Economy

Bank Of America And What It Really Needs

Reports this morning that Bank of America needs $35 billion of 'capital" according to the stress tests are essentially wrong.

What Bank of America needs is about $35 billion of equity in the form of common. It does not, according to sources we've spoken to, need "fresh capital."

This is not to understate the importance of what BAC has to do, or the potential negative effect on the stock price. The bank has a market cap of about $70 billion, so $35 billion of new equity is potentially very dilutive. But the rally in the bank's share price suggest, as CNBC has been reporting, that this is potentially less dilutive than markets had already expected.

Bank of America branch, New York City.
Oliver Quillia for cnbc.com

BAC can satisfy the need for equity in a variety of ways, sources tell CNBC. First, it can sell assets. The government program to buy troubled assets could be up and running in the next month or so.

That's one potential source for the sale of toxic assets, along with just a plain old sale to private investors. BAC also has substantial equity stakes in other business, for example, Blackrock, which can be sold to raise equity.

In addition, CNBC is reporting this morning that earnings in excess of what regulators expect through the fourth quarter can also be counted toward capital.

Sources also tell CNBC the earnings expectations of regulators are pretty conservative. So any upside surprises reduce the common needs of BAC, just as downside surprise raise the need for additional common. Another source: As CNBC's Mary Thompson points out, (watch video) there is $27 billion of privately held preferred that can be converted to common.

Perhaps the most important, and most confusing, source of potential capital is the $45 billion of existing preferred already held by the government in BAC. This preferred is the old preferred under the system set up by former Treasury Secretary Henry Paulson.

Under the new system, banks can exchange that preferred for mandatory convertible preferred (MCP). This can be converted to common—on an as-needed basis—to absorb the decline in common equity that could result in further losses.

But the key is "as needed." That is, sources tell CNBC that regulators will be satisfied that the cushion against tougher times will be sufficient by the holding of mandatory convertible preferred (MCP). The bank does not need to convert the MCP to common immediately, only as needed to maintain a certain common equity percentage of its capital. So that makes the $35 billion a source of potential dilution, but not an absolute dilution.

Is this good news? It would be better if the government had said BAC needs no new common. But it's certainly not the worst news, which would have been if BAC needs to go out and raise $35 billion of new capital.