The Stress Test process is a triumph of form over substance. The entire effort is being highly orchestrated for the benefit of the public. I give Bernanke and the Fed an A+ for ‘managing the news’.
On Tuesday Bernanke spoke. On three separate occasions he repeated this theme:
Banks that require additional capital as a result of the stress test will have the choice of (i) Raising equity in the public market (ii) Selling assets to raise capital (iii) Converting ‘existing’ securities into common stock and finally (iv) Receiving additional equity from TARP.
Each time that he said this, he followed with, “I do no not think that we will be forced to use option iv”.
Shortly thereafter there is a leak to the press that Bank of America (NYSE:BAC) needs $34 billion. This actually had the markets down early, but then more leaks. The capital shortfall will be addressed with a ‘conversion’ of the TARP preferred into common stock and a sale of a BAC’s remaining interest in China Construction Bank (CCB).
My guess is that the significant details on the convert and the assets sales will be on the tape by Friday. Over the weekend Bernanke will be on the talk shows saying:
“Yes we had some issues with the banks. Our largest concern was with BoA. We solved that problem. It only took us 48 hours. The good news is that we did not have to spend any more taxpayer money. So, stop worrying and go back to Wal-Mart. I need to boost consumer confidence and spending ASAP. If I do not, my rosy forecast for the year-end economy will not be met and I probably will be out of a job.”
When one looks at a potential investment in a corporate debt obligation the first question to ask is, “How much is below me?” If you want to buy a senior bond you need to understand what the subordinated debt layers are about. If the Sub debt matures before you do, then it is not Sub debt at all. It is senior to you. The same thinking goes to the preferred level of the balance sheet. Is that money really there? Can it be redeemed? The equity has to be looked at too. Is this an air ball of deferred tax assets and goodwill?
When you apply these rules to the Bank of America $34 billion fix, the deal comes up very short of substance.
Converting the TARP Preferred stock into common equity will improve BoA’s position. They will no longer have to pay the TARP dividends (sorry tax-payer). Overtime that will help BoA earn its way out of trouble. It has very little short-term benefit. On the assumption that the amount of Tarp Pref to be converted to common is $26 billion the net savings amounts to only $1.3 billion a year. A rounding number.
The conversion of Tarp Preferred into common improves BoA’s Tier 1 capital ratio. It is an accounting event, not an economic event. If you want to ‘fix’ BoA you have to put real ‘cash money’ equity into it.
The rumored asset sale of CCB will have a more beneficial impact. But not much. BAC’s remaining holdings could be worth $8 billion. The interest in CCB that is now being sold was purchased in November of 2008. That acquisition was done by the holding company. The investment was financed with debt, not equity. The sale will improve the overall gearing ratios. It will add some ‘equity’ back onto the Tier 1 capital line. It will help make BoA look better. But, at what cost? When BoA completed the purchase of CCB five short months ago they said:
Bank of America intends to remain a long-term and significant strategic investor in CCB...
All of the shareholders of BAC including the taxpayers would have reaped benefits from the CCB investment for many decades. To sell it now, in order to create a short term accounting advantage, is just bad business. This is an example of the bad choices that will be made when DC owns the common stock.
I suspect that this ‘white wash’ is likely to work for the time being. At some point in the next six months BAC is going to come to the market with a new Sub Debt deal. It is going to have a fat coupon. It will be a tempting purchase. I will look at it and likely conclude: the Pref is distressed money that does not want to be there, the common is controlled by the Feds, the equity underneath me does not cover the book losses, the earnings power has been diluted by asset sales of good ‘stuff’, the senior debt above me is guaranteed by the FDIC, the deposit base is not captive and they can no longer pay for the talent that they need. I will take a pass on those ‘beautiful’ bonds. Push come to shove they will get converted to equity and the investors will end up side by side with the Fed. No thanks.
On the Sunday talk shows this coming weekend Mr. Bernanke should speak candidly about B of A and the stress test:
Bank of America showed up as the weakest of the 19 banks we stress tested. This is because we had previously converted the bulk of the Citibank TARP Preferred investment into common stock. As a result the Citi Tier One capital ratio has already been gimmicked up. We will do the same deal with BoA. It is a band aide approach for these important institutions. We are going to do it with most of the other 17 big banks as well.
We had to do it this way. We wanted to put more new equity into them so that they could really address their balance sheet problems and earn their way out of trouble. We could not do that. We only have $90 billion of TARP money left. Congress will not give us any more money, so we had to make do. We have to keep the rest of the TARP money available if there is another emergency. Our cupboard is almost bare.
We know that we are making short-term choices that are in conflict with our longer-term best interests . We simply do not have the resources to address the problem today. The banks can’t raise sufficient capital on their own. Therefore we are trying to buy time to fix our weaknesses. We are doing everything that we can to improve the optics of the situation. Because we have no alternative we are going down the exact same road that Japan did twenty years ago.
We have saved the system. The cost will be high. As was the case in Japan, the result will be an extended period of sub par growth.