Shares in Bank of America (BAC) have dropped throughout the year. At the time of the writing of this article the shares had slumped 41% since January. It is clear that the market is very worried about the company. Earlier this year the Fed refused to allow BAC to increase its dividend based on fears that it may not be able to meet its future capital requirements.
In order to attempt to shore up its capital base, the bank recently sold $5 billion in preferred stock to Warren Buffett with a dividend rate of 6%, along with warrants to buy 700 million shares at an exercise price of $7 a share. Not only that, Buffett extracted the unusual condition that the dividends are cumulative. This means that if the bank doesn’t pay Buffett a dividend it still owes him the money. This form of preferred shares went the way of the dodo bird a couple of decades ago.
These are clearly actions of a bank that is in desperate need of a cash infusion to shore up its capital base. This past week BAC sold half its holdings in China Construction Bank Corp., raking in $3.3 billion. People in the know are now speculating that BAC will sell tracking shares for its Merrill Lynch unit..a precursor to selling off that unit. A unit that accounts for most of its net income!!
One of the big questions in all this is what does Warren Buffett know that the rest of us don`t know. We do know that he announced his deal with BAC a couple days after his meeting with President Obama.
Perhaps the President assured Warren that the Government or the Fed would bailout BAC if needed. After all we do know that after Buffett made a multi-billion dollar deal with Goldman Sachs that GS got preferential treatment in getting paid fully for exposure to AIG..something nobody else got!!
The big question is whether the President can actually deliver on such a promise if he did actually make one to Buffett.
My view is that he can`t and this investment may be the one investment that Buffet and by extension his shareholders will take a hit for.
Frankly this does not concern me much. Buffet is an adult and he can afford to take his licks if it comes to that. The real concern is whether a collapse of BAC would lead to a complete meltdown of the world financial system.
The potential for this to happen is quite large.
Heres why…
According to government data, BAC has about 48 TRILLION in derivatives contracts. The third largest after JP Morgan and CitiBank. The same government data does not breakdown the net position by bank, but does provide a figure for the whole banking industry. The industry-wide net exposure is about 8%.
There is no particular reason to suppose that BACs exposure is different from the industry figure since JPM, C and BAC account for most of the outstanding derivative contracts. So if we take the 8% figure for BAC we get a net exposure of close to four trillion..yep..4 TRILLION!!
To put this number into perspective, Lehman Brothers had a net exposure of about $1 trillion. It was determined at that time that it was too big to save. Unlike Bear Stearns, nobody stepped up to the plate to buy it with so much derivative exposure.
BAC has derivative exposure at least FOUR TIMES larger than Lehman Brothers. It is clear that nobody can step up the plate for that amount of money. Nobody is big enough or strong enough!!
All that being said, a failure of BAC would decimate the world financial system. Lehman Brothers was big enough to basically freeze the whole system. BAC being four times bigger in terms of the size of the problem would have a catastrophic effect.
With the burgeoning government deficits there is really no practical way for the Government to step in. Further it very clear that Main Street has no stomach for the government to do this. Especially after watching what happened with the TARP money and the subsequent record bonuses paid to Wall Street executives. The government and hence taxpayers do, however, have a potentially large liability in the event of a bankruptcy of BAC. The government, through the FDIC, provides deposit insurance of up to $250,000 per account in the case of default for deposits made to a failed bank.
So in effect taxpayers would take it on the chin either way..through a TARP-like government program to save BAC or through ponying up the money to backstop the FDIC. It’s difficult to know how much this would cost taxpayers and by extension how much it would increase the size of the National Debt. It is highly likely that if this were to happen…interest rates in the US would rise dramatically.
This leaves the only organisation capable of riding in to the rescue…the Fed. As lendor of last resort it could do this. The big question would be whether it would have the stomach to do it. The Fed balance sheet is already bloated with the QE 1 and QE 2 asset purchases. Such an action could call into question the very viability of the Fed itself. Sure the Fed can just print money to pay for its losses and as such can never technically go bankrupt..but in practical terms a bailout action by the Fed could lead to an effective bankruptcy of the US Central Bank.
The costs of such an action in terms of depreciation of the US dollar and inflation would be staggering. Main Street would take it on the chin one more time. There are already bipartisan rumblings about doing away with the Fed. A bailout of BAC by the Fed could be the last straw!!
As well, such an action could be the last gasp of the US dollar remaining the reserve currency.
If the US economy was not in a recession before this happened it would be in one after!!
All of these possibilities are quite frankly scary. Sadly, they are all within the realm of possibility, Particularly if the US slips into another recession approximating what happened in early 2009. Other triggers could be a banking crisis in Europe due to the sovereign debt issues related to the euro zone. The Fed has already lent $500 million to an undisclosed European bank to shore up its capital base and it is likely that there will be more to come.
These actions are reminiscent of a famous quote by Albert Einstein….”We can’t solve problems by using the same kind of thinking we used when we created them.”
The bottom line is that people need to walk very carefully over the next year. BAC has introduced yet another big storm cloud to gathering financial hurricane. Given the experience with Bear Stearns and Lehman Brothers..the end can come very quickly for those that did not heed the early warning signs.
In my view the warning signs for BAC are already upon us. The time to act is NOW!!
Soooo…what does one do??
If you believe as I do that the financial equivalent of a Category 4 or 5 hurricane is coming, then you want to be a far away as possible from the eye of the storm. The eye of the storm is the financial services sector. I do not hold any bank shares in my portfolio. I would lighten up on stocks in general (no more than 25%) and overweight those companies that are the most recession proof and also pay good dividends..eg pipelines and telecommunication services. I would also hold corporate bonds in non financial companies. AND keep lots of cash on hand to swoop in when the market tanks as the storm hits.
My current asset allocation is 20% stocks (pipelines, telecommunications and some REITs)…40% bonds…40% cash. Year to date the portfolio is up 4-5% primarily due to dividend income..interest on the bonds and some capital appreciation of the bonds (mostly over the past couple of months). I fully intend to increase the cash portion as it becomes more evident that hurricane is upon us.
As always..comments and discussion are encouraged..