Yesterday, the S&P 500 ended flat, yet Bank of America continued its truly impressive implosion, with its stock tanking 7.89%. It is now trading at a market cap of $65 billion, versus a book value of common equity of roughly $215 billion.
Market commentators were having so much fun discussing the meltdown that FT Alphaville even dedicated a post to the “The Bank of America Explanation Game.” This was its tally, and the post includes an explanation for each:
1. An analyst note suggesting BofA will need to raise $40bn-$50bn
2. Reports that BofA is keeping a stake in China Construction Bank
3. Yet more talk of snags in a broad mortage settlement deal
4. General market weakness and BofA’s susceptibility to HFT
5. Wikileaks has apparently destroyed some of its BofA data files
Henry Blodgett at Clusterstock endorsed the “BofA needs a lot more capital” view, and pointed out the obvious: the bank had had plenty of opportunity to sell equity when its share price was higher, and if it did need to sell stock now, it was going to be extremely painful for existing holders. Concerns about BofA’s ability to bolster its balance sheet are probably not helped by rumors that the bank is trying to unload Merrill and (not surprisingly) finding no takers.
Now narrowly, the trigger yesterday likely was the Jefferies view re Bank of America possibly needing to raise $40 to $50 billion. But that isn’t the most helpful way to frame the issue.
Think about it. BofA has $215 billion in book value of common equity. $40 to $50 billion is a huge number relative to that. For investors to react suddenly to one firm’s view (what, you own the stock and this is news to you?) points to something much more fundamental.
We are now seeing the downside to extend and pretend. Years of regulatory forbearance mean that investors know the marks on the balance sheet of a beast like Bank of America (and frankly all the other big banks) have a ton of air in them. And now that the economy is looking seriously wobbly and the odds of son of Credit Anstalt are well above zero, it means big banks are at real risk of getting seriously whacked in a major stress event. Worse, with Dodd Frank (supposedly) barring bailouts and Tea Partiers on an anti-bank, anti-Fed, anti-spending warpath, it might not be so easy for the authorities to rescue a big bank if a run started (not that I’m advocating a rescue, mind you, I’m looking at this from the vantage of a bank shareholder).
Steve Waldman set forth the basic issue in a very important post last year:
Bank capital cannot be measured. Think about that until you really get it. “Large complex financial institutions” report leverage ratios and “tier one” capital and all kinds of aromatic stuff. But those numbers are meaningless. For any large complex financial institution levered at the House-proposed limit of 15×, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. In English, we cannot distinguish “well capitalized” from insolvent banks, even in good times, and regardless of their formal statements.
Now normally, investors accept the unknowability of bank equity because they have some faith in the system. Does anyone have any confidence in the system now? Financial regulators have shown themselves to be incompetent and/or badly captured by banks. Earth to base: letting off bank management easy is bad for investors in the long run. Being an investor in an overly risky bank looks swell until it suddenly isn’t.
Look at how the officialdom blew the bank stress tests. The sole purpose of that exercise was to goose bank stock prices so they could afford to raise new capital and rebuild their balance sheets affordably. What happened instead? Treasury let the banks sell pretty small amounts of stock and allowed them to “pay off the TARP.” Huh? The economic motivation for that was solely to escape pretty minimal restrictions on executive pay. And to compound the error, banks (BofA being one of the few exceptions) were allowed to resume paying dividends.
It is pretty easy to construct a list things to doubt on Bank of America’s balance sheet. Here are a few:
Second liens. Net of reserves, they are about $80 billion. That should probably be written down by 60%. That gets you to $48 billion, conveniently in range with the capital raise number bandied about today.
Commercial real estate loans. $182 billion, per the bank’s latest Y9. Probably at least some modest impairment there.
Goodwill. $78 billion. Countrywide has been written off, but Ken Lewis loved overpaying. The bank made a botch of its acquisition of US Trust, and given that it is rumored to be unable to ditch Merrill, query whether any goodwill booked in connection with Merrill is worth anything now. Some it not a fair bit of this number is probably vapor-y.
European exposures. Ooh, this is fun. No number here per se. Moynihan was asked in the seriously misbilled “we’ll take tough questions” conference call. He said BofA had $17 billion of European sovereign exposures and claimed it was hedged.
First, hedges of sovereign risk are wrong way hedges. The AIG credit default swaps against CDOs were classic wrong way hedges. An event that will lead you to put in an insurance claim is very likely to kill the insurer, which means your hedge is no good.
Second, sovereign exposures aren’ t likely to be the biggest risk BofA faces in Europe. What about its European bank exposures?
Notice how this list looks pretty bad and we haven’t even gotten to mortgage litigation losses. Not to worry, those are years away.
More immediate is what might happen to other exposures, particularly derivatives positions, in a market stress event. The poster child was Lehman. Pre-crisis, analysts focused on the asset side of its balance sheet. But the black hole in Lehman’s balance sheet has proven to be way beyond anything that could be attributed to either the asset side items that everyone had been watching or the “disorderly collapse”. While the derivatives counterparties grabbed collateral (as they are permitted to do), the bankruptcy judge can and has been contesting cases where the other side looked like it took more than it was entitled to. The open question is whether this sort of blowout was specific to Lehman (and the terrible mess in its derivatives books) or whether this is a more generalized phenomenon when a big trading firm crosses over the finance equivalent of an event horizon.
The point is that there is objectively a lot not to like about Bank of America. And now that investors have decided to start thinking critically, as opposed to blindly accepting bank equity as the faith-based paper that it is, one shouldn’t be surprised that they are getting cold feet. And the fact that the authorities have undermined the limited value of bank balance sheets via allowing all sorts of rosy accounting treatments is a self inflicted wound.