“Bank of America [BAC] probably needs $100 billion of equity in the next 100 days,” said credit expert Sean Egan this past Friday on CNBC. Referring to the Treasury Department’s bank “stress tests,” Egan also stated that under a severe scenario any of the major banks would end up needing more money from us taxpayers. It so happened that BAC filed its year-end 10-k that same day, and your humble blogger couldn’t resist a peek. (Today, on Sunday, Institutional Risk Analytics scored BAC as second weakest of the big four banks, but gave BAC an A, its second strongest grade in its stress testing scale.)
Our analysis has one major caveat, and that is, BAC’s 10-k is as opaque as those of many financial institutions. Many key numbers are not fully explained. Warren Buffett says he has to “reach for aspirin” when trying to make sense of the banks’ SEC filings. Portfolio manager Bill Fleckenstein agrees, deriding financials as “black boxes.”
In our reading, BAC has a horse race going on between the bank’s continuing capacity to generate operating earnings, and the likelihood of additional credit losses driven by our weakening economy.
BAC provided a $26.8 billion allowance for credit losses in 2008, up from $8.39 billion in 2007. On the other hand, even after the loss provision BAC had $139.4 billion in common equity and $57.5 billion in tangible equity to support total assets of $1.82 trillion as of year-end 2008. In other words, with its tangible equity to assets ratio over 3%, and a Tier 1 capital to assets ratio above the required levels regulators say BAC is “well capitalized.” So far so good. In addition, the bank earned $32.5 billion in pretax operating income before credit losses in 2008.
We further suspect that low short term interest rates are good for BAC in two ways. First, they give BAC a low cost of funds and thereby keep the net interest margin healthy. In 2008 BAC’s interest earning assets yielded 5.56%, and its interest bearing liabilities cost 2.88%. Second, low rates are good for those homeowners who can afford to refinance, assuming they have enough equity. That ought to be especially good for the mortgage origination business BAC obtained when it bought Countrywide Financial. So BAC has adequate capital for now and if it can continue generating operating earnings as it did in 2008, it might well survive.
For the moment we have decided to simplify our analysis by neglecting the effect of the Merrill Lynch (MER) acquisition on BAC’s future earnings. The acquisition closed this past January 1, so BAC has not yet accounted for MER in its annual report. More to the point, BAC received a government guarantee against losses on the newly acquired Merrill assets of up to $118 billion, as against MER’s total assets of $667 billion. If that doesn’t buy BAC time to liquidate MER’s dodgy assets, nothing will. With these government guarantees BAC got MER on a heads we win, tails the taxpayer loses basis. On the other hand, MER seems to have lost some of its earnings power. We are not sure when MER’s business will contribute to BAC’s profits; assuming BAC is cleaning house we think that BAC might get the MER business close to breakeven for 2009 rather than absorb the kind of losses MER recorded in 2008. Eventually, though, MER could generate material profits for BAC. Of course the addition of MER’s assets will reduce the ratios of capital to assets but the company offset this in large part with an additional $20 billion of TARP funds from the Treasury.
Here’s the rub, though. If credit losses accelerate, they could overwhelm the capacity of the bank to generate operating earnings and BAC would need more government funds.
Banks often make their big loan loss provisions at year-end and we suspect BAC wanted to set forth the cleanest year-end balance sheet it could. As far as existing balance sheet items go, we focus most on the $44 billion discount between stated loan values and market values. The bank claims it will hold these to maturity and therefore they intend to carry the loans at stated value rather than market value. We suspect that since the market is marking these loans down the market smells some sort of impairment, a likelihood that BAC won’t be paid back on these loans at 100 cents on the dollar. If we assume for the sake of argument that BAC eventually has to charge off half this amount, $22 billion, that would not exactly be welcome news. If BAC needs to take large charge-offs, they no doubt hope to postpone them until the bank can earn enough profit to offset them. As for other balance sheet wildcards: BAC seems to have done a good job in reducing its exposure to derivatives such as credit default swaps since year-end 2007. On the other hand, we wonder about exposure to European banks, whose difficulties have exploded into view during the last several weeks.
Regarding possible problems down the road, the Case-Shiller Home Price Index says that housing prices are still 10-20% overvalued according to the Calculated Risk blog posts of February 27, and weak conditions in the housing market point to further price drops. Home inventory for sale stands at a record 13 months’ supply. In addition, many homeowners still have adjustable rate mortgages that allow the borrower to pay low, introductory, “teaser” rates. The schedule of homeowners slated to experience the shock of having their mortgages reset to market rate tails off in 2011 so we have trouble imagining that house prices will bottom before then. On the employment front, businesses continue cut jobs at the rate of 500,000 per month. These factors will affect BAC’s home mortgages, commercial loans, and commercial real estate loans.
We conclude that BAC is rather too close to call. BAC can afford around $20-25 billion in credit losses per year without eating into its capital, assuming no change in pretax earnings. If the economy rebounds more quickly than we expect BAC could prove to be a profitable investment. Should the economy continue to worsen, however, (and we suspect it might) we are not sure BAC can escape. The combination of deteriorating earnings and increased credit losses might then be just enough to push them into receivership – unless Treasury chooses to put them on life support.