It’s deja vu all over again.The stock of a humongous American bank, Bank of America (BAC), is collapsing.
This is stoking fears that Bank of America will go bust, taking the whole economy down with it.
Why is Bank of America’s stock tanking?
Because the market thinks Bank of America is worth much less than Bank of America’s management says it is.
In fact, in what is fast becoming a formal law of bank-stock thermo-dynamics, the more the bank insists that everything’s fine, the more investors take this as a signal to run for the hills.
Meanwhile, the more the bank’s stock drops, the more expensive and painful it will be for it to raise cash if and when it finally admits that the market was right all along (the next formal law of bank stock thermo-dynamics being that the market is generally right.)
And given that Bank of America has now persuasively broken the $7 barrier and now has a mere $65 billion of equity value left, this death spiral can’t continue much longer. (The good news, we suppose, is that the stock can’t fall below zero).
Let’s leave aside for a moment the question of what will happen if Bank of America’s stock keeps tanking. After observing the government’s behaviour during the financial crisis, the obvious bet would be that Treasury Secretary Tim Geithner is even now cooking up some new bailout scheme that, per usual, will save the bank and hose taxpayers. But Americans certainly have gotten sick to death of bailouts, so maybe that isn’t such a foregone conclusion this time.
(A year or so ago, if memory serves, the Treasury was trumpeting “financial reform” that allows it to go in and seize any huge institution whose failure threatens the economy, so maybe that’s also a possibility. But the government had that power last time, too–at least with respect to the banks–and it refused to use it. So we’re not sure why it would use it this time.)
The question for today is why is Bank of America’s stock collapsing? What does the market see that Bank of America’s management and auditors don’t?
Thanks to the efforts of a few tireless Bank of America observers, including Zero Hedge and Yves Smith at Naked Capitalism, we have our answers.
Bank of America has about $222 billion of “book value”–the amount that’s supposedly left over when you subtract Bank of America’s stated liabilities from its stated assets.
The trouble is that the market doesn’t believe Bank of America’s assets are worth anything close to what Bank of America says they are worth. The market also doesn’t believe that Bank of America has reserved anywhere near enough to pay the costs of litigation surrounding its mortgage behaviour during the housing boom.
And when you put a more reasonable value on Bank of America’s assets, the market thinks, the difference between that reasonable value and today’s current value will have to be subtracted from the company’s “book value.” And that subtraction, the market thinks, will so demolish Bank of America’s book value that the company is basically insolvent. (And, therefore, will need to raise more capital or go bust).
Here are some of the things that the Bank of America observers think should or will be subtracted from the bank’s $222 billion of book value:
- $15-$20 billion in Increased mortgage-litigation reserves. Zero Hedge thinks BOFA is understating the liability for mortgage litigation costs by this amount. See explanation here.
- Some percentage of $80 billion of “second mortgages.” Yves Smith thinks these should probably be written down by 60%, or $48 billion. You can pick your own number.
- Some percentage of $47 billion in commercial real estate loans.* The “extend and pretend” game in commercial real-estate is even more pronounced than in residential real estate. So as Yves Smith observes, there’s almost no chance those loans are actually worth $47 billion. (UPDATE: Our original post said BOFA’s CRE exposure was $182 billion, which was a number cited by Yves Smith. BOFA said this number was off “by a factor of 4.” Yves has since rechecked the filings and realised that she made a mistake. I apologise for relaying it.)
- A healthy percentage of $78 billion of “goodwill.” Bank of America built itself by acquisition. “Goodwill” is what’s left over when management overpays for something. As Yves Smith observes, Bank of America’s former CEO Ken Lewis loved overpaying for things. He overpaid for Countrywide, for example, which has since been written off to zero, and Merrill Lynch, which he could have had for free by waiting a couple more days.
- Untold amounts of exposure to collapsing European banks and sovereign debt.* Yves Smith says Bank of America says its European exposure is $17 billion. (UPDATE: Bank of America issued a statement clarifying that its “sovereign” exposure–to the debt of PIIGS countries–is $1.7 billion. The overall European exposure is $17 billion. But the big concern here is not just sovereign exposure–debt of countries–but bank exposure. Along with the associated derivatives.) Really? Has the firm not written any credit default swaps protecting customers in the event that European banks or countries go belly up? Might the firm have to post some cash “collateral” to satisfy these contracts? That’s what Lehman had to do, after all. And that’s what made Lehman go from “having plenty of capital” to being broke overnight.
So, taking some back of the envelope numbers, it looks as though we could easily come up with, say, $100-$200 billion in write-offs and exposures to “clean up” Bank of America’s balance sheet.
A $100-$200 billion hit to Bank of America’s $222 billion of equity capital, needless to say, would do some serious damage. Specifically, it would force the company to raise about the same amount to restore its capital ratios.
That’s why Bank of America’s stock is tanking. The owners of that stock will be the first folks to get hit if Bank of America has to raise more capital. And the lower Bank of America’s stock is when it raises more capital, the more they’ll get hit.
And, for obvious reasons, they’re not excited about that.
*UPDATE: In an extraordinary move, Bank of America has issued a statement addressing some of the “claims” in this post. In addition to taking a shot at me personally, the bank challenged two of the numbers I relayed from Yves above. One of them did turn out to be wrong, and I apologise for the error (it has now been corrected). The central point of the post still stands, however: The reason the stock is tanking is because the market does not believe Bank of America’s assets are worth what they say they are worth.