Once upon a time, there were three good banks: Bank of America, JP Morgan, and Citigroup.
When the financial crisis started, these banks stepped up and seemingly did some favors for the government. JP Morgan acquired Bear Stearns (with some government help). Bank of America gobbled up Countrywide (the infamous sub-prime lender) and then devoured Merrill Lynch. Citigroup made a deal to grab the troubled Wachovia (with government help).
But the financial crisis kept on going and questions started to arise.
Now the government is barfing money to save both Citi and Bank of America.
And there is no end in sight.
This is the point where I got suspicious. Citi’s oddly walked away from a done deal with Wachovia. Citi had offered $1 per share and the government was going to provide a backstop on Wachovia’s troubled assets.
Wells Fargo showed up after the deal was done and offered $7 and no government backstop. The initial reaction was that Wells Fargo was too late. A deal is a deal. Too late, too bad.
After some initial rumblings, Citi walked away. To me, that raised some red flags. There was something amiss at Citi.
Now the story is clearer. A desperate Citi has taken addition government cash injections and backstops. Citi’s toxic assets + Wachovia’s toxic assets would have been a disaster for the government.
Now, Bank of America is at the trough. They acquired Merrill Lynch for $28 per share (total of $50 billion, in stock). At the time, it seemed like a remarkably generous price. Pundits thought that they saw something in the valuation that the market didn’t.
However, it is obvious now that this was not the case. It is not really clear that Bank of American knew how much Merrill was worth.
It was probably worth zero.
CEO Kenneth Lewis gambled the viability of Bank of America to make these two giant acquisitions.
But why shouldn’t he have done it?
He knew that Bank of America was too big to fail. He knew that the government would fix any bets gone bad.
In economics lingo, this is called moral hazard. It arises when there is no real downside. Why shouldn’t BofA go on a spending spree?
Why shouldn’t they acquire new assets at overvalued prices? If they didn’t do this, one of their competitors would. They know the government would standby with a dump truck full of cash if it didn’t work out. Better that Bank of America gets the dump truck than a competitor.
This week the dump truck arrived and Lewis took $20 billion of extra cash (that’s a total of $45 billion in cash, $15B BofA TARP + $10B Merrill TARP + $20B New). Plus a backstop on $118B of troubled assets
(BofA covers the first $10B of losses, Treasury and FDIC share the next $10B and then government covers 90% of the rest).
Notice the following fact.
Bank of America has 5.02 billion shares outstanding. That means their market capitalization is $36B (share price closed Friday at $7.18 multiplied by shares outstanding). First, the government has injected more cash than the firm is worth.
Second, for that kind of money, they could own the entire firm. But they don’t. Or should I say we don’t.
Obviously, we need a new strategy here.
The government does not want to nationalize even though they have put in more than enough money to have 100% of equity. The government is satisfied to play the role of a passive investor.
But this is not the time to be the passive investor — it is the time to be the activist. There must be some check on management.
Traditionally, the checks on management come from the shareholders. However, in the case of Bank of America, the shareholders have been pummeled. Over the past 52 weeks, the stock is down 80% and the dividend was slashed from $0.32 to one cent.
We need a new approach. Let me reiterate the key elements in my September 2008 plan.
1. Equity injections to all viable financial institutions. This ensures that good money gets to good banks. The good banks will lend it out because they don’t need to reduce risk.
2. Purchase troubled assets at a fair value that reflects a slow recovery in the credit markets at the end of 2009. This ensures that the American taxpayer gets a good price and has a chance at a fair return on the investment.
3. Restructure individual mortgages where the government provides half the principal write down. This is done on mortgages selected by the financial institution and does not apply to mortgagees who took reckless risk buying two or more properties. If the property appreciates when sold, the government and the financial institution would recapture some money.
Unfortunately, we have seen a lethargic, ad hoc, flip-flopping response to this crisis.
The credit crisis began a year and a half ago. The cost of fixing it back then was trivial compared to the cost we face today.
Let’s not forget the math here. There are 154 million Americans working or looking for work. So for every $150 billion, each of us is writing a check for $1,000.
We all wrote the $1,000 check for AIG alone. This firm, supposedly in the insurance business, took a reckless $400 billion unhedged bet. Now, each of us must write a check for $1,000 (or a loan for $1,000). I don’t know about you — but it makes me sick.
I agree that, at this point, the government also needs a fiscal response. I have no problem with spending on infrastructure – it is a productive long-term investment. However, we have to stop throwing good money at bad. Now.
See my comments in the Wall Street Journal.
Also, see my remarks in the Los Angeles Times.