Back in mid-September, when Bank of America (BAC) bought Merrill Lynch (MER) in a $50 billion all-stock transaction, we were told that we were on the verge of witnessing the creation of an institution unrivaled in its breadth of financial services and global reach. Today, without billions more in financial aid from the government, Bank of America is unable to complete the deal.
The Wall Street Journal reported yesterday that Bank of America was unprepared for Merrill’s larger-than-expected fourth-quarter losses. But how exactly did Wall Street’s elite financial advisors, law firms and accountants condone the terms of the share exchange in the first place? On what basis did the Federal Reserve and the Treasury approve the deal? Quite clearly, valuations of Merrill as a going concern failed to address inherent balance-sheet risks and, more disturbingly, it is apparent that nobody in authority has a handle over those risks even today.
Questions surrounding the integrity of Bank of America’s disclosure are now casting a dark shadow over the banking sector. Wall Street insiders are suggesting that the bank’s management was conducting informal talks with Treasury officials to substantially increase the size of the initial $25 billion bailout during the course of December. If the Merrill transaction was in doubt, or subject to more government funds, why did Bank of America make a formal completion announcement on the first day of the New Year?
In after-hours trading, Bank of America’s shares dropped to their lowest level since 1991. But there is much more downside left. What Bank of America’s management has obviously managed is the valuation of an investment banking, wealth management and international loan syndication franchise (Merrill Lynch) within the context of early-2008 data on the domestic and global economy. Contextualized in today’s environment, that valuation cannot withstand scrutiny; that is perhaps one reason why it has not reached the public domain. When the Merrill overvaluation is combined with Bank of America’s own loan-delinquency provision issues, it is not too difficult to make the case that the bank’s shares will follow the Citigroup (C) route, to $5 and below in the days ahead.
Short sellers may wonder if the train has left the station many weeks ago, that the time to short Bank of America was in early November ($24 per share). But trading positions must be predicated on the facts as they are available at a given point in time, not on wisdom in hindsight.
The banking sector can only be viewed from the prism of nationalization; a scenario in which no bank will fail, but few banks will be able to provide heavily diluted shareholders with reliable earnings growth in the foreseeable future. As business-model adjustments remain a work-in-progress, shares of Bank of America and Citigroup are destined to flounder in the low single digits well into 2010. Forthcoming financial results in the banking sector will certainly not capture the prospects of a deepening and extended recession, particularly when fair value measurements (SFAS 157) of Level 2 and Level 3 assets continue to be hopelessly out of tune with reality.
Noticeably, Bank of America’s additional bailout demands are coming at a time when the Congress is under pressure to release the second half of the $700 billion so-called Troubled Asset Relief Program, or TARP. Fed and FDIC officials, testifying before the House Financial Services Committee this week, relentlessly repeated Ben Bernanke’s theme: the money is urgently required to plug holes in the country’s financial system. That theme may or may not have any foundation in hard statistics. But, in the absence of a thorough, publicly-disclosed valuation umbrella, warnings pertaining to systemic risks lack any credibility whatsoever. Perhaps somebody responsible for disbursing taxpayer dollars should start by defining the concept of systemic risk before writing the next check!
Disclosure: Author holds a short position in BAC and is exiting Citigroup, looking to short again on rallies above $6.50.