2012. 

CNN includes another startling statistic: "In 2005, the average time to execute a trade on the New York Stock Exchange was 10 seconds. By 2012, that time dropped to 8/10,000 of a second."

This means that Wall Street in 2012 is a totally different world from Wall Street in 2002, and that things should proceed with enormous caution. Before the financial crisis Wall Street was assured that the possibility of a meltdown of 2008 proportions was extremely remote, a 1000-year flood. But the data they were relying on—especially data about credit derivatives—was only 10-20 years old. Not close to 1000. The data on automated trading is similarly very young.

Since we've already seen lots of cracks in the automated trading process, it's something to watch carefully. 

Former Citigroup CEO, John Reed, said, "I would compartmentalize the industry for the same reason you comparmentalize ships. If you have a leak, the leak doesn't spread and sink the vessel." (source)

This is one reason why switching from the megabanks to a local lender is healthy for the overall economy. If politicians won't compartmentalize the industry, the next best thing is for the citizens to do it.  

These 3 Laws Would Actually Reform Wall Street, and They Deserve Your Support. See Why.
Posted by Jon Ogden · May 20, 2013 4:15 PM

Elizabeth Warren, Nassim Taleb, and Neil Barofsky are just a fraction of the people calling to break up the big banks in this compilation. Time to end "too big to fail."
Posted by Jon Ogden · May 20, 2013 9:23 AM

The Economist: Should Big Banks Be Broken Up?
Posted by Jon Ogden · May 15, 2013 5:20 PM

In 2010, Wells Fargo joined other megabanks—including JPMorgan Chase and Bank of America—who have been sued for rigging overdraft fees in a way that hurt customers the most.  

Here's how they rig overdraft fees. Let's say you had $500 in your account and throughout the day you ran 10 transactions that added up to $75, putting your account at $425. But just before the end of the day, a check you'd written last week for $525 was processed, putting your account at negative $100. 

Instead of running the day's transactions chronologically, these megabanks would process the day's transactions from the highest amount to the lowest amount, making it so you would be charged overdraft fees for all 11 transactions instead of just the $525 transaction that put your account in the negative. If the overdraft fee were $35, those 11 fees would add up to $385—all because the megabank intentionally processed the transactions in a way that hurt you most.

It's clear why customers sued these megabanks for rigging overdraft fees. 

A court in San Francisco led the way for a class-action lawsuit against Wells Fargo, demanding that the megabank pay more than $200M in restitution. But this week an appeals court overturned the suit, saying that national law trumped state law and that it's not against national law for a bank to rig overdraft fees in this way.

Source: Chicago Tribune, WSJ

Link request from Flickr user

Certain large banks in the US—including Bank of America, PNC, JPMorgan Chase, US Bank, Wells Fargo, and SunTrust—have been targeted in ongoing cyber attacks. The first wave of these attacks started in September, with a second major wave hitting yesterday, December 20th. These attacks have focused on large banks and have consisted of flooding each bank's website with traffic so as to render each site unavailable. 

These attacks highlight one downside to increased concentration in the banking industry: cyber attackers only have to choose a few targets to cause widespread customer frustration. Given the choice among the thousands of lenders in the United States, these attackers have consistently chosen the largest targets.

Read more about these attacks here:

Major banks hit with biggest cyber attacks in history (CNN, Sept 28th)
Largest banks under constant cyber attack, feds say (CSO, Nov 2nd)
Major banks under renewed cyber attack targeting websites (Bloomberg, Dec 20th)

Neil Barofsky, author of the book Bailout: "The same incentives that led to the 2008 crisis are still in place today and in many ways, the situation is worse. We have a financial system that concentrates risk in just a handful of large institutions, incentivizes them to take risks, guarantees that they will never be allowed to fail, and ensures that executives will never be held accountable for their actions." (source)

At SwitchYourBank.org, we aim to break up the concentration of banks by encouraging people to support local lenders.

"The motivation here was nothing short of sheer greed, and the scheme was nothing short of a shell game, a Wall Street version of three-card monte." So said Kevin Perkins, associate director of the FBI, about the UBS Libor scandal (source). Our last post revealed some of the insane quotes from UBS traders. 

One additional noteworthy fact about this scandal is that it represents the first time in 23 years that a megabank has pled guilty to fraud (the last time being in 1989 with Drexel Lambert).