WSJ: BofA's government-backed subsidiary financed trades

Bank of America for years used its government-backed U.S. banking subsidiary to finance billions of dollars in controversial trades for clients of its European investment-banking arm, The Wall Street Journal reported today, citing internal documents and people familiar with the matter.

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Last year, the bank's Merrill Lynch unit "quietly" started phasing out the use of funds from its U.S. banking subsidiary to finance transactions that, among other things, helped hedge funds avoid taxes on stock dividends, according to the Journal story.

Merrill Lynch began using the subsidiary's funds to finance the transactions for its clients roughly three years ago. In an email today, a Merrill Lynch spokesman told me that it no longer uses the subsidiary, Charlotte-based Bank of America National Association, to finance so-called "dividend arbitrage."

The transactions worked like this: Bank of America National Association would make secured loans to clients to finance the purchase of stocks. Those stocks could be owned in a jurisdiction where the tax rate is lower than the rate in other jurisdictions. As a result, the withholding taxes on the dividends could be substantially lowered, saving millions of dollars in taxes. The loan itself would be secured by the stocks.

Dividend arbitrage is legal in other countries but not in the U.S.

Bank of America largely runs the strategy from London.

"Like others across the industry, we do offer services outside the United States related to dividend arbitrage through our broker dealer, Merrill Lynch International," the Merrill Lynch spokesman said in the email. The spokesman said Bank of America National Association and other affiliated entities never suffered losses from the transactions.

According to The Wall Street Journal story, experts said it is inappropriate for Bank of America to tap the entity holding federally insured deposits to finance risky investment-banking trades:

“I don’t think it’s an appropriate use,” said Sheila Bair , the former chairman of the Federal Deposit Insurance Corp. “Activities with a substantial reputational risk... should not be done inside a bank. You have explicit government backing inside a bank. There is taxpayer risk there.”

U.S. regulators have questioned Bank of America about its dividend arbitrage activities. In September, I reported that regulators asked Bank of America about the strategy during a routine examination of the bank.

At the time, a Richmond Fed spokesman told me in an email that the Fed "identified dividend arbitrage trading as an activity that required further examination of the risk and governance of the business." The bank cooperated with the Fed's examination of the practice, the spokesman said at the time.