How cute – a well known technology blogger decides to enlist the help of the average investor to crack the case of Bank of America.
All jokes aside, the assertions and speculation around Bank of America the past few weeks has been astounding.
Are they under-capitalised? Do they have a major liquidity problem?
The MBS liability is a real problem, and it remains to be seen whether the ending number is $9bil, $29bil or whatever.
While I will not profess to know whether or not BAC is a good buy or if they face an upcoming crisis – I do hope to shed some light on some very prevalent misconceptions regarding capital and liquidity.
Liquidity- Let’s not be confused. Bank of America is AWASH in liquidity. As of June 30th, they had ~$120bil sitting in cash at the Fed. Further more, they had ~$50bil of US Treasuries & Agency debt as well as $230bil of Agency MBS.
All of these securities can be considered highly liquid. Very reputable commentators have made comments such as, “Buffet’s $5bil investment really helps BAC’s liquidity problem”. This is pure foolishness.
Risk of liquidity comes into play during times of stress when the bank potentially has large outflows of deposits. With total assets as of 6/30/11 of ~$2.3T, you can expect a bank the size of BAC to experience periodic inflows/outflows. In fact, the whole purpose of Basel III’s LCR ration, as I discussed earlier, was to make sure banks had adequate excess liquidity (cash, securities) to meet outflows in a time of extreme stress.
Based on the most recent SEC filings, is there anything to indicate BAC has liquidity problems? Not even close, as you could argue they are drowning in liquidity/cash. Going forward could funding sources dry up? Sure. Core deposits could leave. Unsecured funding lines could be pulled. Repo funding could come under stress. For instance, could anyone have predicted that counter-parties would not lend to Lehman against US Treasuries? One source that will not go away, is of course, the Fed. BAC pledges securities, of which they can borrow a very high percentage against. Forgive me of this rant, please. However, please understand the difference between liquidity and capital!
Capital- If $5 or $10bil in deposits go out the door today, that is not a loss of capital it’s just liabilities (deposits) leaving. This does not hurt capital. Buffett’s $5bil infusion today IS a source of capital and will slightly bolster their Tier 1 ratio’s. Does this help their liquidity situation? As shown above, its barely a blip on the radar. With a Tier 1 ratio of ~8.25%, BAC has over $180 in capital. Could they need additional capital to account for the MBS settlement? Sure.
Something that hasn’t been noted is that BAC has large unrealized gains in their AFS securities portfolio. As of June 30th, they had a total taxable AFS portfolio of ~$328bil. At the time, they had unrealized gains of ~$6.3bil. If we assume an average duration of ~5, and a 1% drop in the 10yr treasury, we can speculate that they have an incremental $16bil in gains for a total of over $22bil. That’s right, if they wanted, BAC could organically raise ~$22bil in capital through taking gains. Yes, that’s over 4x the Buffett investment. There are obviously repercussions for taking gains out of the AFS portfolio (NIM contraction from lower re-investment rates), however the opportunity exists for BAC to take gains and raise their Tier 1 ratios.
The key to remember is that their is a clear distinction between liquidity and capital. It is almost impossible to project whether a banks funding base will be able to withstand a time of stress. However, by looking at some very basic things in the recent 10-Q or 10-K you can draw some simple conclusions regarding their current position.