Bank of America's Desperate Move for Capital

In an unexpected announcement, Bank of America (BAC) released their 3rd quarter earnings results and announced that they will be cutting their dividend and issuing new common shares to raise capital.  After an interview on CNBC yesterday, CEO Ken Lewis stated that a dividend cut wasn’t completely out of the picture, and that they would do what was best for the company going forward.  Bank of America was obviously in worse condition than he made it seem, as they not only had to cut their dividend, but they also sold $10 billion in new capital as management said that “recessionary conditions” are causing problems in the bank.  For the past couple of weeks, Bank of America looked as if it may be the strongest bank after the acquisition of Merrill Lynch (MER), but obviously more capital was needed than many analysts originally thought.

Bank of America decided to release their 3rd quarter earnings results more than 2 weeks before they were expected to.   They reported net income of $1.18 billion, or 15 cents per share, which was 68% lower than last year’s results of $3.70 billion, or 82 cents per share.  The results were much lower than analyst expectations of 62 cents per share, which were the average pole from Thompson Reuters.  Losses on mortgages and credit cards weighed down the results as its provisions for credit losses were $6.45 billion, up from $5.83 billion in the second quarter.  Net charge offs grew 20% to $4.36 billion compared to the 2nd quarter.  Non performing assets were $13.3 billion, or 1.42% of total loans, leases, and foreclosed properties.  The results were much worse than analyst had expected which sent shares down over 10% in after hours trading on Monday.

Along with the earnings announcement, B of A also announced that they will be cutting their dividend by 50% from $0.64 to $0.32.  This move will add more than $1.4 billion in capital each quarter and over $5.6 billion in capital each year.  The company also announced that they will be selling $10 billion in common shares to raise capital.  Management is hoping that these moves will help keep the bank’s Tier 1 capital ratio near 8% and cover the higher than anticipated credit losses.  Bank of America’s Tier 1 ratio was 7.5% at the end of September.  A tier 1 ratio of 6% is required by regulators.

In a recent Wall Street Journal Article, CEO Ken Lewis was quoted while speaking with analysts:  “It’s a damn disaster… We are making every good loan we can find” but “it’s not going to be pretty for awhile.”  In another release, Mr. Lewis blamed “recessionary conditions” for the moves that the bank made to raise capital.  “These are the most difficult times for financial institutions that I have experienced in my 39 years in banking,” he said in a release.  Anticipating displeasure from investors in response to the cut, Mr. Lewis said: “We cannot pay out what we have not earned.”  Mr. Lewis expects these volatile markets to continue with charge offs not peaking until “well” into 2009.

Many analysts have criticized Ken Lewis for making too many acquisitions during his tenure.  During the past five years, he has engineered more than $100 billion in acquisitions.  Earlier in September, Ken Lewis and John Thain came to an agreement where Bank of America purchased all of Merrill Lynch in a 100% stock deal.  The deal valued Merrill Lynch at approximately $50 billion, or $29 per share, which was a 70% premium from their previous day’s close.  The all stock transaction will be based on an exchange ratio of .8595 shares of BAC and will close sometime next quarter.  The deal valued Merrill at 1.83x tangible book value and 12.1x 2009 EPS.  Management is expecting that the deal will be 3% dilutive in 2009 and breakeven in 2010 using synergies of $7 billion.  Personally, I think that this $7 billion pre-tax expense efficiency is a very high target to achieve.  The deal may not end up being accretive to current shareholders until well after 2010.  Bank of America had been looking at Merrill Lynch for a long time, as they valued their investment banking and trading businesses very highly.  Merrill’s operations also give Bank of America the growth in emerging markets that they were looking for.  Immediately following the deal, Standards & Poors cut their credit rating on B of A to AA- from AA and kept the rating on watch for further write-downs.  Management claims that they will be able to merge the two businesses successfully, stating that this isn’t the first time that they have done it.  A merger of this size, especially right after a merger with Countrywide is certain to cause problems in the bank.

Bank of America is growing too fast and is becoming too large to manage.  Without proper control, Bank of America is going to be a repeat, if not worse, of how Citigroup (C) operated for the past 10 years.  This stagnant growth will hurt B of A as they try to expand in too many divisions.  This capital raise shows how desperate Bank of America is for capital.  Ken Lewis is also a power hungry CEO who is looking to grow his business without regards for his shareholders.  I believe that the Merrill Lynch deal will be profitable in the long-run for Bank of America, but will be extremely dilutive to current shareholders in the near term.  If you are looking to diversify your portfolio with a large cap bank, I would lean towards investing in Citigroup or J.P. Morgan Chase (JPM).

Disclosure: The mutual fund the author is associated with seeks to establish a long position in JPM

Comments

[Jimmy Lathrop:]

Yeah, this isn't going to end well at all.

seekingalpha.com/artic...

2008 Oct 08 08:00 AM

[paul:]

Best info I can find says that the min Tier 1 capital requirement is 4%. Unless this has changed recently.

2008 Oct 09 02:49 PM

[directcommu...:]

The fed is interested in using the 700 bil bail out fund to buy an ownership stake on these financial institutions. Maybe GWB is really a brilliant man who thought this whole scheme out in the beginning.

2008 Oct 09 07:47 PM