Today, Bank of America management finally acknowledged what the market has long suspected—the company needs money.
This morning, Bank of America sold 50,000 shares of preferred stock and 700 million options to Warren Buffett for $5 billion.
This was very expensive money. Six months ago, Bank of America could have raised this capital at a vastly lower cost to its shareholders. But that’s the penalty for failing to be conservative and waiting to raise money until you absolutely have to.
Relieved that management is finally facing reality, Bank of America shareholders have bid the stock back up to $8 a share. This is still less than half of the company’s book value, though, which suggests the market thinks there’s still plenty of reality that management has yet to face up to.
As you may recall, I wrote an article earlier this week about why Bank of America’s stock has tanked ~40% in a month.
The article explained that the market does not believe that Bank of America’s assets are worth what Bank of America says they are worth.
The market thinks that Bank of America will eventually be forced to acknowledge that its assets are not worth what it says they are worth and write down their value. And this action, the market thinks, will demolish Bank of America’s book value and force it to raise even more additional capital. (Or, if the losses are spread out over many years, just become a colossal, lumbering zombie).
As you may also recall, my article made Bank of America so apoplectic that it threw a mud-pie at me. This, in turn, prompted a lot of opining on TV and elsewhere about the condition of Bank of America. It also prompted one person to call me a “d-bag”—direct quote!—and suggest that writing posts about why Bank of America’s stock is collapsing is “irresponsible.”
Well, to be honest, the last thing I want to do with the last few days of summer is waste our collective time thinking about Bank of America, especially when there are so many more important things to focus on. But given the attention my article received, as well as the fact that Bank of America is one of the biggest banks in the country and its stock price suggests it still has serious problems, I also wanted to delve in a bit deeper.
I asked readers to help by sending me analyses of Bank of America, and they sent in a lot of great stuff (thank you!). I also had some exchanges with a couple of bank analysts who know far more about banks and Bank of America than I ever will. These were also extremely helpful.
Thankfully for Bank of America shareholders (like me), Bank of America management has begun to face up to reality. This reduces the risk that Bank of America will enter a death-spiral and go down the tubes. Today’s Warren Buffett investment, however, was a classically brilliant Warren Buffett investment in that it takes care of Warren Buffett first: Buffett will collect a 6% dividend and own a preferred security that will be partially protected from future Bank of America losses. And he will also get an option to buy a staggering 7% of the company. Regular old Bank of America shareholders like me get neither of those things. If Bank of America is forced to raise additional capital, the dilution will come right out of our hides. So assessing how much capital, if any, Bank of America will need will continue to be important.
One could spend months peering into the depths of Bank of America and never know anything for certain. But here, in bullet form, is what I have concluded so far:
- No one knows what Bank of America’s assets are worth—including Warren Buffett and including the experts opining all day on TV. The market’s collective assessment—that Bank of America’s assets are worth much less than Bank of America says they are worth—is probably the most meaningful estimate out there. Bank of America itself may have a better idea of what its assets are worth than the market does, but Bank of America is keeping critical information secret.
- Assessing the value of Bank of America’s assets is extraordinarily complicated, and Bank of America has not disclosed enough information for even super-sophisticated bank analysts (or Warren Buffett) to reliably do it. Bank of America has published a mind-boggling amount of detail about its assets and business, but according to several professional bank analysts, this is not nearly enough detail for any outsider to really know what’s going on.
- Bank of America’s balance sheet is so huge—$2.2 trillion—that even a 5%–10% “haircut” to the value of its assets would result in write-offs of $100-$200 billion. This would zero out Bank of America’s tangible equity and wallop its book value.
- Bank of America’s stock is behaving exactly the way the stocks of AIG, Lehman Brothers, Bear Stearns, Wachovia, and other doomed financial institutions behaved in the early stages of the financial crisis. Which is to say, the stock keeps dropping, with intermittent rallies, while management keeps insisting that everything is OK.
- Bank of America’s management is behaving exactly the way the managements of AIG, Lehman, Bear, Wachovia, and other doomed financial institutions behaved in the early stages of the financial crisis. Which is to say, they are indignantly insisting that everything is OK and blaming their stock price declines on “shortsellers” (and me). Thankfully, now, with the Warren Buffett deal, they are finally facing reality.
- Bank of America has several categories of assets that might well be worth less than Bank of America says they are worth. Taken together, these add up to big numbers. The categories include (but are probably not limited to):$17 billion of European exposure, including $1.7 billion of sovereign debt of PIIGS countries $67 billion of net “derivatives” assets—(~$1.9 trillion before netting). Derivatives are what Warren Buffett once referred to as “financial weapons of mass destruction.” No one outside Bank of America knows what’s in them, what they’re worth, or what might cause them to explode. Derivatives played a role in killing Lehman and AIG—and no one on the outside of these companies had any idea what was about to hit them. $78 billion of “goodwill,” which is the residual carrying value of acquisitions Bank of America made long ago. This goodwill may or may not be worth anything. $47 billion of commercial real-estate loans, per two analysts $408 billion of residential mortgage loans (as of Q1), comprised of $274 billion of first mortgages and $134 billion of Home Equity Lines Of Credit, per one bank analyst (more on these below). Some of the above assets roll up into… $73 billion of “level 3” assets, which are carried at extremely subjective valuations (These assets don’t have freely traded market comparables. It was this category of assets, in part, that killed Lehman Brothers) ~$500 billion of “level 2” assets, whose values are determined with models (which, in turn, are driven by assumptions that may or may not be conservative).
- $17 billion of European exposure, including $1.7 billion of sovereign debt of PIIGS countries
- $67 billion of net “derivatives” assets—(~$1.9 trillion before netting). Derivatives are what Warren Buffett once referred to as “financial weapons of mass destruction.” No one outside Bank of America knows what’s in them, what they’re worth, or what might cause them to explode. Derivatives played a role in killing Lehman and AIG—and no one on the outside of these companies had any idea what was about to hit them.
- $78 billion of “goodwill,” which is the residual carrying value of acquisitions Bank of America made long ago. This goodwill may or may not be worth anything.
- $47 billion of commercial real-estate loans, per two analysts
- $408 billion of residential mortgage loans (as of Q1), comprised of $274 billion of first mortgages and $134 billion of Home Equity Lines Of Credit, per one bank analyst (more on these below).
- Some of the above assets roll up into…
- $73 billion of “level 3” assets, which are carried at extremely subjective valuations (These assets don’t have freely traded market comparables. It was this category of assets, in part, that killed Lehman Brothers)
- ~$500 billion of “level 2” assets, whose values are determined with models (which, in turn, are driven by assumptions that may or may not be conservative).
- All of these assets are balanced against about $230 billion of shareholder’s equity (“book value”) at June 30, including Buffett’s investment. $230 billion of shareholder’s equity may sound like a lot, but it’s not when measured against the size of the balance sheet ($2.2 trillion). Again, a 5%–10% haircut in the value of the assets would blow a huge hole in the balance sheet (or, if the hit is spread out, depress earnings for many years).
- It is not just Bank of America’s reported assets and liabilities that could clobber the company––it’s the unreported ones. Think back to why Lehman, AIG, and other financial firms imploded with little warning: A big contributing factor was the “collateral” the companies suddenly had to come up with to satisfy derivative contracts no one knew existed. No one knows who the counterparties for Bank of America’s $1.9 trillion of derivatives are. No one knows what the terms of these contracts are. Hopefully, we’ll never know––but if things get bad enough, we might suddenly find out.
- It is now the consensus of Wall Street analysts that Bank of America needs to raise more capital––the only question is how much. A couple of months ago, most analysts were saying that Bank of America had plenty of capital. Now, even Bank of America bulls are arguing that its capital needs are “manageable.” This, too, is reminiscent of the fall of 2008, when analysts moved from insisting that financial firms had plenty of capital to saying that they needed capital to watching them go bust. Most analysts think Bank of America needs a lot more capital than the $5 billion Warren Buffett just injected into it. I wonder what the Bank of America consensus will be in a few months.
- It’s certainly possible that the market is wrong about Bank of America and that, as management insists, everything’s fine. Sometimes the market is wrong. Sometimes the market just gets nervous for a while and then gets comfortable again. Perhaps that’s what’s happening this time.
- But Bank of America’s management is not behaving as if everything is fine. I’ve been observing management teams for two decades now. Generally, the more management teams make their communications about “shooting the messenger” (often a shortseller or sceptical analyst), the more likely it is that the messenger has hit close to the mark. The mud-pie that Bank of America threw at me earlier this week, in my opinion, was a classic example of shooting the messenger.
So that’s what I’ve concluded about Bank of America so far. Again, this does not mean Bank of America is hosed––and as a Bank of America shareholder and American taxpayer, I certainly hope it isn’t. It just leaves me concerned that the market is right about Bank of America and Bank of America management is wrong.
ONE MORE THING: ABOUT THOSE REAL-ESTATE LOANS…Before I leave this topic, I want to shine some additional light on one category of Bank of America’s assets that gives one analyst I spoke to serious pause.
That category is real-estate.
Bank of America has approximately $450 billion of real-estate loans on its books, ~$400 billion of which are residential.
The analyst I spoke with thinks that Bank of America may well end up booking $80-$100 billion of losses on this asset category alone.
What follows is this one analyst’s assessment of Bank of America’s real-estate loans, and the potential losses embedded within them. I am sure many other bank analysts disagree vehemently and think this analyst is an idiot. Dick Bove of Rochdale, for example, seems to think that Bank of America is in pristine shape. John Hempton of Bronte Capital, who is the farthest thing from an idiot, thinks that the market’s overreacting and Bank of America is fine.
To understand why the analyst I talked to is so bearish about Bank of America’s real-estate loan portfolio––and why his analysis likely merits some consideration––you need some backstory.
Bank of America, you will recall, bought Countrywide, which was one of the worst mortgage-underwriting-and-securitizing offenders during the housing bubble. It also bought Merrill Lynch, which was another.Merrill Lynch and Countrywide blew up during the financial crisis, almost taking Bank of America down with them. Bank of America wrote off much of the Merrill-Countrywide damage, strengthening its balance sheet in the process. But the wreckage of these two companies’ mortgage “assets,” however, has not been completely rinsed away. And the analyst I spoke with thinks that what remains may be giving Bank of America big trouble.
The reason that Merrill Lynch and Countrywide blew up so fast, in part, is that most of their loans were “securitized”––which means that they were rolled up into mortgage-backed securities and resold by Wall Street. Mortgage-backed securities are generally “marked to market” on bank balance sheets, which means that their values are adjusted depending on the prevailing market values. When the housing bubble burst, the market values of mortgage-backed securities plummeted, and, as they fell, companies like Merrill had to take huge write-offs. These losses demolished the companies’ capital, forcing them to raise additional capital to survive (which many didn’t).
Since the peak of the housing bubble, my analyst tells me, the value of “securitized” residential mortgage assets across the industry has been written off or paid down by ~$700 billion, from ~$1.9 billion at the peak of the bubble to about ~$1.2 billion today.
And that’s actually good news.
Because, thanks to write-offs (and other forms of resolution), the current carrying values of mortgage-backed securities are much lower than they were at the peak of the bubble. This means that there is less potential downside to the values of these assets than there was a few years ago.
But now for the bad news…
Another huge class of residential mortgage assets––whole loans that were NOT securitized by Wall Street––does not have to be “marked to market” on bank balance sheets. Instead, as long as a bank intends to hold a loan as an investment, the loan can be carried at the price at which it was acquired (less any provisions for loan losses, which are highly subjective).
Collectively, says my analyst, U.S. banks own about $2.7 trillion of residential mortgage loans, of which about $700 billion are home equity lines of credit (HELOCs). The top 4 banks, which includes Bank of America, own $1.15 trillion of these loans, including more than half of the HELOCs. These loans are subject to the same real-estate market pressures that destroyed the value and performance of the securitized mortgages, but banks have hardly written down their values at all.
(My analyst did not have an industry-wide figure for the dollar value of these loans that have been written off since the peak of the bubble, but he believes it’s small. If any readers have such a figure, please send it along.)
On a percentage basis, my analyst says, the value of securitized mortgages has been written off or paid down by about 35% since the peak of the bubble, from $1.9 trillion to $1.2 trillion. The value of whole loans, meanwhile––$2.7 trillion, according to my analyst––has barely budged. And almost all of it–except for $77 billion of newly issued mortgages–consists of bubble-era legacy loans.
Instead of writing down the value of whole loans, my analyst says, banks are simply reserving against them in their provisions for loan losses. But in the analyst’s opinion, they aren’t reserving anywhere near enough.
(In fact, in recent quarters, before the economy weakened again, banks have been reversing these loan losses, which has inflated their earnings.)
The other problem, says the analyst, is the way the the remaining $1.2 trillion of securitized loans are performing. (Unlike the whole loans, we have accurate and detailed industry data on the performance of the securitized loans–so we can analyse them in detail).
According to a recent analysis by Amherst Securities, one of the experts in the field, about $370 billion, or ~30%, of the $1.2 trillion of outstanding securitized loans are not performing–meaning that the borrowers are not making their payments and may be on their way to defaulting.
The performance of the securitized loans, the analyst says, suggests that a similar level of the whole loans may not be performing, despite what the banks are saying about them.
Another potentially important piece of data from the securitized loans is that another ~$200 billion, or ~15%, are classified as “re-performing,” which means that owners were not making payments but have started making them again. The risk is that many of these loans may slip back into non-performing status, as modifications fail or homeowners finally give up on saving their houses as the economy weakens again.
If the “non-performing” and “re-performing” securitized loans are taken together, a staggering ~50% of the securitized loans are having problems. If the percentage of whole loans that are having problems is anywhere close to this percentage, the implications could be huge.
According to a recent report by the Office of the Comptroller of the Currency (OCC) and Office of Thrift Supervision (OTS), approximately 20% of the loans held by banks and thrifts were in some stage of non-performance at the end of Q1. The OCC and OTS do not provide a breakdown of this performance by bank. But it’s another indication that the performance of whole loans may be worse than many banks are letting on.
AND THAT BRINGS US TO BANK OF AMERICA…At the end of the first quarter, my analyst says, Bank of America was carrying $408 billion of residential mortgages held for investment (ie, not marked to market). Against this, my analyst says, the bank had only reserved $20 billion in loan-loss provisions.
$20 billion of losses on $408 billion of loans is about a 5% loss rate.
This compares to the ~30% of industrywide securitized loans that are non-performing and the ~50% of industrywide securitized loans that are either non-performing or “re-performing.” It also compares to the OCC/OTS conclusion that 20% of industry-wide loans were in some stage of non-performance at the end of Q1.
So that gives my analyst pause.
(Bank of America’s loans could be better than the industry average, obviously. But they would have to be a lot better for the 5% loan-loss provision to be conservative.)
The other thing that gives my analyst pause is his belief that most of the loans that Bank of America is carrying as whole loans are among the worst mortgage loans of all the mortgage loans made during the housing bubble.
Because, according to the analyst, only a relatively small percentage of these loans have been originated since the housing bubble burst (i.e., on saner, more sustainable housing values). Most of the loans that were originated in the early years of the housing bubble, meanwhile––which were also issued on saner, more sustainable house values––were securitized by the Wall Street securitization machine.
So my analyst is betting that the loans that banks like Bank of America are carrying as whole loans are mostly loans that were originated near the peak of the housing bubble, when the securitization machine began to break down and when house prices were at their highest. On average, therefore, my analyst thinks, those whole loans may have a worse loss rate than the ones that were securitized.
SO, WHY AREN’T THESE CRAPPY LOANS SHOWING UP IN BANK OF AMERICA’S FINANCIAL STATEMENTS?So if Bank of America’s residential loan portfolio is so bad, why isn’t this visible in the company’s non-performing loan statistics? And why haven’t banks like Bank of America started being more aggressive about foreclosing on these bad loans and writing them off?
On the first question––why haven’t the loans been showing up in the banks’ Non-Performing-Loan totals––my analyst thinks that banks like Bank of America are gaming the accounting rules to avoid taking write-offs.
For example, my analyst thinks banks are allowing delinquent homeowners to skip a few months of payments and then make one payment just before the loan would have to be classified as non-performing. This technique, the analyst says, would “reset the clock” and thus allow banks to make it appear that loans are performing when they aren’t.
As to why banks like Bank of America won’t just foreclose on deadbeat borrowers, or permanently modify their mortgages by writing down the principal balances, my analyst is convinced that banks just don’t want to take the capital hits. Doing either of these things––foreclosing or permanently modifying a loan with a principal write-down––would force the bank to take a big write-off. And the banks, my analyst thinks, are doing everything they can to avoid taking those losses.
THE BOTTOM LINE
So, in short, my analyst thinks that banks like Bank of America have huge “embedded” losses in their mortgage portfolios–losses that have yet to be taken as write-offs and, therefore, have yet to hit the banks’ capital. These losses, my analyst believes, will eventually inflict themselves on the banks one way or another.
Now, importantly, my analyst does not KNOW any of this. The banks are not required to disclose the information necessary for the analyst to precisely determine the actual condition of the banks’ whole loans, so it is impossible for the analyst to verify his suspicions. But based on anecdotal information, he is confident that he is right.
This analyst, by the way, is not a “shortseller.” He’s just a well-connected industry analyst who wants to remain anonymous so banks and bank investors don’t get mad at him and call him a “d-bag.”
So, is this analyst right? Do Bank of America and other huge US banks have hundreds of billions of dollars of embedded loan losses that they have yet to recognise?
No one knows–except, perhaps, the banks.
But to this non-bank analyst, at least (me), the bearish analyst’s concerns sound valid.
And that leaves me even more concerned that the market is right about Bank of America and Bank of America management is wrong–and that the bank needs a lot more capital.
If you have information or insight that would support or refute the analyst’s thesis–or otherwise help our investigation of Bank of America–I would love to hear from you. Please write to me at [email protected]