“I’m as mad as hell, and I’m not going to take this anymore!”  That line from the 1976 satirical film “Network”, bellowed by lead character Howard Beale (actor Peter Finch), could easily resonate from B of A’s executive suite in these challenging times.

Bank of America CEO Ken Lewis’ most recent pique could no doubt result from the pronouncement on el siete de mayo by the Federal Reserve Bank, in conjunction with United States Department of Treasury and supported by the Obama administration, that Bank of America needs to raise $33.9 billion in additional capital.  Ben Bernanke and Timothy Geithner (respectively, Chairman of the Board of Governors of the Federal Reserve System and Secretary of the Treasury) were motivated to issue such an edict given the results of the “stress test” that assessed whether Bank of America had enough capital to survive a protracted economic slump.  To be fair, 18 other banks also were placed under the microscope along with Bank of America.

Mr. Lewis and Bank of America’s troubles began when it acquired (December 2007) Countrywide Financial Corp., which was on the verge of insolvency due to its mortgage lending activities and its exposure in the secondary market (i.e., securitized mortgage obligations).  The acquisition of Countrywide was a shrewd deal ($209 billion in assets and $55 billion in deposits at purchase price of approximately $4 billion— an all stock transaction) for Mr. Lewis’ Bank of America, as it gained, at the time, the leading position in the consumer real estate market (production franchise, servicing capabilities, and technology platform).  However, little did Mr. Lewis imagine that this acquisition along with financial market tailspin would begin to erode his company’s value on the Street.

Let us not forget, Bank of America also acquired Merrill Lynch & Co., Inc. (long coveted by Mr. Lewis) under intense government pressure.  At the time of the acquisition, Merrill Lynch was preparing to report a $15.8 billion loss for the fourth quarter of 2008.  In this brokered agreement/deal, the U.S. government agreed to assist in the Merrill acquisition by making a further investment in Bank of America of $20 billion in preferred stock carrying an 8 percent dividend rate.  The U.S. government agreed to provide protection against further losses on $118 billion in a selected capital markets exposure, primarily from the former Merrill Lynch portfolio.  For this guarantee, Bank of America agreed to pay a premium of 3.4 percent of those assets for this protection program.

For taking such actions, Mr. Lewis’s supporters would contend that he be considered a pillar in U.S. banking history.  Further, his supporters would suggest that he be revered by shareholders as a banking leader who expanded his company’s reach in consumer real estate lending, investment banking, retail brokerage and wealth management.  However, facing a continual fallout from the Merrill Lynch acquisition, a bloc of Bank of America shareholders voted (in late April) by a narrow margin (50.34 percent) to split the Chairman of the Board and the Chief Executive Officer positions.  As a result, Mr. Lewis relinquished his chairperson’s position, but retained his position as president and CEO.  It should be pointed out that shortly after the vote to split the chairman and CEO positions, a separate shareholder vote re-elected Mr. Lewis to the bank’s board as a director.  Perhaps the bank’s first quarter earnings report swayed them, given that the bank generated a $4.2 billion profit, compared to generating a $4.0 billion profit for all of 2008.  It only goes to show you that shareholder loyalty is only predicated on the next earnings release. 

Now comes the results of the government’s stress test.  The Obama administration and regulators have asserted that the stress tests were a “forward-looking” exercise designed to estimate bank losses in 2009 and 2010 under two economic scenarios.  One scenario reflected the expectations about the current recession (unemployment reaching 8.8 percent in 2010 and home values dropping another 14 percent this year).  The second scenario envisioned a recession deeper than what analysts predict (unemployment rising to 10.3 percent next year and home values losing another 22 percent this year).  Under the second scenario, banks were expected to ensure they would have Tier 1 risk-based capital ratios of 6.0 percent, and Tier 1 common risk-based capital ratios of 4.0 percent at the end of 2010.  The Obama administration has further asserted that the evaluation was/is an attempt to avoid nationalizing banks and to ensure that institutions can lend money.  In fact, Obama administration officials contend that most banks are considered well capitalized under current conditions.  However, economic uncertainty has hindered their ability to lend money and/or attract private capital.  Chairman Bernanke has echoed that all of the 19 banks that underwent the stress test assessment are solvent, and the exam results will reassure markets that banks can continue lending.  Further, Chairman Bernanke has asserted that the stress test exercise could help guide any overhaul of bank supervision and regulation that lawmakers are considering (i.e., a harbinger for banks of all asset sizes).

Banks, like Bank of America, that have been singled out by the stress test as being undercapitalized will have until June 8, 2009, to come up with a plan to raise funds, and have that plan approved by their regulators.  Further, these banks will have until Nov. 9, 2009, to raise the designated capital amount.  Banks that are deemed to need more capital could sell assets, raise money from private investors, and/or once again tap the government.  Banks that cannot tap the private sector would be encouraged to refurbish capital through “mandatory convertible preferred” shares.  A mandatory convertible preferred share is a new instrument that allows banks to apply for new funds from the government by selling it to the Treasury.  The new instrument can convert to common shares (TCE – tangible common equity) when a bank or its regulator deems it appropriate, or after seven years.  Ostensibly, with the new instrument, the government remains a passive investor, and only gains voting rights once shares are converted into common equity.  In addition, banks that are deemed undercapitalized and have received TARP money can exchange TARP shares for mandatory convertible preferred shares. 

As with TARP shares, the drawback with mandatory convertible preferred shares is that those institutions that obtain such a government investment will be restricted in paying dividends and buying back their own stock, and must comply with strict executive-compensation restrictions, including curtailed bonuses for top executives and earners.  Further, when mandatory convertible preferred shares are converted (required after seven years), the instrument will dilute shareholder value.

Given the dilutive nature of mandatory convertible preferred shares, it is more than likely that Mr. Lewis and Bank of America will take other routes (i.e., raise private capital, sell assets, or convert non-governmental equity into common shares) to replenish its capital shortfall.  Granted the other options available to the bank also will dilute shareholder value, but it would not be “as dilutive” if it were to sell mandatory convertible preferred shares to the Treasury, and ultimately have the government as one of its major shareholders.  In fact, Bank of America has already taken the initial step (within one-week of the stress test results) to raise capital.  The banking behemoth raised $7.3 billion from Asian investors through the sale of its ownership stake (roughly 5.7 percent) in China Construction Bank Corp.

If this is not enough, Bank of America and other big banks are now facing another hurdle to overcome.  Our nationally representative consumer survey of 1,555 (February 2009) has found a lack of consumer interest in banking with Bank of America, Chase, Citibank, or Wells Fargo.  Specifically, our survey detailed that one-half of all consumer households nationwide currently have a banking relationship with those Big Four banks. Further, while 63 percent of the Big Four’s customers remain loyal to those banks (i.e., “extremely or very likely” to remain as customers), 25 percent are undecided if they will remain as customers, while 12 percent suggest that they are not very or not at all likely to remain as customers.  The survey further showed that the Big Four are poorly perceived by non-customers with not one household indicating that they would be “extremely likely” to become their customer, and less than one percent indicating that they would be “very likely” to become their customer.  In contrast, 72 percent of non-customers indicated that they were “not at all likely” to become customers of these banks. 

Such findings suggest that Bank of America and other big banks will be limited in their ability to acquire new customers due to the financial crisis.  Although being limited in the short-term, Bank of America and other big banks have the wherewithal (resources, technology, etc.) to weather this storm.   However, in the interim, regional and local banks, savings institutions, credit unions and Internet banks have an opportunity to grow.

And for Mr. Lewis, he will not take it anymore.   Mr. Lewis has reported that he will step down as CEO as early as the financial crisis ends or within three years.

 

The opinions published on this Web site are those of the authors alone and do not reflect those of Raddon Financial Group as a whole. All care but no responsibility is taken for errors and omissions.

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