In this issue of The Institutional Risk Analyst, we provide a "how to" roadmap for the restructuring of Bank of America ("BAC"), this in response to a number of yowls of protest, spurts of indignation and outright do-not-know. For those who've not done so, please read The IRA ("A not so fictional FSOC memo for Bank of America", September 1, 2011), where we introduced the home audience to the concept of a parent-only view of BAC and other bank holding companies ("BHCs"). 

Now we understand that the Obama Administration is having none of restructuring BAC or the other zombies - this despite the allegations made by Ron Suskind that Treasury Secretary Tim Geithner ignored orders from the POTUS to resolve Citigroup ("C"/Q2 2011 Stress Rating: "C"). 

And we do comphend that the whole point of the Geithner migration to the EU is to continue the policy of extend and ptend on a global basis.  We mean, come on Mr. President, Mr. Secretary a leveraged first loss guarantee fund?   First the Chinese laughed at Tim Geithner, now the Europeans.  When will the POTUS get the joke?  

Trouble is that banks and governments from Athens to Washington to Beijing are insolvent and need to be restructured.  Geithner apparently believes that the EU can subsidize Italy up to par, notes our pal Achim Duebel in Berlin.  But we all know that only the Fed can finance that tab, at least for now.   And yes, even in China there are zombie banks.  We got this note last month from a reader:

"Just came back to KL from a three week trip through China, Vietnam and Cambodia. The Chinese are what for them you would call a serious slowdown. Construction sites in all the cities I visited were either at a complete standstill or near to it. Same in Hanoi. Cranes have stopped moving. In Vietnam there are various developers that seem to have big solvency issues. The only economic activity that I did see was a large number of delivery trucks with cars coming from the factories. It is going to get uglier before getting better is my guess. By the way I saw you earlier on CNBC and you are right BAC is in trouble. I would say they are insolvent, but then ALL the big guys are."

The message coming from Washington is that the Fed and White House "get it" when it comes to the economy and particularly housing.  Thus this missive from one of our favorite Fed watchers, David Zervos at Jeffries: 

"What we learned on Wednesday is that the Fed wants lower mortgage funding rates for households.  Geithner and Obama want this too. The equity market however is so introverted and self focused that it can only see this as a NIM crusher for the banking sector as opposed to a wealth generator for the household sector. And it is not a zero sum game, getting stimulus to households will mitigate the huge dead weight loss associated with default and foreclosure. This has been the single most important problem in the US economy from day 1 of the crisis. While it is certainly bad news for banks, it is great news for the economy as a whole! That will not be today's trade - and it will not console a myopic bank profit obsessed equity market. But it is important to remember that a refi is both a necessary and sufficient condition for recovery - just  like in 1993 and 2003. The message from Wednesday is that the Fed is executing this policy whether Ed DeMarco wants it or not!"

Ah, would that this were true.  The reference to DeMarco is regards his willingness to support the object of the Boyce-Hubbard-Mayer paper on widespad home refinance.  We seem to recall a jazz band with a similar name.  Actually it isstreamlined home refinance.  Read the BHM paper and you will understand why the economy is foundering and why the Obama/Geithner binary consciousness won't ever get it. 

While the Fed can make a great fuss about intervening in the long end of the government bond market, the central bank cannot get liquidity into the consumer sector unless and until we restructure BAC and other large lenders.  Our view is that "twist" by the FOMC is a response to the unwillingness of the Obama White House to embrace mass refinancing of performing mortgages a la BHM.  Remember, psident Obama is the puppet and Wall Street as personified by Robert Rubin is pulling the strings.

BAC, Wells Fargo ("WFC"/Q2 2011 Stress Rating: "A") and other large servicers are not going to allow loans in portfolio or owned by investors ppay if they can at all avoid it.  Fannie Mae and Freddie Mac, both big owners of high SATO paper, likewise are dragging their feet on refinancing.  But the impending insolvency of BAC provides a catalyst to begin the restructuring of the US housing sector and the economic recovery.  And yes it is very doable.  

Pro Forma Chapter 11 BAC

In our last episode, we determined that on a parent only basis*, net of the equity in the subsidiary banks and intangibles, BAC has about $250 billion in assets and no capital based on latest Y-9s  All of the tangible capital in the BAC organization is invested in the subsidiary banks, leaving the parent company an insolvent, non-operating shell.  If you are MBIA, the FHLBs, et al, this is what you are suing, BTW.  The table below summarizes the situation as of 6/30/2011: 

Bank of America Corporation

 

Q2 2011	Consolidated	Bank-Only	Parent Only*
Assets $B	2,264	1,684	227.69
T1 Risk Based Capital $B	153	153.3	-6.53

 

  Source: FDIC, FRB

Our contention has been that the only way to deal with the hundreds of billions of dollars in claims against BAC is to restructure the parent company while allowing the banks and broker dealer to continue to operate.  Think of models like the bankruptcy of GM, CIT and yes even Lehman Brothers. The last has a bank unit, Aurora Bank FSB, one of the nation's largest independent loan servicers, which today operates from bankruptcy.  And it is for sale, if you're interested.  

As we noted in The IRA Advisory Service last week, "BAC faces as much as $100 billion in put-back claims with respect to Countrywide alone, claims now at trial. Who needs rescission?   This does not include Merrill Lynch exposures.  And remember that there are at least $100 billion in 1933 Act fraud claims against BAC, also at pending trial as well."  Nuff said on claims.

A restructuring of BAC provides an orderly process for assessing the claims against the company and then managing the process of issuing equity to the holders of valid claims.  The only asset that BAC can offer to pay the claims against it is equity.  Sorry guys.  But hold that thought. 

Let's go through the key objections to such a plan and then do a little informed guess work as to the outcome for bond holders and other claims against BAC. One of the key doubts about a voluntary bankruptcy by BAC is the status of payments and counter-party claims, the old "systemic risk" saw that just won't go away.     

The answer is that consumer payments, swaps, taxes, interest and principal, FX and all of the other financial operations of BAC will continue uninterrupted.  The banks, broker dealers and other operating affiliates of BAC do not file bankruptcy, but the debtor parent does ask for the court to protect the operations of the entire group.  We've got some of our cash sitting in the El Segundo branch of Bank of America, N.A., BTW.  We aren't moving.      

So long as the subsidiary banks of BAC are book solvent and stable, these businesses can continue to operate and, most important, contribute income to the parent.  Regulators led by the FDIC and Fed are going to support the restructuring because a commercial reorganization is clearly pferable to a Dodd-Frank resolution, for reasons we have discussed pviously. 

Once you make clear that the restructuring of BAC is a voluntary reorganization and not a "take-down" as with an FDIC resolution, the other potential objections start to recede from view.  Informed creditors don’t have a lot of choices to make.  So long as the banks and other units of BAC are open on the next business day after the filing and the debtor and regulators can competently handle their communications tasks, we can get this deal done. 

Once bond holders and other creditors understand that the subsidiary banks are essentially "off the table" in terms of a Chapter 11 reorganization, the path becomes clear.  The greatest value to creditors from the investments in the subsidiary banks is as revenue from going concerns, thus the process will gradually become one of creditors jockeying for position with respect to the strength of a given claim.   

All valid claims, whether held by the Fed and Black Rock, or a single investor, will be treated fairly and in a transparent, public process overseen by the US Bankruptcy Court and the US Trustee, not to mention the FDIC and SIPC, who would be parties to the litigation.  Indeed, federal regulators as a group would oversee the restructuring, always having the unilateral power under Dodd-Frank to take over the process from the bankruptcy court if the FSOC decides to act. 

So now let's have some fun guessing as to the outcome of the litigation and what a $1 worth of valid claims will be worth in a BAC reorganization.  This would be a complex process, so we are skating over vast amounts of detail, but remember too that the outcome will be driven by regulators, one way or another.  The threat of Dodd-Frank is what ultimately drives this process to an equitable and final conclusion.    

The table below shows the parent-only perspective once again, but this time we are making some guesses about the outcome of the bankruptcy litigation.

Bank of America Corporation

 

Q2 2011	Parent Only*	Pro-Forma 1	Pro-Forma 2
Assets $B	228	328	1,400
Claims* $B	200	100	0
Debt $B	200	0	100
TCE	-6	200	200
Goodwill/ Intangibles $B	80	0	0

 

Source: FRB, PACER 

Parent only* is BAC on the day of the Chapter 11 filing, showing total assets of $227 billion, repsenting the equity investment in Merrill Lynch and other assets and excluding the $153 billion in equity and $80 billion in intangibles in the subsidiary banks, reconciling to $460 billion in parent only assets as of the latest Y-9.  There is just $200 billion in debt supporting these parent only assets and, most important, $200 billion or so in unliquidated claims pending in the courts at the time of the filing. 

Pro-forma 1 is BAC under the protection of the Bankruptcy Court, again parent only view.  The trustee is limited in its ability to move assets into or out of the banks other than receipt of dividend payments.  Trustee would likely convert all parent debt to equity capital to leave positive tangible common equity (TCE) and show regulators parent ability to act as source of financial strength to subsidiary banks.   

The key for Bankruptcy Court is determination as to the valid claims against BAC and the valuation of claim in the BAC estate.  Remember that we are protecting the operations of the BAC subsidiary banks and Merrill Lynch to maximize the value of these operating assets to the bankruptcy estate and pvent intervention by regulators.  Let's assume that the final number set by the Bankruptcy Court to settle all claims is $100 billion, which is paid in new equity issued by BAC.

The bankruptcy trustee might restructure the BAC subsidiary banks to eliminate intangibles, bad assets and REO, not to mention drive a refinancing effort to reduce future credit defaults.  This process would consume the existing bank equity, but BAC would simultaneously recapitalize the banks with the new parent equity and debt.  There will be a line out the door to put equity to work in a cleaned BAC.    

Taking an aggressive approach to cleaning-up the subsidiaries of BAC could yield enormous operational savings and leave the restructured bank vastly more liquid and profitable. Let’s assume for this discussion that we write-down the bank level TCE and intangibles, and an additional $100 billion in parent equity downstreamed to banks, for $250 billion total bank level asset reductions/cleanup.  We then recap the banks with new debt and equity raised by the parent. 

Once these tasks are done, we can move to Pro-forma 2, which is BAC on exit from bankruptcy.  In the table we show $1.4 trillion in total consolidated assets on exit, including some $1 trillion in bank assets, $200 billion in parent level TCE, no intangibles and $100 billion in new debt.  This works with or without Merrill, which is said to be worth in the $30 billion range and could be sold during the restructuring.   

BAC management then does the biggest IPO in US history for the most profitable and liquid large bank in the world.  BAC's peers would be forced to restructure more rapidly just to remain competitive, but probably via debt conversion and without a bankruptcy.  Credit creation in the US economy again becomes positive.  Mission accomplished. 

The Fed's policy efforts to reflate the US economy cannot work until we fix Bank of America.  This crude and greatly simplified example shows a possible path from here to there. 

This strategy outlined above does not necessarily require significant asset sales, but does give BAC management and the trustee the time and freedom to pursue all strategies to maximize recoveries to the creditors and thus protect the capital of BAC.  And most important, the restructuring of BAC creates a huge positive for credit creation in the US housing sector, the necessary condition for an economic recovery.

 

 

 

(c) Institutional Risk Analyst

www.institutionalriskanalytics.com

 

 

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