Whalen: Bank of America is Worth Zero
Posted in Zeitgiest on October 7th, 2009 by AGY – Be the first to commentCrackback: http://dailybail.com/home/guest-post-from-analyst-chris-whalen-bank-of-americas-equity.html
Bank Of America–How Much Should Bondholders Be Haircut To Restore Solvency?
“Banking in all countries hangs together so closely that the strength of the best may easily be that of the weakest if scandal arises owning to the mistakes of the worst… Just as a man cycling down a crowded street depends for his life not only on his skill, but more on the course of the traffic there.”
Hartley Withers The Meaning of Money
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This past week in the IRA Advisory Service, we added M&T Bancorp (NYSE:MTB) to our coverage list. As of Q2 2009, MTB was rated “A” by the IRA Bank Monitor’s Stress Index due to its below-peer loss rate and strong operating results. We also started to describe for our clients our concerns about the outlook for Bank of America (NYSE:BAC), which was rated “C” as of Q2 2009 by the IRA Bank Monitor.
Click here to register for the IRA Bank Cart and look up the rating for your bank.
If you reduce the increasingly difficult situation facing the largest banks down to its essence, the problem is politicians picking winners and losers. If we don’t have losers in our economic life, then there are no winners either. If we don’t resolve troubled banks, then all of our banks will be bad, as the century-old Whithers quote above suggests. And the fact that Washington will not let large, mediocre institutions such as BAC fail means that our entire financial system is getting sicker, not recovering as the politicians ask you to believe. The different financial and operational situations facing BAC and other members of the large bank peer group illustrate the point.
As we told CNBC’s Fast Money on Friday, the departure of Ken Lewis as CEO is probably the best news for BAC equity and bond holders in many years. Whoever is eventually selected to replace Lewis, though, is facing a tough task. In his column in the New York Times over the weekend, Joe Nocera makes that point as he talks about the culture of mediocrity that Lewis promoted at BAC, a culture where competent managers were systematically forced out by the human resources department of BAC.
For all of his insider savvy and HR muscle within the bank, Lewis really was not an operator. BAC, after all, is a combination of dozens of companies merged over the last 30 years that were never actually integrated. The mergers “worked” because the old NCNB HR department ruthlessly squeezed down personnel costs. These are “process” people, after all, who believe that you can identify tasks that can be done by one person, then train that person and pay him/her well below average. This is what they call “synergies” at BAC. This goal of short-term cost cutting pervades BAC and has led to an organization that produces narrowly focused employees and business units, with no incentive to innovate or manage risk on an enterprise basis as required by Sarbanes-Oxley, not to mention federal banking laws.
The operational mess left behind by Lewis at BAC makes a mockery of terms like “internal systems and controls,” as used in the Sarbanes-Oxley. As Nocera describes, Lewis forced his managers into product silos instead of a customer focused horizontal organization, and never attempted to fully integrate the organization so as to have a complete view of the risks the bank takes on both retail and institutional exposures. For example, an individual customer at BAC could have many distinct contacts with the bank; a branch banker, private banker, high touch brokerage, discount brokerage, a HELOC lending officer, a mortgage lending officer, a credit card representative, and a P&C insurance rep, to name just a few of the possibilities. And all of these silos come together only in Ken Lewis’ office. Thus there was no way for the mortgage credit guys to stop the HELOC guys from making huge credit mistakes. And like most big lenders, they did make huge mistakes.
Keep in mind that Hugh McColl and Lewis reportedly disliked to spend money on integration. Few of the IT systems in the various targets acquired over the years actually talk to one another. Even had Lewis wanted his managers to, they could not do so. This is why, to this day, each state in which BAC operates has a distinct ABA#. Inter-district deposits and payments must be processed by hand. And the same penny-wise mentality has now stripped most of the value — that is, highly skilled, experienced people — out of Countrywide and Merrill Lynch.
Now contrast the situation at BAC with JPMorgan Chase (NYSE:JPM), which has for many years excelled at integrating acquisitions quickly and onto a common IT platform. Indeed, while many give Jaime Dimon high marks as an M&A banker - and we do as well - the real secret of the JPM deal machine is the excellent back office staff, a rich legacy that goes all the way back to the merger with Chemical Bank. Yeah, that’s right, Chemical Bank, one of the most technologically advanced institutions of its time. This is one reason why we constantly remind our clients that banks, even large banks, are vastly different one to the next. But in addition to operations, the key distinction to make between BAC and JPM is senior management.
As we have noted before and we’ll probably state again, the difference between BAC and Wells Fargo (NYSE:WFC), on the one hand, and JPM on the other, is that Jaime Dimon had the good sense to buy WaMu from the FDIC after it was restructured via the resolution process. All of the legacy liabilities of WaMu, including the legal liabilities from the massive securitizations sponsored by Washington Mutual Inc., were left in the DE bankruptcy court after the FDIC took control of the bank unit. That is why the cleansing process of bankruptcy is so important to the restoration of a healthy, growing economy.
The founders of the United States did not embed a requirement in the Constitution that the Congress create federal bankruptcy courts because they were nice guys. Rather, they knew that a healthy society needs finality in matters of insolvency, a crucial truth that concepts such as “too big to fail” and “systemic risk” short-circuit. For every loser in a business failure, like the equity and bond holders of Washington Mutual Inc., there is a winner, as in the equity and bond holders of JPM. This is why arguments made by economists and politicians about the frightful “systemic” effects of large bank failures do us all such a disservice. Economists, never forget, are basically risk averse, otherwise they would run real businesses, employ real people and take real risks in the markets instead of just talking about them in theory.
While the Big Media focuses on the personalities and political problems at BAC, we instead focus our Advisory Service clients on the rest of the story, namely the bank’s festering off-balance sheet (”OBS”) exposure from securitized HELOCs, first lien mortgages and complex structured assets that are a legacy of the Countrywide and Merrill transactions, and also of BAC’s own securitization activities. Countrywide reportedly securitized nearly 80% of its HELOC loans, rancid credits that now trade in the 40s in the distressed markets, so just do the math.
Banks currently report that 5% of the $1 trillion or so in existing HELOCs are delinquent, but our sources in the secondary market say that the true situation is closer to 15%. In the current deflationary environment in real estate, the loss severity on these HELOCs is likely to be 100%. Now you know why the largest banks are working so hard to reduce unused lines (See “Exposure at Default: As Banks Shrink, So Does the Economy”), but EAD only measures on-balance sheet exposures. If you want to understand the totality of the potential loss exposure facing the largest banks that were active in securitization, take the FDIC data series for unused credit lines and add a zero.
By eschewing securitization and buying banks after they have been restructured, JPM gained a huge advantage for its equity and bond holders. BAC and WFC, on the other hand, still face the daunting task of cleaning up the mess left by the troubled acquisitions of Countrywide, Merrill Lynch and Wachovia. In the case of BAC, we hear that this includes buying defaulted mortgage paper at par from the various securitization vehicles sponsored by BAC directly or acquired from Countrywide and/or Merrill Lynch. The latter, in case you’ve forgotten, was the biggest CDO sponsor on Wall Street. This is one reason we told our friends at Fast Money that we believe BAC is next in line behind Citigroup (NYSE:C) in terms of financial problems and could be back in the arms of the US government by the middle of 2010.
The thing that many people still don’t understand about securitizations is that it was not just overtly profitable for the sponsors. There also was a hidden profit in many deals that were not disclosed, a profit that is now become a liability. Consider a hypothetical example based on actual deals. Say Countrywide created a new DE trust and contributed $100 million face amount of loans to the entity, call it “QSPE1″ for “qualifying special purpose entity” under the FASB rules, which incidentally are scheduled to be rescinded at the end of the year. The folks at Moody’s (NYSE:MCO), S&P or Fitch would then be paid a fee to provide a rating for the new entity prior to the issuance of securities. We’ll come back to this point in a future comment.
In return, QSPE1 gave Countrywide an IOU for $100 million and then sold bonds to investors for at least that amount, allowing QSPE1 to repay the IOU to Countrywide. But the dirty little secret that Wall Street still conceals from the Congress, the public and the shareholders of all banks is that the collateral contributed by Countrywide to QSPE1 was not worth nearly $100 million, but in some cases closer to $95 million or even less. This is why during the interview earlier this year(”Back to Basis for Securitization and Structured Credit: Interview With Ann Rutledge’), Ann talked about the fact that the mezzanine tranches of many late-vintage securitizations never converge on “AAA,” unlike an auto or credit card securitization. In plain English, this means that there is never enough collateral inside QSPE1 to pay the investors interest and principal — without an under-the-table subsidy from the sponsor.
For many years in the securitization sector, the fact of a secular increase in the value of collateral masked these unsafe and unsound practices in the banking industry. Sponsors such as Countrywide were assumed to be willing to “cure” such defects — that is, substitute collateral in the event of a default or advance cash to the securitization trust — in order to make sure that the trustee in charge of QSPE1 was able to make timely payments to bond holders. The legal fiction was that QSPE1 and Countrywide were separate entities, but the economic reality is that QSPE1 and Countrywide are one and the same.
Click here to see Ann’s presentation from the June 10, 2009 PRMIA event, “Regulation of Credit Default Swaps & Collateralized Debt Obligations.” Look at slides 12-16, showing various securitizations by Ford (NYSE:F) and the last by Countrywide. Notice that while all of the F deals converge on “AAA” early, the Countrywide deal never accumulates sufficient collateral and cash to ensure repayment of bond investors. Only because Countrywide and other issuers were willing to “cure” these deals with undocumented payments to the securitization trust could investors ever be repaid.
In fact, the reliance by Buy Side investors and regulators on the reps & warranties by sponsors of securitizations provided a source of hidden recourse all the way up the securitization food chain. And not just in residential mortgages. By the early part of this decade, the practice of under-collateralization of securitizations became a pervasive problem for any type of origination that had scale, at least inside the institutions for whom cheating was the business model, including Countrywide, C and Lehman Brothers.
Securitization was once a hidden cash cow for the sponsors, but now that the situation is reversed. Collateral values have fallen dramatically and will fall further in the next 12-18 months, thus banks such as BAC, WFC and C must take that hidden windfall profit out of their pockets and essentially reverse the original transaction - and then some. Otherwise they get sued. This is why the dealers are desperately trying to buy-off prospective plaintiffs with under-the-table payoffs to prevent this ugly reality from being exposed through litigation. This is yet another reason why we laugh uncontrollably when the economists suggest that Lehman should or could have been bailed out.
So now you know why we remain so bearish on BAC, WFC, C and other aggressive sponsors of the trillions of dollars in securitizations originated over the past decade. And the sad part is that for retail investors, there is still virtually no disclosure by these banks describing this specific risk factor. That is why many Sell Side firms are still able to post “Buy” recommendations on BAC and its peers, because they can point to the paltry public disclosure filed with the SEC and say: “Gee, we didn’t know.” But you can bet that just about every Sell Side analysts who follows money center banks for a living knows precisely those hidden risk factors of which we speak.
And now you too understand why the banking industry and even federal bank regulators have been making noises about delaying the change in the FASB rules regarding OBS vehicles like QSPE1 in our hypothetical example above. But as we explained to subscribers to The IRA Advisory Service last week, whether the FASB changes the rules or not will be irrelevant to the economic and true legal reality facing the large issuers of securitization. We’ll be digging into the details of BAC’s OBS black hole in the IRA Advisory Service in coming weeks.
Keep in mind that federal regulators, who have been aware of the problems with securitization since day one, have made this situation progressively worse by allowing large zombie banks to continue to merge with one another, especially in the case of BAC. Ken Lewis and the HR department of BAC have already destroyed much of the value of Countrywide and Merrill Lynch by driving many of the best people out of these organizations. But the real question to ask is why the economists and lawyers who populate the federal bank supervision community permitted and even encouraged these mergers in the first instance.
Just as Lewis and his henchmen in the HR department of BAC drove the best people out of that organization by picking winners, our political class in Washington, in the Congress and among the regulatory community, is doing the same thing with the “too big to fail” banks. And by continuing to protect large zombie banks under the ridiculous rubric of “systemic risk,” we are dooming the US economy to years of economic stagnation and mediocrity.
The only reason the US economy regenerates itself is because we allow failure. When we legislate away the opportunity for failure, we also eliminate the possibility of renewal and gain. The more we try to avoid systemic risk, the more America will become like the moribund states of the EU, where corporate failures are effectively outlawed, there is no private capital formation to create new banks and companies, and there is no growth in employment or opportunities for the vast majority of Europeans.
At the end of the day, the true threat of “systemic risk” is not financial, but political. Until we purge this creation of the economists from our national vocabulary, we are not going to make any progress toward emerging from the current crisis. As we told our friends on Fast Money , the good news is the recession is over, but the bad news is that the depression has begun. And this next downward leg of the economic crisis will be deeper and more painful because we allow politicians in Washington to pick winners and losers in our financial markets.
So far, the winners have been the bond holders and the counterparties of the zombie banks and AIG, who are subsidized by equity infusions from the US Treasury. But we notice that Bloomberg News reports that FDIC Chairman Sheila Bair suggested yesterday that creditors of large banks should help to pay for future bank failures by limiting their claims in the event of insolvency. So we ask this question of the readers of The IRA: If you assume, as we do, that the equity of BAC is a zero, where should bond holders be haircut in order to recapitalize the bank without further financial support from the US taxpayer? We’ll start the bidding at 70 cents on the dollar.
No Way Out: Government Response to the Financial Crisis
IRA co-founder Christopher Whalen will be appearing this Friday, October 9th, at American Enterprise Institute in Washington to discuss solutions to the crisis. Join AEI Resident Scholar Vincent R. Reinhart, Greg Ip of The Economist, and Angel Ubide of Tudor Corporation for what promises to be a most interesting discussion. Click here to register for this event.
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