Thinking the Impossible: Could Bank of America Go to Zero?

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Includes: BAC, C, JPM, XLF
by: Bruce Vanderveen

Just about all of us recognize Bank of America's (NYSE:BAC) familiar red and blue flag logo. Millions of Americans have accounts there. Bank of America, along with Citigroup (NYSE:C) and JP Morgan Chase (NYSE:JPM), are arguably three largest banks in the US. All have serious problems.

The thought of Bank of America's common stock becoming worthless was unthinkable just a few weeks ago. Now, however, the mega-banks are again in big trouble. Most US and European banks have dropped to new lows within the last week or two. Back in September, the month of the Merrill deal, Bank of America common was between 30 and 35. On January 23 of this year it touched 5.2. How could "America's Bank" get in such dire straits?

Under normal conditions, the index committee removes from the index a DJIA component which drops below $10. These aren't normal conditions. So, Bank of America and Citigroup remain on the DJIA. Removing two of the top banks (not to mention General Motors (NYSE:GM)) from the DJIA is politically undesirable at this time. Maybe a reverse split?

Acquisitions of Countrywide Financial and Merrill Lynch were, at the time, thought to be advantageous to Bank of America. Toxic assets held by these two companies, as the recession has deepened, are now found to be significantly larger than originally thought. This week we have John Thain, ousted Merrill chief, and Ken Lewis, Bank of America's CEO, trading blame over the possible $50 billion mistake.

Nouriel Roubini (as re-published through John Mauldin) says the US banking system needs $1.4 trillion to recapitalize and in its current state is insolvent:

The US banking system is borderline insolvent in the aggregate and it will take a huge amount of public financial resources and complex and time-consuming work-out of insolvent institutions to restore its financial health and allow it to lend again in ways that support sustained economic growth.

The US Dept. of Treasuries OCC's Quarterly Report (see page 23) shows just how deeply the mega-banks are into derivatives. Bank of America has assets of $1.836 trillion and derivatives of $39.979 trillion, (mostly swaps). With the demise of the Shadow Banking System (non bank financial institutions), trading derivatives is much more difficult. If marked to market, one wonders just how much of a loss would be realized in this $39.979 trillion portfolio. Nobody, who will talk about it anyway, seems to know. It wouldn't take much to wipe out $1.8 trillion in assets. Not surprisingly, there is a major confidence problem. With a continually slumping housing market, commercial real estate problems accelerating, increasing credit card debt defaults and a deep recession that's driving foreclosures to record levels, you can only guess. Investors don't like guessing.

There are more reasons why Bank of America could go to zero. If the bank is insolvent, the US government will have to use not only TARP2, but also a TARP3 and a TARP4. Imagine the bickering in Congress. Someone, somewhere, somehow, sometime, has to own up to the toxic assets. Only the US government (taxpayers) can do this (lucky us). With government funding, dilution can wipe out the common stock holders. With politicians calling the shots, you can forget dividends and other "extravagances" such as bonuses, private jets, etc.

The establishment of a "bad bank" to hold toxic assets is now being talked about, and Wall Street hails it as a possible solution. But how do you determine the price to pay for the toxic assets? Face value is a bad deal for tax payers, while mark to market is a bad deal for the banks. Either way, today's common shares may not be worth much, if anything.

Eventually, the US government may "nationalize" the mega-banks along with some of the regionals. The Obama administration will have to keep the depositors happy and calm at all costs. They have to do this to avoid major social unrest; everything else is secondary. The toxic assets end up in a bad bank worth who knows what. Then the mega-banks emerge somewhere down the line as recapitalized private entities. The FDIC will keep depositors and some bond holders happy (we hope). Everyone else: good luck and fasten your seat belts.

Disclosures: No positions.