Bank of America Gets Buffetted
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Last week, our financial Superman, the mild-mannered Midwesterner Warren E. Buffett, swooped in again to save another bank, the financial markets, the American economy and just maybe our precious way of life.
Mr. Buffett's purchase of $5 billion worth of Bank of America preferred stock (on his usual generous terms, including long-lasting warrants to buy common stock at an attractive price) immediately stiffened the upper lips of chattering investors and pundits. Bank of America's chairman hailed it as a "vote of confidence" in the bank. It was also celebrated as a signal that the worst was over in the rout recently experienced by the American financial sector.
For the moment, that all seems right: Bank of America's stock is up 17 percent from the Aug. 25 announcement, and stocks of the other three major American banks—JPMorgan Chase, Citigroup and Wells Fargo—are also up.
But as the news is digested, it could set off the opposite effect. The Buffett investment just might turn out to erode, not increase, confidence. And not only for Bank of America, but for the banking sector as a whole.
Mr. Buffett's investment reveals something both infuriating and scary. Bank of America has not been talking straight about its need for capital.
"You cannot have the largest bank in the country saying, 'We don't need the money,' and then paying this kind of price to Warren Buffett for capital they say they don't need," said Daniel Alpert, who runs the investment firm Westwood Capital. "Industrywide, it's a potential boomerang because we think, ‘Why should we believe any of these guys when they say they don't need the money?' "
"We've been through a massive crisis in 2007 and '08 where executives of major financial institutions tried to hide their insolvency," he added. "They said, ‘No, no, a thousand times no, we're fine.' And then they were gone."
Sure, Mr. Buffett reportedly approached Brian T. Moynihan, Bank of America's chief executive, who initially rebuffed the investment offer—suggesting that Bank of America didn't really need capital. Even so, Mr. Moynihan's reticence didn't last long. And if the bank truly didn't need capital, why make such an expensive deal that could dilute other shareholders?
The more investors think about it, the more Mr. Buffett's announcement will intensify, not allay, their fears about Bank of America's capital position. Indeed, Mr. Buffett is making something more resembling a loan than an equity investment. His $5 billion doesn't fully count in the important measure of capital that regulators look at, called Tier 1.
That is perhaps why Bank of America's money-raising has not stopped with Mr. Buffett. On Monday, the bank sold about half of its stake in China Construction Bank for more than $8 billion. And over the last year, Bank of America has been jettisoning multiple businesses to raise cash and shore up its capital.
Prudent, yes, and we can hope the bank's management has learned a lesson about credibility. Last year, Mr. Moynihan suggested that the bank would be able to raise its dividend after it passed the Federal Reserve's second round of stress tests. No such luck. That plan was blocked, rightly, by the Fed, whose exams revealed, among other perils, Bank of America's overexposure to the sickly real estate sector.
Yet Mr. Moynihan and Bank of America persisted, with analysts expecting the bank to come back in the middle of the year to push the Fed to revisit the dividend issue. So much for that now.
Still, even with these moves, some investors and analysts do not think the bank's actions will be sufficient and that it will have to sell common shares to raise capital.
Bank of America disagrees. Yes, the stock has "an overhang" thanks to economic and legal uncertainty, but "we understand that and are working very aggressively to address that," said Jerome F. Dubrowski, a spokesman. "We have more than enough capital to run our business" based on current rules, he said.
The bank has clearly explained to investors and regulators how it will reach compliance with the new rules ahead of schedule, he added. The Buffett opportunity was too good to pass up, Mr. Dubrowski said: "There's only one Warren Buffett. We are very happy to have him, but it wasn't driven by capital."
Yet Bank of America investors had whipped themselves into a panic in August because of the giant legal liability faced by the bank. The Buffett investment does not remove that, let alone any of the bank's other millstones.
Not only does the bank still face billions in legal settlement costs from Countrywide Financial, but it also has to buy back billions in faulty mortgages. Bank of America's questionable foreclosure practices continue to drag it down, and in addition it faces Securities and Exchange Commission investigations into the actions of its subsidiary, Merrill Lynch, in the lead-up to the financial crisis. Bank of America acquired Merrill in 2008, under heavy pressure from the Federal Reserve and the Treasury Department.
The big problem, however, is not the unknown legal costs, but the exceedingly well-known exposure to real estate, both home mortgages and home-equity lines of credit.
The bears will return, armed with a soft economy and the declining housing market. As they do, what is to stop them from jumping from bank to bank?
Compared with Bank of America, Wells Fargo has more exposure to real estate and less capital. The bank classifies about 19 percent of its residential mortgage loans as either delinquent or nonperforming, a number similar to that of Bank of America. Wells Fargo says it's fine, but where have we heard that before?
Of all the big American banks, JPMorgan Chase, perhaps surprisingly, has the highest proportion of bad mortgages, at about 24 percent, according to Bankregdata.com. Citigroup is lowest at less than 14 percent. But JPMorgan's balance sheet is more solid than that of any of the country's other megabanks.
Even if the major banks do not experience additional capital crises, the Fed plans to keep interest rates low for years. That will almost certainly depress bank lending rates, squeezing profits.
That is, if the banks lend at all. In one of the most important business lines for Bank of America and the other Big Three banks, residential mortgages, the banks are pricing themselves out of the market, offering uncompetitive rates. The mortgage market remains shattered.
Why aren't the banks lending? They fear potential future litigation, for one. And they claim there is not enough demand from high-quality borrowers. But if they had conviction that the economy and housing markets were recovering, those concerns would ebb.
So, if bank leaders are not exhibiting confidence, why should the rest of us?
Correction (9/1): This column referred incorrectly to the investment's impact on the bank's capital. Of the $5 billion, $2 billion will count in the measure of capital called Tier 1, under the current capital standard known as Basel 1. The column erroneously said that none of the $5 billion would count as Tier 1 capital.
About The Trade
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