Bank of America Corp: A Beached Whale

Bank of America (BAC) reported earnings today that modestly exceeded analyst consensus estimates. However, as we noted in April (Shulmaven: Winter Comes to the Bank Stocks), BAC was suffering from huge embedded mark-to-market losses on its held to maturity securities holdings which amounted to $108 billion at yearend 2022. Today BAC reported those losses, as of the end of the third quarter, increased to $132 billion on a cost basis of $603 billion, not chump change.

The bank also reported that its tangible book value per share was $23.79. The $132 billion in embedded losses amounts to $16.35/share. Thus the true tangible book value would be a meagre $7.44/share. With BAC stock trading this morning at $27.15, it is being valued at a very pricey 3.6X "true" tangible book value. To me this means, that unless interest rates fall dramatically, BAC's share price will be weighed down for years.

Shulmaven Way Ahead of the Fed on Silicon Valley Bank Failure

Why did it take more than a month for the Fed's autopsy of the Silicon Valley Bank (see below) when this blogger had it figured out as early as March 11, 2023?

From the "Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank April 2023," Released April 28, 2023

"1. Silicon Valley Bank’s board of directors and management failed to manage their risks;

 2. Supervisors did not fully appreciate the extent of the vulnerabilities as Silicon Valley Bank grew in size and complexity; 

 3. When supervisors did identify vulnerabilities, they did not take sufficient steps to ensure that Silicon Valley Bank fixed those problems quickly enough; and 

 4. The Board’s tailoring approach in response to the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) and a shift in the stance of supervisory policy impeded effective supervision by reducing standards, increasing complexity, and promoting a less assertive supervisory approach."

From Shulmaven March 11, 2023 Shulmaven: Random Thoughts on the Economy and the Stock Market - No. 3

* Last week a black swan flew over the markets in the form of the failure of the Silicon Valley Bank (SIVB) with assets of $211 billion, making it the second largest bank failure in U.S. history. Although shorts were hovering over the stock for awhile, the suddenness of the collapse shocked the markets. The failure was the result of two cardinal sins of banking: 1) like an early 1980's S&L the yield on its assets were far below its funding cost due to the rapid rise in interest rates and 2) like the Texas banks of the 1980s its assets and deposits were concentrated in one industry; oil in the case of Texas and technology in this case.

Thus far, unlike in 1984 when the FDIC bailed out all of the creditors of the Continental Illinois National Bank, with $40 billion in assets and the it being the 7th largest bank in the U.S., Silicon Valley depositors above the $250k insurance threshold (87% of the deposits) will have to wait in line to get paid out of the receivership. Thus there are more than a few companies that will not be able to meet payroll. Just to note the Continental Illinois bailout gave rise to the term "too big to fail."

From Shulmaven, March 18,2023 Shulmaven: Random Thoughts on the Economy and the Stock Market - No. 4

*- This episode represents a complete failure of the bank regulatory apparatus in that Silicon Valley's 86% deposit growth in a year represented an unmistakable yellow flag. Further, the bank invested those deposits in long duration assets which should have been viewed as a per se violation of safe and sound banking practice. That would have triggered either the closing of the bank or the firing of its officers. I can't wait to hear the testimony of the regulators from the FDIC, the San Francisco Fed and the State of California testifying before Congress.

And don't forget Shulmaven April 2, 2023 Shulmaven: Winter Comes to the Bank Stocks

My guess is that when the Federal Reserve adopts new stress tests it will include the hitherto omitted interest rate risk as a key criterion. If that criterion were included it is highly likely that at minimum BAC would be prohibited from buying back stock and increasing its dividend. In fact the Fed might require the bank to cuts its dividend and increase its equity capital. Why? On a mark to market basis BAC currently has book equity capital/assets ratio amounting to a meagre 5.4% compared to its accounting book value of 9.0%. 

Winter Comes to the Bank Stocks

Although the now defunct Silicon Valley Bank is viewed as the poster child for gross duration mismatch of bank asset/liability management, the real poster child is the giant Bank of America. ( See: Shulmaven: Random Thoughts on the Economy and the Stock Market - No. 3) How so? As of yearend BAC was sitting on a mark to market loss of a whopping $108 billion in its held to maturity portfolio up from $9 billion the year before. If those losses were recognized on its books it would slash the the common equity capital on its books by 44%. For tangible book value per common share the reduction would be a staggering 62%.

Now lets look at the numbers.

Common Equity/share  -                        $30.61

Adjusted for Mark to Market Loss -      $17.11

Tangible Book Value/Share  -                $21.83

Adjusted for Mark to Market Loss -       $ 8.33

With BAC shares closing Friday at $28.60 this means that instead of trading at a modest 1.3X tangible book value the shares are really trading at a very high 3.4X tangible book. My guess is that when the Federal Reserve adopts new stress tests it will include the hitherto omitted interest rate risk as a key criterion. If that criterion were included it is highly likely that at minimum BAC would be prohibited from buying back stock and increasing its dividend. In fact the Fed might require the bank to cuts its dividend and increase its equity capital. Why? On a mark to market basis BAC currently has book equity capital/assets ratio amounting to a meagre 5.4% compared to its accounting book value of 9.0%. 

Simply put the bank is way under-capitalized. My suggestion for Brian Moynihan, the bank's CEO, is launch a $100 billion rights offering  by issuing 5 billion shares at $20/share on the basis of 1 share for each 1.6 shares held. Sure it would massively dilutive, but the bank would then be freed up to sell its long term bonds and get on with the business of banking.

Mark to market losses of held to maturity assets is not the only issue facing the banking system. FDIC premiums are going to soar to pay for the Silicon Valley Bank depositor bailout and there are huge embedded losses on the banking system's  commercial real estate loan portfolios. As a result much like in the early 1980s when the money center banks were saddled with unrecognized losses on their Latin debt portfolios, bank stocks will have a long slog ahead of them. Winter is here.

My Amazon Review of Nicholas Sargen's "JPMorgan's Fall and Revival: How the Wave of Consolidation Changed America's Premier Bank"

 

A Reflection on the House of Morgan

 

Nick Sargen, longtime Wall Street economist and a friend and former colleague, has written a personal memoir of his working at JPMorgan, a history of the financial markets from 1978-2005 and a too endearing recent history of JP Morgan and the strategic issues it faced in the late 20^th century.* To me it is a misnomer to call JPMorgan “America’s premier bank,” in that as of yearend 1976 Morgan, with $28 billion in assets was the fifth largest bank holding company with roughly one-third the assets of Bank of America and standing behind Citicorp, Chase Manhattan, and Manufacturers Hanover. Simply put JPMorgan’s past was brighter than its future.

 

Sargen arrives at Morgan in early 1978 with an economics Ph.D. from Stanford after a stint at the Federal Reserve Bank of San Francisco where he specialized in international economics. He is thrust into a rapidly inflating global economy and the world of sovereign lending to Asia and Latin America and is taken under the wing of the banks lead international economist, the highly respected Rimmer De Vries. In the early 1980’s Morgan had a virtual murderers row of economists that included Dick Berner (later Morgan Stanley’s chief economist), Bill Dudley (later Goldman Sachs’ chief economist and later President of the NY Fed), and Steven Roach (later Morgan Stanley’s chief economist). It was quite the intellectual hothouse.

 

By 1982 the American banking system and JPMorgan found themselves facing the imminent default of a host of Latin American countries as their scheme to recycle petro-dollars went awry. For all practical purposes the banks were insolvent. Sargen whose early warning system at the San Francisco Fed signaled the crisis, was not heeded at Morgan and elsewhere as the lure of high spreads dazzled the commercial banker of that day. To me, of all banks, Morgan should have stayed away given its experience with the Dawes Plan of the 1920s which recycled German reparations payments. Morgan partner Tommy Lamont was in up to his eyeballs with German loans. Of course, that all came crashing down when the New York call money market sucked money in from all over the world and the Fed’s 1929 tightening brought that episode to an ignominious end. The Volcker tightening of 1979-82 had the same effect. Simply put, Morgan should have known better.

 

Sargen describes a very insular and elite coat and tie “WASP” culture that only hired from the best of schools. There is no way Morgan would have hired me as a Jewish street kid from Queens with a UCLA finance Ph.D.  Although it was somewhat of a culture shock when Sargen was lured away from Morgan to the rough and tumble shirt-sleeve culture of Salomon Brothers. Sargen arrived in 1984 and I arrived there two years later. There Sargen learned the power of Salomon’s trading floor and he was shocked to see the firm’s chairman John Gutfreund sitting at open desk right on the floor. A far cry from JPMorgan. While there Sargen witnessed the collapse of the dollar, the 1987 stock market crash and the Brady Plan for Latin debt and Salomon’s infamous treasury scandal. By 1991 he was looking for greener pastures and ended up running money for Prudential and then in 1995 he returned to Morgan to be the chief strategist for its Private Bank. All the while he keeps up with the fits and starts problems facing Morgan as it enters investment banking.

 

Sargen rightly notes that Morgan’s strategic dilemma was that its core strength of banking for America’s top corporations was being disintermediated by the Wall Street investment banks who picked off its clients by offering better terms and conditions via the short-term commercial paper and long-term capital markets. Morgan under the leadership of Lew Preston and Dennis Weatherstone understood the problem and began to build an investment bank skirting around the requirements of the Glass Steagall Act that limited commercial banks from underwriting securities. They were successful to a degree, but at great cost. According to Sargen, Morgan’s biggest strategic mistake was not buying State Street Bank in 1990 when it had the chance.

 

With the late 1990’s bull market in full swing Morgan is left behind. All the action is in the new economy, while Morgan is wedded to the old economy. Its stock lags and of a sudden Morgan becomes takeover bait. Sargen cites an interesting vignette when Morgan invites twenty something TheGlobe.com CEO to address their annual managing directors meeting. Krizelman addresses the crowd in jeans and a tie-dyed T-shirt. The game was over, and Chase Manhattan Bank would soon acquire Morgan. However, the culture class was enormous with Chase and Morgan people hating each other’s guts. It would only settle down after JPMorgan Chase would acquire Bank One bringing with it a star banker named Jamie Dimon. It would be Dimon who restores the franchise to its past glory, but in a completely unrecognizable incarnation. Sargen would be long gone by then.

 

Because I am a finance and history geek and was involved in many of the big events discussed in the book, I thoroughly enjoyed reading Nick’s account. However, I am not so sure about the general reader. It would have helped if either there was more discussion about all the Morgan executives named in the book, or alternatively dropping a host of names. It was confusing at times. Further it would have helped to have annual data on Morgan’s profitability metrics and stock price. Nevertheless, from my biased perspective it is well worth the read.

 

*-I received the book from Sargen.

For the full Amazon URL see: A Reflection on the House of Morgan (amazon.com)

 

Will the Activist Consumer Come to Apartmentland?

Paul Polman, the CEO of the consumer products behemoth Unilever, was recently quoted in The Wall Street Journal as saying, "Where we had activist investors in the 2000s, we will see activist consumers this decade." Over the past few months activist consumers armed with a social networking infrastructure have over-turned what appeared to be arbitrary and capricious debit card fees at the Bank of America and billing fees at Verizon Wireless. What the B of A and Verizon have in common is high switching costs. This same factor holds true, even more so, for apartment tenants.

To be sure the apartment business is far more decentralized than wireless services and banking, but make no mistake it is certainly susceptible to the same type of consumer activism. Afterall what can seem more arbitrary than tenants paying different prices for essentially the same apartment unit; a phenomenon created by the use of airline-type yield management software now utilized by large landlords. Furthermore with hotter markets on both coasts exhibiting rental increases well in excess of wage growth, it doesn't take a genius to figure out that tech savvy consumers will soon link up to share information and start to raise a ruckus.

Because of decade low vacancy rates and rising rents, apartments have been the darling of real estate and REIT investors over the past few years. Although rent growth has slowed somewhat in recent months, most investors continue to project out-sized increases over the next few years, especially in Manhattan, Washington, D.C. and the greater San Francisco Bay area. I would doubt that not one in a hundred real estate investors are factoring in the liklihood that their industry will soon be the target of the new activist consumer. The bottom line is that it is highly likely that the apartment sector will soon face headline and in some cases real economic risk to the rosy rent projections now being forecast.