Bank Investors Beware, Shareholder Interests Are Secondary

As the financial system continues to crash under the weight of falling asset values and shrinking availability of capital outside of government investments and guarantees, it is rapidly becoming clear that the emperor has no clothes. When the rumors hit the tape on Wednesday night that Bank of America (BAC) had been secretly negotiating with the government since mid-December to keep its Merrill Lynch (MER) deal alive, the failure of the stock to bounce and its subsequent weakness from early January became quite explicable.

What's not as easily understood is why shareholders didn't learn of this (they had voted, but the deal hadn't closed), unless one understands that the interests of the shareholders in large banks are subordinate to the "national interest". According to a NY Times report, CEO Ken Lewis stated during the conference call yesterday (no transcript on Seeking Alpha yet): “I do think we were doing the right thing for the country.” We heard similar type of discussion when Treasury Secretary Paulson "forced" TARP funds on some banks as well as in some of the previous shotgun merger discussions.

The Philadelphia Stock Exchange Banking Index (BKX) has already declined 29% in just 11 trading days of 2009 (after falling in each of the prior three months a combined 35%). Investors in banks and other companies on the receiving end of government assistance need to be aware that these companies don't necessarily have the interests of the equity investor at the top of their list of priorities.

Investors in general need to understand how this deference to the "greater good" indicates the true magnitude of this crisis. While stocks have actually rebounded somewhat since this revelation, I believe that options expiration, rotation into other sectors and some expectation of a potential post-inauguration bounce are at play.

The conclusion I draw is that the need for secrecy of the negotations, the abrogation of shareholder rights, the massive "investment" required by the government and yet still vast damage to the stock price suggest that investors don't like to invest when the game is rigged.

Disclosure: None

Comments

[Sher Rana:]

Unless stockholders are fully aware of the facts all bets are off. Now-a-days one does not sit down with a pencil and paper to calculate future earnings, balancehseets, cash-flows etc. because these analysis are really worthless when decisions are being made behind the curtain. Previously we blamed analysts because they could not /or did not go behind the doors. Now the facts are getting known and intelligent people are moving away from the market.



On Jan 17 01:31 PM ironmen wrote:

> Now you tell us: must be time to buy.

Jan 17 03:17 PM

[DiscerningWord:]

Thanks for pointing this out. It is a significant issue. Shareowners will be sacrificed for the sake of politics. Preferred securities are the new common. It is sad that we are floating toward becoming a dull neutered nation like Europe. How sad to see America give up on capitalism for....what.....tempor... politics. I heard that Sheilabair (needs to be said in one word) of all places the FDIC is backing a national bank. Pretty sick. After this round the government will control or have interests in every area of finance - student loans, home loans, insurance, banks, brokers. And not one Nobel Prize winner has the guts to say a word. Not one elected official has resisted this disaster of freedom. The arrogance of a government that harms its citizens was in the past only appropriate for the third world. Now its the favored American approach. Seem extreme? It would be if it were not true.

Jan 17 03:52 PM

[{5U}:]

Great article Alan. What do you think the government's policy will be in regard to the preferreds? The TARP investments are preferreds so I cannot see the government stopping their dividend payments or wiping out the preferreds. However, the government also can change the rules at any time and many of the bank preferreds are trading at either stressed or distressed levels.

The preferreds do look interesting and Barron's even wrote an article on them a few weeks ago, but the big is changing government policy?

Any thoughts? The PFF is heavily weighted with financial preffreds. Single names could be a way to play it too.

Jan 17 04:19 PM

[{5U}:]

As in "big" i meant the big risk is changing government policy....the govie maybe invested thru TARP but are they willing to destroy the preferred market a la Fannie and Freddie? Not that there is new issuance in that market but it would create giant holes in terms of losses on a global basis like Fannie/Freddie did across the world.

Jan 17 04:21 PM

[apppro:]

It's always nice to blame everyone who you THINK caused the problem because they're the only visible entities trying to correct things.
"We need them on that wall! We want them at that wall!"

Yeah, the common shreholders are the ones getting screwed over again. Pisses me off because without the common there would be no stock to destroy in the 1st place. But that's another discussion entirely.

What really pisses me off is that everyone is blaming Ken Lewis, the Fed, the corner drug dealer, everyone but who really did this to us.

Fine we all got piggy and neeedy! We all wanted far more then what we rightfully could afford. BUT it was not the right of a few narcissitic short sellers to prove that point to all of us! Who asked them to gangshort and naked short the financial industry and our Country into oblivion? I didn't - did you? Place the blame for the end results in the lap of the the true culprits & criminals, and not on the people that tried to give us all a life style we all longed for.

Jan 17 04:50 PM

[andruomail:]

re TARP preferreds: while that 1st round was issued with equal seniority to existing lines, I think TARP's were cumulative, while a lot of normal lines are non-cumulative -- TARP's dividends could be stopped and would still have to be repaid someday, but missed noncumulative ones would be lost. So read the fine print if you're thinking about buying preferred today.

Jan 17 06:04 PM

[Alan Brochs...:]

Equity Has No Clue,

Thanks for your comments. I don't really have an expectation regarding what the government will do regarding preferreds. I assume you are asking if ultimately they will protect the preferred shareholder despite their inability to shelter what's remaining of common equity at the large banks. What they should do and what they will do are two distinctly different questions.

I have a very libertarian philosophical leaning, so it has pained me greatly to advocate government intervention in order to stem (not fix) this crisis. The Bush Administration actually had the right idea initially, but class warfare broke out. The key to ending the death-spiral of forced selling was to put a temporary floor on assets. In all fairness, the political process was as challenging as could be given the timing of the national elections. The way the program was sold and then implemented is a complete travesty of the constitution, though action was necessary.

The goal shouldn't be to save the various classes of owners of certain institutions but rather to abate the pressure on asset sales. Some folks push the ridiculous concept of eliminating mark-to-market (let's just pretend this away). Sheil Bair is advocating now what I have advocated for quite some time, which is an RTC-like solution. I addressed these issues several times over the past year or so. Most recently, I discussed this issue as the original TARP deal died in Congress: seekingalpha.com/artic...

I shared my plan, which included:

Create a Government Agency to oversee the process.

Fund the Agency with $100 billion by selling interest-guaranteed tax-exempt bonds.

Create a list of eligible securities and assets for the program.

Allow purchasers of eligible assets to purchase insurance (say for 3.33% of the principal).

Insurance would cover the first 10% of losses.

Suspend capital gains tax on any eligible securities held for more than a year.

This is an area about which I had given considerable thought. When I became extremely bearish in the summer of 2007, I tried to imagine the end-game (and underestimated wildly, unfortunately, in my prediction that the nationalization of the GSEs would do the trick). In February, after that late January bounce last year, I published seekingalpha.com/autho.... There, I argued:

The policy responses from our government have been highly inappropriate at best and potentially extremely dangerous. The Federal Reserve, in trying to help the banks by lowering FF, looks desperate and reactionary. It runs the risk of alienating our “outside investors”, devaluing our currency, raising inflation prospects and hurting our senior citizens who live off of their savings. The steepening of the yield curve is alarming. There is NO rate low enough to create a spread (between short-term borrowing costs and long-term lending or investing rates) to compensate lenders to borrowers that are impaired. Efforts need to be directed towards stabilizing the value and/or liquidity of all of the CDOs and other distressed securities that litter the balance sheets of our financial institutions. Some might argue that we will have a refi boom with the lower mortgage rates. Good luck to those who NEED to refinance, because your loan appraiser may want to see you kick in some equity (the “cash-in” refi). The fiscal stimulus package is barely a finger in the dike and smells of politics. Recipients may pay down some of their debt or build savings: It is very unlikely to do much more than cause a temporary blip in spending at best. Keep your eyes on the dollar/yen and dollar/euro relationships as well as the 10yr Treasury (absolute yield, relationship to short-term rates and to corporate bonds) to monitor the risks of these policies.

In January, when the market plunged as I had anticipated, I shared a post suggesting that Bernanke was barking up the wrong tree: seekingalpha.com/artic.... I stated:

What can and must be done? Very simply, while it pains me as one who believes that government solutions are suboptimal at best and often disastrous, I believe that the government must resurrect a play from the S&L crisis and create an entity similar to the RTC to buy securities. By providing a floor on the value of municipal bonds, asset-backed securities or mortgages that lose their ratings, the financial calamity of a self-fulfilling prophecy of mass liquidation can be avoided. THE GOVERNMENT MUST STEP IN AND PROVIDE DIRECT LIQUIDITY TO THE HOLDERS OF THESE DISTRESSED FIXED-INCOME AND DERIVATIVE SECURITIES.

I say this all because I continue to believe that the government has gone very slowly up a steep learning curve, and I don't quite get it. The RTC program had flaws, but it was effective in helping solve the commercial real estate crisis in the early 90s. This challenge is of much greater significance, and the failure of the Fed, the Treasury and Congress to show leadership rather than cater to politics has cost us millions of jobs. I firmly believe that had the government been proactive in setting up liquidity programs as I was advocating early on, we could have avoided going over the cliff this past Fall.

Not sure I answered your question, but I hope my thoughts shed some light on how things ought to be done.


On Jan 17 04:19 PM Equity Has No Clue wrote:

> Great article Alan. What do you think the government's policy will
> be in regard to the preferreds? The TARP investments are preferreds
> so I cannot see the government stopping their dividend payments or
> wiping out the preferreds. However, the government also can change
> the rules at any time and many of the bank preferreds are trading
> at either stressed or distressed levels.
>
> The preferreds do look interesting and Barron's even wrote an article
> on them a few weeks ago, but the big is changing government policy?
>
>
> Any thoughts? The PFF is heavily weighted with financial preffreds.
> Single names could be a way to play it too.

Jan 17 07:35 PM

[{5U}:]

Good stuff. Thanks for getting back to me. And I agree with your philosophy. I hate this class warfare b.s. Especially since I was a prop trader! Blech. In many ways I would rather be ignorant about the politics and the economy right now but that does not make for great investing.

I was just referring to the preferred asset class, not the common stock. Normally, it would make sense for companies to suspend all preferred dividends, not just certain preferred issues. And the government's TARP money is a preferred. However, the government can change the rules. It certainly would set a new precedence.

Because of the aftermath what happened to Lehman, I do not think the government can allow another bank to fail because of the systematic risk.

us.ishares.com/product...


On Jan 17 07:35 PM Alan Brochstein wrote:

> Equity Has No Clue,
>
> Thanks for your comments. I don't really have an expectation regarding
> what the government will do regarding preferreds. I assume you are
> asking if ultimately they will protect the preferred shareholder
> despite their inability to shelter what's remaining of common equity
> at the large banks. What they should do and what they will do are
> two distinctly different questions.
>
> I have a very libertarian philosophical leaning, so it has pained
> me greatly to advocate government intervention in order to stem (not
> fix) this crisis. The Bush Administration actually had the right
> idea initially, but class warfare broke out. The key to ending the
> death-spiral of forced selling was to put a temporary floor on assets.
> In all fairness, the political process was as challenging as could
> be given the timing of the national elections. The way the program
> was sold and then implemented is a complete travesty of the constitution,
> though action was necessary.
>
> The goal shouldn't be to save the various classes of owners of certain
> institutions but rather to abate the pressure on asset sales. Some
> folks push the ridiculous concept of eliminating mark-to-market (let's
> just pretend this away). Sheil Bair is advocating now what I have
> advocated for quite some time, which is an RTC-like solution. I
> addressed these issues several times over the past year or so. Most
> recently, I discussed this issue as the original TARP deal died in
> Congress: seekingalpha.com/artic...

>
>
> I shared my plan, which included:
>
> Create a Government Agency to oversee the process.
>
> Fund the Agency with $100 billion by selling interest-guaranteed
> tax-exempt bonds.
>
> Create a list of eligible securities and assets for the program.

>
>
> Allow purchasers of eligible assets to purchase insurance (say for
> 3.33% of the principal).
>
> Insurance would cover the first 10% of losses.
>
> Suspend capital gains tax on any eligible securities held for more
> than a year.
>
> This is an area about which I had given considerable thought. When
> I became extremely bearish in the summer of 2007, I tried to imagine
> the end-game (and underestimated wildly, unfortunately, in my prediction
> that the nationalization of the GSEs would do the trick). In February,
> after that late January bounce last year, I published seekingalpha.com/autho....
> There, I argued:
>
> The policy responses from our government have been highly inappropriate
> at best and potentially extremely dangerous. The Federal Reserve,
> in trying to help the banks by lowering FF, looks desperate and reactionary.
> It runs the risk of alienating our “outside investors”, devaluing
> our currency, raising inflation prospects and hurting our senior
> citizens who live off of their savings. The steepening of the yield
> curve is alarming. There is NO rate low enough to create a spread
> (between short-term borrowing costs and long-term lending or investing
> rates) to compensate lenders to borrowers that are impaired. Efforts
> need to be directed towards stabilizing the value and/or liquidity
> of all of the CDOs and other distressed securities that litter the
> balance sheets of our financial institutions. Some might argue that
> we will have a refi boom with the lower mortgage rates. Good luck
> to those who NEED to refinance, because your loan appraiser may want
> to see you kick in some equity (the “cash-in” refi). The fiscal stimulus
> package is barely a finger in the dike and smells of politics. Recipients
> may pay down some of their debt or build savings: It is very unlikely
> to do much more than cause a temporary blip in spending at best.
> Keep your eyes on the dollar/yen and dollar/euro relationships as
> well as the 10yr Treasury (absolute yield, relationship to short-term
> rates and to corporate bonds) to monitor the risks of these policies.

>
>
> In January, when the market plunged as I had anticipated, I shared
> a post suggesting that Bernanke was barking up the wrong tree: seekingalpha.com/artic....
> I stated:
>
> What can and must be done? Very simply, while it pains me as one
> who believes that government solutions are suboptimal at best and
> often disastrous, I believe that the government must resurrect a
> play from the S&L crisis and create an entity similar to the
> RTC to buy securities. By providing a floor on the value of municipal
> bonds, asset-backed securities or mortgages that lose their ratings,
> the financial calamity of a self-fulfilling prophecy of mass liquidation
> can be avoided. THE GOVERNMENT MUST STEP IN AND PROVIDE DIRECT LIQUIDITY
> TO THE HOLDERS OF THESE DISTRESSED FIXED-INCOME AND DERIVATIVE SECURITIES.
>
>
> I say this all because I continue to believe that the government
> has gone very slowly up a steep learning curve, and I don't quite
> get it. The RTC program had flaws, but it was effective in helping
> solve the commercial real estate crisis in the early 90s. This challenge
> is of much greater significance, and the failure of the Fed, the
> Treasury and Congress to show leadership rather than cater to politics
> has cost us millions of jobs. I firmly believe that had the government
> been proactive in setting up liquidity programs as I was advocating
> early on, we could have avoided going over the cliff this past Fall.
>
>
> Not sure I answered your question, but I hope my thoughts shed some
> light on how things ought to be done.
>
>
> On Jan 17 04:19 PM Equity Has No Clue wrote:

Jan 17 08:24 PM

[{5U}:]

And when I meant another bank to fail...I meant default on their bonds.

The banks I would lump in that category are banks that are ladden with CDS, toxic assets, and massive counter party risk.

Not the little P.O.S. banks that are not intertwined in the economy through a web of sloppy contracts like AIG was.

Jan 17 08:27 PM

[Chickenpookie:]

Roy,
Sorry dude, blame it on the private bank known as the FED. These banks are in bed with your congress and they are sticking it to US citizens who were savers by taking their 401K's and giving them a 50% off haircut, along with saddling the born and unborn with over a generation of debt. The entire outstanding US mortgage debt is only $10T, so what are the banks doing with the $8T they've been given?

Do you remember NAFTA and the new rules against personal bankruptcy? These were your first clue.

Wake up and smell the coffee bro!!!


On Jan 17 01:23 PM Roy M. wrote:

> Hope the government will find out what exactly is going on with all
> these banks. It can't be just the bad mortgage that caused all these
> problems. Must be some thing else. Maybe criminal in nature. A thorough
> investigation is needed.

Jan 17 08:38 PM

[{5U}:]

Everyone is to blame for this. The main pillars are:

1) Fannie/Freddie
2) Greenspan
3) Paulson
4) The Housing Derby

When things go the other way, the politics come into play. They will try to clean up the mess. Hide some of it and reinflate the bubble. And hope it does not pop again while they are in office.

Hopefully people come out of this mess more fiscally responsible and smarter about allocating their assets.

It is amazing people will spend hours shopping for the best deal on everything but their biggest purchases: financial assets.
On Jan 17 08:38 PM Chickenpookie wrote:

> Roy,
> Sorry dude, blame it on the private bank known as the FED. These
> banks are in bed with your congress and they are sticking it to US
> citizens who were savers by taking their 401K's and giving them a
> 50% off haircut, along with saddling the born and unborn with over
> a generation of debt. The entire outstanding US mortgage debt is
> only $10T, so what are the banks doing with the $8T they've been
> given?
>
> Do you remember NAFTA and the new rules against personal bankruptcy?
> These were your first clue.
>
> Wake up and smell the coffee bro!!!

Jan 17 11:29 PM

[icandoitdon:]

the federal government is ruining the banking system in their misguided attempts to rescue it. the feds themselves acknowlege that these banks need private capital. who is going to provide it given the utter disregard for shareholder interests as demonstrated by the federal government and the banks themselves during this financial meltdown?

as for the cause of all this capital destruction in the finacial system, i've always believed that it extends well beyond home mortgages and bad loans. every major bank has financial exposure to myriad deritive financial instruments, many of which reside in off balance sheet entities. the risk extends beyond the contracts themselves, which are often horrendously levered, to solvency of counterparties involved. if you are stuck with your losing bets and can't get your winners to pay off, that's a big problem. kind of like your house burning down and finding out the issuer of your insurance policy doesn't exist.

i don't think a solution exists to this crisis because the only means to solve it is large amounts of private capital. would you buy a public offering of any of these major banks? would you buy their debt securities without a federal guarantee? neither would i. matter of fact i wouldn't buy them with a federal guarantee.

Jan 17 11:55 PM

[Jake Berzon:]

I would think that to invest in banks right now you would have to be either much smarter than anyone I know or suicidal, but I have been saying something like this since April 2007 - stockvalues.org/stock-...

Jan 18 01:11 AM

[L. SMITH:]

How many bank investors really understand the business and the financial reports of these large banks.

I bet there's "none".

Very simple all these bank investors are pure gamblers, 100% like crap player in Las Vegas.

End of story.

Jan 18 01:33 AM

[Anthony Alfidi:]

Ken Lewis (BAC) and John Thain (MER) are less interested in the greater good than they are in the value of their bonus packages and reputations as dealmakers. Both of those carry weight in any post-bailout jobs they might be after (you know, in case the whole bailout thing goes south, gotta have a way out somehow).

Jan 18 02:23 AM

[Maxe Paul:]

I would like to add that investing in Australian banks may look good on the surface, with a high yeild and government guarantee, but they are capital raising every few months and diluting shareholders in the process, they will more than likely cut dividends as time goes by and business bankruptcies take there toll.

Australian banks are seen as the strongest in the world ATM, but the risk reward is amongst the worlds worst in my opinion as they are fully priced. Buyer beware.

Jan 18 08:59 AM

[vatexas645:]

I was a shareholder of WB, and now WFC. Government interfered in exactly the wrong way to entice future investment via common shares. They should have (past) and should (future) stick with the original TARP plan, and purchase the bad assets at some value, then hold them for future sale at a profit. You appear to believe MtoM is good. It is but is too strict when companies have to mark to CURRENT market value instead of future worth under a stabilized market. This method (future value) would allow low value for bad assets while allowing higher value for good assets. Only the holder of assets can properly value assets. Using a global rule for valuation punishes all investors. Further, eliminate naked shorts completely, and allow shorting ONLY with complete transparency to help eliminate the apparent equity market manipulation IMHO.

Jan 18 09:22 AM

[Alan Brochs...:]

You make some good points, and I agree with you on more transparency by shorts. I have been struck for years by the lack of logic in requiring longs to file quarterly but not shorts. While I understand that we may not be able to demand real-time information, it is unreasonable that it isn't collected by the government real-time and disseminated to the public with a lag.

I don't know if Mark-to-Market is "good", but it is better than carrying it at cost. In any case, analysts need to be able to clearly see discrepancies. Perhaps the ultimate solution is to have the asset carried at cost on the balance sheet and a liability carried as well that is clear to delineate. Your suggestion of some sort of smoothing process could be feasible.

We can try to blame the accounting methods for the problems, but the real issue was that the issues were real (high levels of debt, low quality assets) and the mechanisms in the market were faulty (lack of enforcement by the SEC with respect to naked shorting, for instance). Had alleged depression expert Bernanke moved in late 2007 along with Washington to implement plans to help alleviate the pressure on illiquid securities (rather than blindly cutting rates and expecting that tactic to make things better), the margin calls would have slowed and the unwind would not been nearly as violent. Still, we would have faced a lot of pain nonetheless.

Jan 18 10:07 AM

[morph366:]

There is a strange asymmetry about the liquidity/illiquidity of securities. When the financial world is behaving well (i.e. asset prices are going up) lots of funds are perfectly happy to own illiquid securities - using some variation on a mark to model method of accounting. When markets are behaving badly the investors in funds with illiquid holdings want their money back immediately if not sooner.

Jan 18 10:38 AM

[Jose39:]

It's just not home mortgages but commercial mortgages, credit card debt and investments in highly leveraged derivatives and of course bad management.


On Jan 17 01:23 PM Roy M. wrote:

> Hope the government will find out what exactly is going on with all
> these banks. It can't be just the bad mortgage that caused all these
> problems. Must be some thing else. Maybe criminal in nature. A thorough
> investigation is needed.

Jan 18 10:43 AM