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Bank of America's unappetizing menu

by William McConnell and Ira Teinowitz in Washington | Published August 24, 2011 at 5:26 PM

Shares of Bank of America Corp. led a rebound in financial stocks Wednesday, Aug. 24, after well-known analysts Richard Bove of Rochdale Research and Meredith Whitney of Meredith Whitney Advisory Group LLC issued statements arguing that the embattled bank holding company has sufficient liquidity to weather the troubles in its mortgage portfolio and the legal storm stirred up by bond insurers and investors in mortgage securities the company issued. Bank of America shares finished just under $7, up from their $6.30 close Tuesday.

A one-day rally in BofA's shares, however, will not end speculation that the company will be forced to take dramatic action to right its balance sheet. Predictions about the institution's future have sparked a variety of rumors on Wall Street, including reports that regulators are arranging a takeover by J.P. Morgan Chase & Co. or that an investor is preparing to make a huge investment.

Bank of America has denied that any drastic action is in the works, and most analysts and Washington sources have scoffed at the notion that J.P. Morgan could acquire the troubled institution.

One source called the notion of a Federal Deposit Insurance Corp.-arranged buyout by J.P. Morgan an "investment banker's wet dream." Others noted that J.P. Morgan has its hands full paring down its own portfolio of bad mortgages and is unlikely to take on an even bigger headache in the form of BofA. Furthermore, the FDIC and the Obama administration would have to pull off some regulatory sleight of hand to approve the deal because it would tear a huge hole in the 10% cap on nationwide deposits.

Bank of America instead might put its Countrywide Financial Corp. unit -- the source of most of its problems -- into Chapter 11, said Douglas G. Baird, former dean of the University of Chicago Law School and now a professor there who focuses on corporate reorganization and contracts. Baird said another option might be for the government to subject Bank of America to an orderly liquidation under the new Dodd-Frank Act authority, but he said that latter route comes with a variety of obstacles.

"My guess [Bank of America] would not be a candidate [for reorganization under the Dodd-Frank regime]," said Baird, who owns some BofA stock. "It would need a whole number of i's dotted and t's crossed. You would need to show that an ordinary bankruptcy wouldn't work. Then get the secretary of the Treasury and several other entities to sign off and finally show it was 'systemically important.' There are so many other alternatives, and you don't go to Dodd-Frank and orderly liquidation until you've already broke through other firewalls."

Deriding Countrywide, acquired by BofA in 2008, as "the gift that keeps on giving," Baird said it's more likely the bank would try to take some other step to dispose of the Countrywide assets.

If they remain partitioned from the rest of the bank, the obvious route would be to simply put the Countrywide assets into bankruptcy, he said. "You could throw it overboard and put it in Chapter 11."

While that alternative wouldn't entirely eliminate BofA's problems, it could leave the bank much less exposed, he said.

He said suits against BofA for its own actions, rather than Countrywide's, even those from state attorneys general, are "not that straightforward."

"You are still exposed to liability, but one that is smaller. You could imaging them saying, 'Now is the time to cut [Countrywide] loose.'/"

Bank of America's harshest critics insist, however, that putting only Countrywide in Chapter 11 would not eliminate the legal claims against the holding company. Already, legal setbacks in the company's effort to fend off lawsuits from investors and insurers of mortgage securities packaged by Countrywide create uncertainty about BofA's total exposure. That uncertainty will mount for months to come, said Chris Whalen, a banking analyst with Institutional Risk Analytics, who has been calling for the restructuring of Bank of America and the country's other largest banks since the beginning of the financial panic in 2008.

"For the past three years, Bank of America has been using the prospect of a Countrywide bankruptcy filing as a stalking horse in their negotiations with plaintiffs, but it's not a real alternative. The headline risk alone would kill them," Whalen said.

BofA cannot withstand the downward pressure on its stock price that the uncertainty continues to create, said Whalen, who once was a seemingly quixotic voice but now has a growing number of adherents on Wall Street -- when it comes to BofA anyway.

"I don't think the company can survive if the stock price and the risk spread on the company's debt stay where they are," Whalen said.

In Whalen's view, the company has two options: either voluntarily put the entire holding company in Chapter 11 or wait until its financial condition deteriorates to the point where the regulators have no choice but to put it into receivership of the FDIC under the Dodd-Frank resolution regime.

A voluntary restructuring is the best choice for shareholders and bondholders, he said, because they would end up with shares in a well-capitalized, highly liquid institution that will be capable of expanding credit.

"Chapter 11 allows BofA to force creditors and state attorneys general to file claims but also allows BofA debt to be converted to equity. Suddenly Bank of America has $300 billion in common equity instead of $100 billion," he said.

Despite political resistance to the idea, Whalen argued, a restructuring of BofA would have immediate positive effects on the U.S. economy. "The government has to use receivership to give us certainty," he said. "It's not fun; it's not pretty. But the day after you have an idea of what Bank of America's liabilities really look like, and it can move forward and support leverage and start to grow. If we don't get credit to grow in this country, we are not going to get economic recovery -- end of story."

Stockholders and bondholders will fare worse if the government carries out a forced restructuring, he said. The FDIC would create a bridge bank that would keep depositors whole, and its balance sheet would be rounded out with good loans. However, investors would have no interest in the new bank. "They would be sitting on the dead bank holding company and would get whatever recovery they can manage. If I'm a bondholder, option A [voluntary restructuring] looks better."

Bert Ely, another banking analyst, insisted that BofA's legal woes will not force the institution under. As they play out, BofA should try to convince Wall Street that its ongoing operations are healthy. Ely said Bank of America would be wise to split its operations in two, as Citigroup Inc. did in 2009. Citi's core transaction services, investment and retail banking, and private banking units were placed in its Citicorp unit. Citi Holdings was created to manage its brokerage and asset management and local consumer finance units as well as bad assets until they could be sold.

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