Contemplating the Demise of Bank of America, Citi and JPMorgan

Includes: BAC, C, JPM
by: Prudent Speculations

The collapse in the share prices of our country’s three largest money center banks over the last week has been truly stunning and is assuredly a crisis of confidence. What started out as a growing unease that the losses of the past year would continue into late 2009 and early 2010 for Bank of America (NYSE:BAC), J.P. Morgan (NYSE:JPM) and Citigroup (NYSE:C) has now snowballed into utter fear that these banks, along with their European peers, could potentially face nationalization as government regulators strive to save a financial system that is still on the brink of cataclysmic failure.

Bank of America, Citigroup and J.P. Morgan have all reported results over the last week and they have ranged from being appalling and awful to just plain bad. One bright spot has been that each of these banks appears to have reduced their exposure to various mortgage securities and derivatives to acceptable levels when compared to where they were in 2007; however, this has come at an enormous cost. Primarily in the form of vast infusions of dilutive government capital that these banks have been required to take since the passage of the first half of the U.S. government’s TARP program.

While losses associated with Bank of America’s, Citigroup’s and J.P. Morgan’s exposure to securities tied to the credit market has likely peaked, each of these banks still face enormous pressures from the rapid economic deterioration that has engulfed the United States and the world. In essence, the banks that toiled in credit market sensitive instruments are facing a double blow; as they must now deal with deterioration in the core of their balance sheets as loans to consumer across the United States begin to deteriorate in quality.

What began with subprime mortgage backed securities and spread to the credit market and its alphabet soup of credit derivative products is on the verge of engulfing Main St. U.S.A. and the bread and butter of these institutions' productive assets. Whereas the regional banks received TARP money to bolster their balance sheets for what was widely viewed as a coming storm, it is painfully apparent that the TARP money received by Bank of America, Citigroup and J.P. Morgan was only used to help the companies recover partially from the implosion of the credit markets. This has left them acutely exposed to a worsening U.S. economy.

As it stands now, the big three U.S. money center banks are clearly unprepared to deal with a severe and deep recession. Had Bank of America, Citigroup and J.P. Morgan found themselves in a position where they did not have to worry about a deteriorating macroeconomic environment, the TARP money that they have already received would have been more than enough; however, this is not the case as December's unemployment data shows. With unemployment creeping up to 7.2% from 6.2% in September and with no sign of any improvement in payrolls we can be assured that the statement made recently by the Chicago Fed Board president that unemployment will rise significantly throughout 2009 and into 2010 is accurate.

For Bank of America, Citigroup & J.P. Morgan such a rise will likely be a deathblow as their significant earnings power will be unable to catch up to surging defaults in their consumer banking divisions. Given their current reserves and their own acknowledged expectations for unemployment rates going forward the balance sheets of these banks will begin to become impaired yet again as the unemployment rate rises above 7.5% and it is likely that they will face near catastrophic stress should the unemployment approach 8.5% - 9%. As a result, it is without a doubt that a significant portion of the second half of the TARP will be designated to these banks, as their capital bases will likely become impaired beyond self-repair in 2009.

In September, J.P. Morgan stated that the bank would face nearly $56 billion in loan losses should unemployment rise to 8% and $42 billion in losses should unemployment rise to 7.5%, yet in its most recent quarterly report, J.P. Morgan stated that it is only likely to experience $32 - $36 billion in losses going forward. This is curious as such a loss projection pays little attention to their past expectations and most importantly to the recent surge in the unemployment rate.

Instead of breaking out their losses in relation to the unemployment rate, as they did previously, the bank is now correlating their losses to a decline in housing prices. Such a correlation is surprising as home prices could easily stabilize before the unemployment rate. Given the bank’s $81 billion in tangible capital and $136 billion in tier 1 capital it is clear that it could survive under its current expectations but increasingly doubtful should the unemployment rate approach and pass 8.5%. If we use the bank’s September numbers as a guide, J.P. Morgan could face an additional $10 billion in losses for each .5% rise in the unemployment rate above 8%.

In looking at Bank of America and Citigroup, one must be a little more creative as neither of these two banks are as open as J.P. Morgan is about their balance sheets and their potential exposures to assets that are in danger of becoming impaired. As a result, we must look at their current loss rates on important sections of their loan portfolios.

For Bank of America the key figure is the fact that the bank only had $1.3 billion of reserves tied to $255 billion in first lien mortgages or about .56%. Such a low reserve amount is shocking and will likely be the point by which Bank of America faces the worst pain going forward. The bank’s total managed consumer portfolio was better, yet still only had reserves of 2.83% on a $694 billion portfolio. In addition, its total commercial portfolio of $380 billion only had reserves amounting to 1.96%.

In comparison, Citigroup sports a larger loan loss reserve pool that will be needed to support a portfolio that is performing significantly worse than either of its larger domestic peers. In a cruel twist of fate, Citigroup’s more global operations could very well prepare it better to deal with a surge in unemployment in the United States.

The future of Bank of America, J.P. Morgan & Citigroup is unquestionably tied to the rise of the unemployment rate in the United States. Should it peak at 8%, the current valuations on these companies make them the buy of a lifetime. On the other hand, should the economy deteriorate significantly and unemployment rise well above 8%, these three titans will become the primary recipients of the second half of the TARP fund.

The United States, despite acting faster than its European peers to battle the credit crisis, is dangerously close to following them down the path of nationalization and must take whatever measures necessary to avoid such an event. With the inauguration of a new administration in Washington we can only hope that Obama’s massive stimulus plan will be expanded, that a national moratorium on foreclosures becomes a reality and that the idea of an “aggregator bank,” as proposed by the head of the FDIC, is given serious credence as these are likely the only steps that will limit federal ownership of Bank of America, J.P. Morgan and Citigroup to current levels.

Disclosure: None