Bank of America and Citi
Feb 22, 2009
Posted by Jody Eisenman | Filed under Uncategorized
The stock market continued to decline last week. The DJIA closed at 7365, down 567 points for the week, and over 1600 points year to date. The S and P 500 closed at 770. Both indices have lost about half their values since their peaks in October of 2007. What is of primary concern is the banking system in this country. Right now, two banks in particular (Citi and Bank of America) are believed to be in incredible financial distress. Citi closed at $1.95. BAC closed at $3.79, after trading as low as $2.53. The CDS spreads on both have skyrocketed, as investors believe that their bonds are essentially junk. Of course, if the bondholders don’t get paid, the common shareholders won’t either. On Friday afternoon, I heard a prominent analyst on CNBC saying that BAC common was a steal at these levels. This analyst has been bullish on BAC for a long time. I personally participated in a conference call a few months ago with this analyst where he thought BAC was incredibly cheap and should be purchased. At the time, the price was in the mid twenties.
Here’s a link from Seeking Alpha by Jason Schwarz that also thinks BAC is going much higher from here: Link – I guess even a broken clock could be right twice a day.
The question is, “What will the government do?” Here is a list, from least likely to most likely, of what I believe will happen:
- Do nothing and let the chips fall where they may – The problem here is that bankruptcy is almost a certainty if the banks do not get additional capital. This will lead to 2 major problems: the fact that FDIC has only a fraction of the funds available to cover all the deposits, and the Credit Default Swaps (CDS). The CDS on these 2 banks may very well total in the trillions. While it is true that in the case of Lehman, many of the CDS were crosses (in other words, the party that issued it originally bought back some to cover themselves), the actual payouts will probably be staggering. If the usual parties have issued the CDS (i.e. Merrill, now BAC, AIG, Ge Capital, etc.), there is no way these swaps are going to be paid off without massive government assistance. Therefore, I do not see this as a realistic scenario.
- Buy the toxic debt off the banks’ books for original face value. This would shore up the capital base, and allow the banks to operate normally. I do not believe the government, fearing a public backlash, could execute this. The government would take a massive immediate write down on this paper.
- Buy the toxic debt off the banks’ books for actual mark to market value. While this would be fair to the government, it would only cause the banks to recognize the losses. At that point, they would still need an immediate bailout. Not likely.
- Inject new capital under TARP 2. This is possible, but after the debacle of TARP 1, I don’t think the government and public has much appetite for this. However, if the proper strings are attached, this would be a preferable alternative to options 1-3.
- Eliminate the mark to market rule. This would allow the banks to free up their capital. However, it would also lead to a situation where investors could never be clear what exactly a banks’ assets and liabilities were actually worth. In a world of already weakened confidence, this would not exactly help matters. However, I can see the government believing that this would be a small price to pay for keeping the banks solvent. If the assets increase in value, the government could gradually return to mark to market rules over time.
- Nationalization – I believe this is the most likely scenario, despite the governments’ protestations to the contrary. What does this mean? The government, under the right of eminent domain, has the right to seize any asset they deem to be in the public interest. Thus, hypothetically the government could seize your home or factory in a time of war if they deem it necessary. This has rarely been done historically, although it did happen to Amtrak and almost happened to Conrail. The government takeover of FNM and FRE could be considered to be nationalization. Although it is not exactly clear how this would work, here is the scenario that I think makes sense:
- eliminate all equity shareholders
- continue to cover all deposits, including those in excess of $250,000
- change management
- payoff bondholders at the rate of around 75-80 cents on the dollar, and give bondholders an equity stake in the future spin off of the banks
- assume control of all debts
- sell off all money management and brokerage units to the highest bidder. As these are profitable, they are the easiest to sell.
- use these proceeds to pay down debt
- eventually spin off the new bank to the public in a sharply reduced form without the toxic debt. Banks will no longer be permitted to leverage at the phenomenal rates that the law currently allows.
I believe this plan makes the most sense. Currently, such prominent people as Alan Greenspan, Paul Krugman and Nouriel Roubini are in favor of nationalization. Whether or not the government will actually do this is up in the air, but I believe that they probably will be forced to sooner rather than later. Either way, I expect a turbulent trading week.
