Uncertainty and indecision threaten Bank America and global markets

August 9, 2011

For the past several years, my firm has been arguing that restructuring is the only way to solve the problems facing the largest US banks — the top four institutions that exercise a de facto cartel over the US housing market. After years of earning what seemed to be supra normal returns from the “gain on sale” world of US mortgage originations, the large service banks are now drowning in the same sea of risk that once made them seem so profitable.

As investors have slowly become aware of the concentration of housing risk that surrounds these large banks, they have increasingly shunned them. First with Bear Stearns, then Lehman Brothers, and then the housing GSEs Fannie Mae and Freddie Mac, markets stopped facing these names in the interbank credit markets, then accelerated into a crisis which compelled government intervention.

Now the Obama Administration faces the same threat with Bank of America (“BAC”), an institution that is one of the largest lenders and also servicer of loans in the US.  Millions of payroll deductions, property tax payments and remittances flow through BAC daily. But losses from acquisitions such as Countrywide, Merrill Lynch, as well as hundreds of other operating entities, threaten to bring the bank down. Yet herein is an opportunity for national salvation.

BAC is a too big to fail zombie created by the Obama Administration and the Fed to protect US financial markets, but is now so vast and unstable that it threatens the global economy. But more corrosive and dangerous than the torrents of red ink inside BAC is the steady erosion of public confidence. Uncertainty is the enemy now, both with respect to BAC and to its large bank peers.

The only way to end the uncertainty and also accelerate the economic recovery is to put BAC through a restructuring using the powers under the Dodd-Frank legislation. While a restructuring by the FDIC may seem to be a horrible prospect, in fact it offers the first real hope of definiteness in the housing crisis, the multi-trillion dollar millstone around our collective necks. Indeed, the BAC situation illustrates why the Founders of the US embedded bankruptcy in the Constitution, namely the need for finality.

In mechanical terms, here is how it works. Let’s start the narrative with a last, Hail Mary move by BAC CEO Brian Moynihan, who put the shell corporation that is the legal successor to the Countrywide business into bankruptcy after settlement efforts fail. This engraved message from Moynihan to BAC’s creditors, litigants and even Treasury Secretary Timothy Geithner — “foxtrot oscar” — begins the real endgame.

Hopefully Secretary Geithner will know about the BAC filing before it occurs and will have begun the process under Dodd-Frank to give regulators and especially the FDIC the power to move immediately to protect BAC and its subsidiary banks. In our narrative, FDIC enters the bankruptcy litigation for Countrywide and asserts control of the entire BAC group. BAC becomes effectively a subsidiary of the FDIC, with the full capital and assets of the entire industry behind it.

Once the FDIC is in control of BAC, the process will then proceed like a typical bankruptcy, with the operating units continuing to do business in the normal course. For consumers and business customers, the situation at BAC will be mostly the same. But for investors and especially creditors, the situation will be far from normal.

In a Dodd-Frank resolution, the creditors of BAC will have an opportunity to file claims, much as with any failed bank. Unlike a bankruptcy, however, the FDIC will make all depositors of the subsidiary banks whole before considering claims of creditors of the parent, a significant difference investors ought to consider. Most important, however, will be the process of converting debt to equity in the restructured BAC, providing the resources to absorb losses, fund continuing operations and restructure.

The beauty of a restructuring is that it forces all parties with a claim on the failed company to speak now or forever hold their peace. It also requires the conversion of debt to equity, which increases capital dramatically and also lowers the operating expenses of the enterprise. A super-capitalized BAC with 2-3% asset returns, 30% tangible equity and gobs of cash flow will then be ready to sell assets, modify mortgages and do whatever it takes to restore the ability of the bank to support new leverage. That is why restructuring is the key to US economic revival.

Economists from Irving Fisher to Henry Kaufman have noted that without credit expansion, the US economy cannot grow. In fact, credit is contracting with public confidence in America’s banks. The solution to the financial crisis affecting BAC and the US economic malaise are the same, namely an orderly, immediate public process of restructuring for the top banks and housing agencies. Think of a BAC restructuring as a working model for the rest of the US and EU to emulate.

The good news is that a growing number of observers see what needs to be done, much to the delight of this lonely herald of woe. The bad news is that the Obama White House is clueless, but such is life in a democracy. We can only hope that some of the Americans I now hear talking about the need for restructuring will speak to President Obama and Secretary Geithner sooner rather than later. And if they need help, they know where to find me.




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True that this is what needs to be done, I have a couple of questions for Chris (great work, I have been following you for a while now!).

1. Are you surmising that Moynihan will be forced to file Countrywide? What if they settle (Obama adm cajoles counterparties to settle with BAC?).

2. Any Dodd Frank restructuring of one bank could set off a market panic that other banks would no longer be deemed TBTF – at a minimum won’t other bank stocks/bank bonds collapse due to the ensuing panic? Or is your view that this is a small price to pay for ending this malaise (with which I eesntially agree)?

Posted by haris07 | Report as abusive

I’ve got to say that this opinion has been the most refreshing in days to come from Reuters. You are actually talking about how to solve the problem. You are not talking through lenses but actually unfiltered now.
I like this very much! Great article.

BOA has very serious customer problems, even as I type this I think about the nearly thousand they literally stole from me by telling me my business account was free, having it go on for 3 years then secretly charging me and REFUSING to reverse the charges even though they acknowledged that it was a free business account.

In America there is much ill will against BOA because of these tactics and others. But even with this said, you are on to something here.

I don’t know if Dodd Frank would give the FDIC so much authority, from plain reading of the Act it gives the FDIC authority over “state thrifts”. The OCC covers the national banks. But even if we could get a restructuring accomplished, Dodd Frank is not fully implemented by the federal agencies it supposedly is supposed to change. They haven’t even responded with proposals as of 2 months ago and had to be prodded to do so.
Dodd Frank allows the bank to continue to trade in derivatives, like before. And although there are some great things that resulted, Say on Pay for example(which to my surprise most of corporate America has latched on to), the very people on the committee that are supposed to enact the changed under DF are part of the problem.

Restructuring would be excellent. But with America’s corrupt politicians and corrupt Treasury Secretary can we trust the right outcome?

Sadly, I think not!

Posted by Independent007 | Report as abusive

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Excellent plan. My fear is that it makes too much sense and that usually provides the kiss of death as far as politicians are concerned. Moreover, it begs the question, why wasn’t something like this done in 2008? I think eventually something very close to Mr. Whalen’s plan will be what it takes to turn things around. Unfortunately, first TPTB must admit that they blew it and that’s not going to be easy.

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Great proposal Chris but I think the FDIC DIF fund (which would be used for liquidity in BAC takedown) is nearly empty of cash.

The assumption has always been that FDIC would draw a line of credit with the Treasury. But with the debt ceiling and supercommittee machinations can the FDIC still draw funds from there? So how would it be executed?

Markit CDS on BAC http://twitpic.com/63wbn9

Posted by Cate_Long | Report as abusive

Great idea, Chris. Not.gonna.happen. The administration is captured, big time.

Posted by evodevo | Report as abusive

Fabulous proposal Chris, but isn’t there an argument that the major reason why BAC is presently a too big to fail zombie is because it bought Merril Lynch in October 2008 at the behest of the Treasury and Fed? Moreover, in November 2008 when BAC discovered that ML was in far worse shape than they expected, BAC tried to back out, but was instead coaxed/coerced into staying the course by the Treasury and Fed (at the tail end of Henry Paulson’s term). Would it not be perverse if the Treasury and the Fed now turn around and restructure BAC wiping out equity holders and haircutting creditors? Could not the argument be made by many of the equity holders that they suffered this loss because of intervention of the Treasury and Fed in November 2008?

Restructuring BAC is problematic because of the Treasury and Fed actions. But instead of restructuring BAC, why not go after Citigroup? It too is a too big to fail zombie, but to the best of my knowledge, it did not receive the same commitments that BAC did in the fall of 2008.

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