Options for Bank of America
Posted on: May 11, 2009 - Email Article - Printable Version
Following the release of the government’s “Stress Test” results, 10 of the largest 19 banks will be required to raise additional capital. This additional capital needed by these 10 banks will cushion their existing capital in the event of a further market deterioration. Among the top banks that need to raise additional capital is Bank of America [BAC: 13.235, +0.0275 (+0.21%)]. Fed officials are forcing BofA to raise more capital to ensure it will have sufficient Tier 1 capital to absorb losses from an adverse scenario.
Fed officials targeted the largest banks and provided them with a scenario in which 2 year loan loss rates increased substantially. From these increased rates, fed officials estimated that
another $599 billion could be written down by the largest 19 financial institutions. The hardest hit bank in this scenario is Bank of America, who was asked to raise $33.9 billion to protect its capital ratios against this adverse scenario. If the results of the stress test showed that this ratio for any bank would dip below 4% of common equity to total assets, then further research was done to determine whether or not that bank would need to raise additional capital.
These estimated losses stem from a variety of asset classes, adding up to a staggering $136.6 billion in loss estimates. The closest loss estimates from BofA’s competitors comes from Citigroup [C: 3.875, +0.0275 (+0.71%)], which is estimated to witness $104.7 billion in losses. J.P. Morgan Chase [JPM: 37.89, +0.15 (+0.40%)] came in third an estimated total of loan losses with $97.4 billion. These estimated losses are by no means surprising given the size of their respective balance sheets. BofA is the hardest hit firm out of this report, as they were targeted as needing the most additional capital.
As you may remember, the CEO of Bank of America, Ken Lewis, was quick to announce that they wanted to pay back the government’s TARP money as soon as possible. This has now created an interesting situation for BofA’s leadership, now having to raise additional capital to back-stop against future potential losses. Ken Lewis remains confident that they will be able to raise additional capital and do it in a reasonable amount of time. “Our game plan,” said Ken Lewis, is to “get the government out of our bank as quickly as possible.” Bank of America has already taken $45 billion in TARP funds (right behind Citi’s $50 billion) from the government in exchange for preferred stock.
Although this will be a difficult task, BofA does have some options on the table to meet the government’s additional capital requirements. Those options include selling assets, spinning off businesses, issuing more common shares, or converting the government’s preferred stock investment into common shares.
Bank of America’s Most Likely Decision:
- $8 billion from sale of China Construction Bank
- $14-16 billion in newly issued common equity
- $10-12 billion converted preferred equity
Selling assets seems like a great idea to raise cash to stem off this capital requirement, but the bank will likely choose not to go this route. BofA will likely hold onto a majority of its assets, because if they do choose to sell now they will be taking steep book losses on assets they believe will be worth much more in the coming years. Selling now at current discounted market prices would be a huge mistake.
Spinning off businesses is also extremely unlikely given Ken Lewis’ destructive path towards acquisitions. In the span of one year, BofA acquired financial firm behemoths Countrywide Financial and Merrill Lynch. Management is 100% committed to these acquisitions and will not reverse their decisions. One of the most likely sales could come from its stake in China Construction Bank. A lock-up provision on roughly a third of BofA’s stake expired late last week and could bring in roughly $8 billion. There are other possibilities to spin off businesses, but I wouldn’t expect the majority of their capital raise to come from these scenarios.
Issuing more common shares seems like BofA’s best option, but the real question will be: Will it be enough? My guess is absolutely not. Share dilution will be a huge concern for the bank, and everyone is uncertain as to how this would get priced in the open market. A $34 billion common equity issuance would be approximately 37% of its current market cap of $90 billion. Unless the markets continue to improve (which they likely won’t at this rate), it is extremely unlikely that BofA will be able to meet its needs in the public market. There is a strong possibility that a few large private institutions and/or funds could step-in to purchase equity in BofA, especially following the past couple weeks of improved market conditions. This private issuance of equity is unlikely, unless there are significant changes with BofA’s top management.
Finally the last option and backstop to raise capital is to convert a portion of its outstanding preferred equity into common equity. Bank of America has publicly stated that they will not be converting any of its TARP funds into common equity. A big question is how much will this conversion dilute current common equity ownership.
- Steve Murray
Disclosure: The Fund the author is associated with is long JPM.
The Following Stocks Were Mentioned In This Article: BAC, C, JPM
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