Pac-Man Game Ends for Bank of America

The Pac-Man era of banking in the United States has ended for Bank of America. Its transformation from the once sleepy North Carolina National Bank (NCNB) of Charlotte, North Carolina into the largest bank in the nation was truly remarkable. It was made possible by the fact that it was well capitalized with a clean balance sheet at a time when other banks ran into financial difficulties.

NCNB’s first big acquisition was the purchase of First RepublicBank Corporation of Dallas, Texas from the FDIC in 1988. That was followed by the purchase of over 200 thrifts and community banks, many through the Resolution Trust program. Included in those acquisitions was C&S/Sovran Corp of Atlanta in 1991 and at that time it renamed itself NationsBank. It continued its bank purchasing spree by acquiring Maryland National Corporation in 1992, BankSouth in 1995, Boatmen's Bancshares in 1996, and Barnett Bank in 1997.

It was able to acquire and assimilate banks with a speed that took competitors’ breath away. Transitions from old to new management happened swiftly and numerous people lost jobs as cost savings were maximized.

The flurry of acquisitions culminated with the merger of NationsBank and Bank of America in April 1998. The fact that Charlotte, NC was named the official headquarters of the merged entity spoke volumes about the leadership of Hugh McColl, who retired in 2001 after naming Ken Lewis his successor. McColl had been CEO since 1983.

The smooth transition in leadership following the merger and McColl’s departure brought with it a five year period during which management focused its attention internally on integration and efficiency. In 2004 Ken Lewis decided it was time to once again enter the bank acquisition arena as BAC acquired FleetBoston Financial Corporation. Fleet itself was the product of the Pac-Man The Providence, RI based Fleet morphed itself into the seventh largest bank in the nation by the time of its merger.

The year following BAC’s acquisition of Fleet it acquired MBNA Corp., the world’s largest independent credit card issuer. In 2007 it purchased ABN Amro North America Holding Company, which was the parent of LaSalle Bank Corporation.

These bank acquisitions and mergers were blessed by regulatory authorities who embraced the resulting loan diversification and economies of scale as beneficial to the commercial banking industry. The regulatory authorities became so enamored with loan diversification among industrial categories that they allowed Pac-Man banks to operate with significantly lower equity capital ratios. They also allowed them to fund their assets with a greater portion of borrowed funds (fed funds, brokered CDs, commercial paper) than other commercial banks.

Historically, the Federal Reserve Board always examined the concentration of resources that would result within a Standard Metropolitan Statistical Area (SMSA) from a bank merger. It, however, never considered a national problem that might arise from a given bank reaching a certain size. It is doubtful that the top four commercial banking organizations would have been allowed to reach today’s level of 60% of all commercial banking assets if the Fed considered the systemic problem issue.

The first move that drew unwanted attention to BAC and caused people to question Ken Lewis’ leadership was BAC’s purchase of U.S. Trust in late 2006 from Charles Schwab Corp. The purchase price was $3.3 billion and was $600 million more than Schwab had paid for it in 2000. Furthermore, U.S. Trust was rumored to be for sale for more than two years following the July 2004 departure of Schwab Chief Executive David Pottruck.

The acquisition of U.S. Trust and its $94 billion in assets enabled BAC to claim that it had more assets under management, $261 billion, than any other bank. It was apparent that Lewis prized bigness.

In August 2007 BAC made what it dubbed a $2 billion strategic investment in Countrywide. This was done through a 7.25% non-voting convertible preferred security, with a conversion price of $18 per share. On January 11, 2008 BAC then announced that it would acquire Countrywide Financial Corporation for $4 billion. This announcement stunned the financial community, because the embattled Countrywide was the widely accepted poster child for the rapidly bursting real estate bubble.

These two Countrywide transactions marked the beginning of the end for Ken Lewis. Stockholders lost faith and dumped the stock, while the financial press had a field day questioning his decision making ability. He doggedly insisted on closing the transaction in the summer of 2008 even as evidence mounted that the residential real estate market was collapsing.

He wrongly thought BAC’s underwriting standards immunized it from credit problems sweeping the nation. Accordingly, he jumped at the chance to meet with John Thain on September 14, 2008 and agree to buy Merrill Lynch. That was the final nail in his coffin.

The consensus was that BAC grossly overpaid. This view was later confirmed when Lewis told Paulson and Bernanke that BAC needed assistance to complete the deal, because of unforeseen losses in Merrill’s portfolio. Lewis agreed to complete the acquisition only after he allegedly received heavy handed threats from government officials.

The sad thing is Lewis has said that the strategic plan was that one day the organization would include a major investment bank. They had actually thought about Merrill Lynch and its army of brokers. That must have seemed like an incredible dream for a bunch of people from the mountains of North Carolina. Unfortunately for Ken Lewis the dream of owning a major investment bank came true.

The chance of fully integrating Merrill Lynch and Countrywide into Bank of America is remote. After all, Bank of America couldn’t assimilate Charles Schwab which it bought in 1981 and sold back to Schwab in 1987 after a contentious six years.

Commercial banking and investment banking have vastly different corporate cultures and compensation. The Glass-Steagall wall may have crumbled, but the culture wall remain intact.

BAC needs to return to the basics of commercial banking whereby it makes loans and investments that it keeps on its balance sheet. It needs to focus on getting payments or additional collateral on existing loans and investments, while making new loans and investments.

No resources need to be spent on looking for acquisitions. Instead, BAC should consider selling some assets, especially Merrill Lynch, and repaying the U.S. Government as soon as possible. It’s time for banking’s version of Pac-Man to rest while it recovers from a serious case of financial indigestion.

Storm Clouds Gather

Bank stock investors have seen their investments soar during the past six weeks. The percentage gains in bank stocks have dwarfed all general market indices.

Citicorp ( C ) stock rose from the ashes of $0.97 per share on March 5th to an inter-day high of $4.48 on April 14, 2009. During relatively the same period, Bank of America
( BAC ) rose from its all-time low of $2.53 to $11.58; J P Morgan ( JPM ) rose from $14.96 to $33.70; Wells Fargo ( WFC ) rose from $7.80 to $19.67, and US Bancorp (USB) rose from $8.06 to $18.01.

Bank stocks initially perked-up when bank officials made favorable comments about their earnings for the first two months of 2009. They really took off, however, when WFC reported robust earnings for the first quarter, which were well above street estimates.

The observed volatility in the bank stock sector reflected the extremes of despair and optimism regarding a financially fragile economy. Nowhere has the battle between market bulls and bears been more evident.

For the past six weeks the voices of Paul Krugman, Nourel Roubini, Dylan Rattigan, Meredith Whitney and others have been muffled as their calls for nationalization were widely dismissed. Of course it didn’t hurt that Rattigan lost his perch, Whitney switched jobs, and Roubini was abroad for much of this time.

These pundits are about to be replaced by the angry voices of people being led to believe that the time for Washington to be reigned in is now. A coalition of commentators who favor small government and balanced budgets has chosen April 15, 2009 as the day to launch taxpayer protests against Federal bailouts. In general, the people leading this movement believe that the United States would be far better off if we allowed banks and businesses to fail.

It is highly likely that this populist movement will gather momentum as the unemployment rate rises and tent cities become more prevalent. Federal Reserve Chairman Bernanke has said that the economy will recover as long as we have the political will. At present, the likelihood of getting another spending bill through Congress is remote. As the anti-bailout movement gathers momentum, the possibility of additional spending packages will disappear entirely as the nation’s political will disappears.

If the current stock rally proves to be short-lived and the anti-bailout forces gather momentum, then the nation will be in for a long, hot summer of discontent and civil unrest. In such an environment, people working for specific organizations could become targets of discontent just as AIG executives have.

Bank Nationalization Fever Wanes

Remarks by Federal Reserve Board Chairman Ben Bernanke allayed fears of the federal government nationalizing major banks. Appearing before the House Financial Services Committee he said the major banks were not in jeopardy of failing and nationalization was not necessary.

Bernanke stated that nationalization is when the government seizes the bank, zeros out the shareholders, and manages the bank; and, they don't have anything like that planned. His remarks caused a significant rally in beaten down bank stocks.

The positive comments by the Fed Chairman came the day after President Obama’s optimistic State of the Union address. Their remarks were the first meaningful statements to effectively offset the cries for nationalization that had been increasingly dominating the print and cable media.

The loud voices favoring bank nationalization have suffered their first major setback. Those opposed to nationalization hope this is the first of many defeats that the talking heads will receive going forward. Baseless rhetoric by inexperienced pundits has simply become too much for the nation to bear.

A Name Can Hurt

On December 11, 1930 the Bank of United States failed setting off runs on numerous other banks that had refused to come to its aid. It was only one of the 352 banks that failed that month but its failure had worldwide repercussions, because many thought it was owned by the federal government. It was actually a relatively small state-chartered bank with slightly over $200 million in deposits located in New York City. But - it had an imposing name!

In the aftermath of that confidence shattering failure it was determined that no newly chartered bank would be allowed to use “United States” in its name. Of course that did not affect the Bank of America, which was already operating under that name.

Those now shouting fire in the bank theater would do well to read about the failure of the Bank of the United States. That bank was not nearly as large or as important as its name implied, but its failure helped usher in the last depression as it helped erode confidence at home and abroad.

By contrast, the Bank of America is a truly dominant bank that holds more than 10% of the total deposits of the entire banking industry. It claims that 50% of the people in the Unites States are customers of the Bank of America.

Those talking heads who daily spread the view that the Bank of America needs to be nationalized so that this economy can turn around are, at best, illinformed. They have no background in banking and they fail to appreciate the shock such an announcement would have domestically and internationally.

Bank Nationalization Opponents Need To Thank Greenspan

Alan Greenspan, the former Chairman of the Federal Reserve, who many view as the primary culprit for today’s economic problems, has come out of hiding to express his views on the subject of bank nationalization. Greenspan told The Financial Times “It may be necessary to temporarily nationalize some banks in order to facilitate a swift and orderly restructuring.”

Opponents of bank nationalization should thank Greenspan. After all, who in their right mind would rely on the views of a person weighed down with an admittedly broken economic model. He greased the skids for this slide into the abyss; he does not hold the solution.

Bank Nationalization is Wrong

The clamor for nationalizing big banks grows each day. Those favoring nationalization recommend removing all bad assets from bank balance sheets thereby wiping out, as needed, the equity of common shareholders followed by the interests of preferred stockholders and then the bond owners.

The bad assets would then become assets of the FDIC or a special entity established by the federal government. The new owners could then keep them or sell them to private investors, who are reportedly waiting anxiously to acquire these bad assets.

Proponents of this approach strongly suggest that nationalization is necessary for the nation to end its economic death spiral and begin a recovery. Bank nationalization also has widespread popular appeal, because it supposedly punishes the culprits for destroying the economy and it provides just punishment for making stupid decisions.

Nationalization is neither a necessary nor a sufficient condition to solving today’s problems. The treatment of Continental Illinois in the 1980s and the purported success of the RTC are not appropriate templates to follow. Such actions today could easily aggravate economic conditions by causing further consumer despair and calling into question the value of the U S currency and our U S government debt.

The truth is that de-leveraging by financial institutions, corporations, and individuals takes time. The bad assets on the books of the banks will disappear as they either heal, are liquidated, or are charged off through earnings. The debt of corporations will be reduced as corporations either take bankruptcy or use their cash flow to reduce debt. Individuals will similarly de-lever by either erasing debt through bankruptcy or curtailing consumption. During this period the level of economic activity will be negatively impacted unless the government expands its expenditures and levers its balance sheet. Nationalization of banks will not prevent this process from occurring.

The fact that “vulture investors” are among the most vocal supporters of nationalization testifies to the fortunes they made when the government engaged in widespread closures of financial institutions in the 1980s and 1990s. They can’t wait to once again be the beneficiaries of a large transfer of wealth courtesy of the federal government.

While fans of the RTC cover it in accolades, the beneficiaries of its largess chuckle. Here is what one person had to say about the RTC, “When working on a mortgage-backed trading desk back in the '80s, the RTC went to the street to solicit bids for the assets that they had taken over from the insolvent thrifts. We made a killing. It was an unadulterated field day. We bought the stuff at a discount to the projected cash flows and resold it within hours for huge profits. In anticipation of once again earning huge profits, the likely beneficiaries are doing their best to drive banks off the cliff so they can once again buy distressed assets at fire sale prices. It is the way of the street.”

Bank nationalization proponents claim that the only proper way to value banks is on the basis of liquidating value or tangible common equity. Such an approach is understandable, because that is in their best interests. Valuing banks on a going concern basis has no place in their playbook. Calling these investors “vulture investors” gives vultures a bad name!

Unwittingly, regular citizens, including the unemployed, have joined forces with these people to form an unofficial bank nationalization coalition. The fact that these disparate groups increasingly favor nationalization is disturbing and requires examination.

There are two issues that merit careful consideration before being swept up in this drive for nationalization. First, who determines what “bad assets” need to be excised from a bank being nationalized? Second. who determines the price of a bad asset at the time of its removal?

In the case where a loan is determined to be a bad asset and is transferred to another entity that borrower loses their right to renegotiate that debt with the original lender. This puts the borrower in a less favorable position than they would otherwise be, since the new holder of the loan would either be unable or less likely to lend more money, extend the term, and/or lower the interest rate. Borrowers and the local economy are better served by loans staying where they are originated.

Recent events with securitization prove beyond a reasonable doubt that original lenders have a greater likelihood of getting repaid. Accordingly, the intrinsic value of a bad loan on the balance sheet of a bank that made it is greater than the intrinsic value of that loan when it is housed and administered elsewhere. Furthermore, an original lender is far more likely to advance additional funds to borrowers, thus extending the economic life of a borrower.

Similarly, it can be argued that the intrinsic values of securitized assets held by a bank are greater than the comparable values if they are held by most private investors. This is so because banks benefit from having a much lower cost of funds, especially today. Banks also have more secure and virtually unlimited funds available thanks to expanded FDIC coverage, which removes the fear of bank runs, and an aggressively accommodative Federal Reserve. The intrinsic values of assets on the balance sheet of a bank today are understandably greater than what non-bank investors’ claim.

We cannot afford to experiment with nationalizing our banks. It is not necessary, especially in view of the fact they do not face deposit runs; their cost of funding is plummeting; they have very favorable interest spreads; and, their earning assets exceed their paying liabilities.

The truth is that almost all of the banks and savings and loans that were closed during the past 30 years would have survived if they had today’s deposit guarantees, deposit rates, and were given some time. The exceptions are those institutions that were caught by persistent negative interest rate spreads when interest rates soared and those banks closed because of fraud and malfeasance.

The federal government needs to ignore the cry for bank nationalization. This is not like the 1980s or 1990s.

Bank of America’s Stock Action For Week Ending February 6th

Volatility in the price of bank stocks returned last week with renewed vigor as bears and bulls clashed over the Obama administration’s failure to release its bank rescue plan. Rumors regarding imminent nationalization focused especially on Citigroup ( C ) and Bank of America ( BAC ) and caused those stocks to plummet on Thursday morning. Citigroup traded as low as $3.20, which was still above its $2.80 low of January 20th.

BAC, however, was really taken to the woodshed and collapsed to $3.77, which was a 27 year low. The last time Bank of America stock was this low was 1982. At that time it was known as North Carolina National Bank and at the end of 1982 it only owned three small banks (all in Florida) outside its home state. Those current and past executives who have followed a buy and hold strategy have watched their net worth disappear along with the price of BAC stock.

Members of the Obama administration much have been watching the deterioration, because news began to leak regarding the forthcoming bank plan. The leaks were all attributed to unidentified sources close to the discussions and revealed that this administration was not hell-bent on destroying the last remnants of common equity in the large banks.

As that news spread, the shorts ran for cover, the longs said “gotcha,” and the market in bank stocks improved dramatically along with the rest of the market. At the close on Friday, BAC was trading at $6.13. In after hours trading it continued to trade higher and finished trading at about $6.36.

The rising price of BAC stock coincided with a TV interview of CEO Kenneth Lewis in which he did a masterful job of fielding tough questions and giving short, positive answers. For example, when he was asked about the prospects of nationalization he said he has never heard a regulator, member of Congress, and an administration official ever mention the word. He said talk of nationalization is absurd.

Lewis went on to say that Bank of America has plenty of capital and does not intend to ask for any more funds from the U.S. Government. Furthermore, he said he hopes that Bank of America will be able to return all of the government’s money within three years. Lewis also suggested that January was a pretty good month.

Lewis could not have done a better job of saying the right thing at the right time. If he does lose his job as CEO, he could get top dollar coaching other CEO’s on how to answer tough questions in a public forum.

Get The Wagon

The origins of the Bank of America trace back to the legendary banker Amadeo Pietro Giannini who opened the Bank of Italy in a former San Francisco Saloon on October 17, 1904. Total deposits at the end of that first day amounted to $8,780.

The first crisis to face the bank was the great San Francisco Earthquake of 1906. A.P. Giannini reportedly managed to get the money out of the vault of his ravaged bank and transport it in a horsedrawn wagon. The money was hidden under produce and taken to his home in San Mateo.

The Bank of Italy was one of the few banks that had money and was able to provide loans in the immediate aftermath of the quake. Giannini himself loaned money on the basis of handshakes while standing behind a plank supported by two barrels. In later years he relished telling this story and the fact that every loan was repaid. He died in 1949.

The Bank of America has been hit by economic forces that are at least as powerful as those that rocked its headquarters in 1906. This time, however, it will not be as simple as finding a horsedrawn wagon to save the bank assets.

Senator Schumer Favors Guarantees

Bloomberg and the Financial Times report that Senator Charles Schumer in a CNBC interview today said he favored the guarantee of troubled bank assets rather than the establishment of a so-called “bad bank.” His views carry weight because he is a leading Senate Democrat and member of the influential Senate Finance Committee.

The guarantee of $301 billion of Citigroup (Citi) assets in November 2008 might very well serve as a template for any such guarantees. In that deal the U.S. Government agreed to "ring-fence" $306 billion (later modified to $301 billion) of loans, investments, and commitments. These assets remain on the books of Citi; however, it is responsible for only the first $39.5 billion loss plus 10% of any losses greater than that. Citi's total exposure on these toxic assets is therefore $65.65 billion.

In return for this guarantee, Citi issued $4.034 billion in 8% Cumulative Perpetual Preferred Stock to the U.S. Treasury and $3.025 billion in the same 8% preferred to the FDIC as a "fee". Citigroup also issued to the U.S. Treasury a warrant for an additional 66,531,728 shares of common stock at the $10.61 strike price, which was the average of the closing prices of Citigroup common stock for the preceding 20 trading days.

Interestingly, the arrangement is really like Citigroup buying an insurance policy with an initial non-cash premium of $7.059 billion, which is the sum of the awarded preferred stock, and a quarterly cash premium of $141.2 million. As the insurer the U.S. Treasury is also given an equity kicker via the warrant.