Bank of America May Have to Sell Merrill to Survive

Bank of America could be forced to spin-off Merrill Lynch, which is the company's most profitable unit.

Bank of America
Oliver Quillia for
Bank of America

As the company faces a perfect storm of mortgage putback risk—with daily pressure from a flurry of lawsuits, including filings by American International Group, a subsidiary of U.S. Bancorp, Goldman Sachs, the Federal Deposit Insurance Corp. and a coming suit from the Federal Housing Finance Agency, according to published reports—Bank of America is poorly-positioned to comply with enhanced Basel III capital requirements, and the Federal Reserve's request for contingency capital plans sheds light on a possible spin-off of Merrill Lynch.

According to a Wall Street Journal report citing unnamed sources, the Federal Reserve has requested contingency plans from Bank of America, covering how the nation's largest bank holding company would navigate more extreme economic uncertainty.

According to the report, the bank submitted several options to the Fed including the more "theoretical" option of raising capital by issuing tracking shares for the Merrill Lynch unit, which was acquired by Bank of America on January 1, 2009, in an in exchange of common and preferred shares, valued at $29.1 billion.

Bank of America declined to comment for this article, but mere mention of issuing tracking shares on the Merrill unit's performance puts a spin-off on the table.

FBR Capital Markets analyst Paul Miller says that Bank of America "has been very good at telling people there's no way to spin it off, as there hasn't been any sector analysis of Merrill Lynch" in Bank of America's financial statements. "If they did any, Merrill themselves would want to be spun-off," Miller says, adding, "if you're Merrill Lynch and you're making pretty good money and all your profits are going to pay-off Angelo's mistakes, why would you want to do that?"

Miller refers to Angelo Mozilo, the former CEO of Countrywide, which was acquired by Bank of America in 2008, and which is the source of most of Bank of America's mortgage pain.

Meanwhile, Richard Staite of Atlantic Equities makes a strong case that Bank of America's path to compliance with enhanced Basel III capital requirements will be much more difficult than CEO Brian Moynihan let on earlier this year.

According to a report put out by Staite on Thursday, the analyst estimates that Bank of America "will be $45 (billion) below proforma Basel III requirements at end 2012." This estimate was reduced from a $50 billion shortfall, following the company's decision to sell its international credit card business, which the analyst says "could free up more capital than initially expected." The estimate also factors in the gain from the company's sale of half of its investment in China Construction Bank.

The recent $5 billion preferred stock investment by Warren Buffett's Berkshire Hathaway won't boost Bank of America's Tier 1 capital ratios, because the preferred shares feature a cumulative dividend. If Berkshire were to exercise the 700,000 warrants that were granted as part of its preferred investment, it would, of course, boost Bank of America's Tier 1 capital, but "given the warrants have a ten year life," Staite doesn't "expect them to be exercised any time soon."

While the enhanced Basel III capital requirements won't be fully phased-in until January 2019, Staite says that Bank of America "cannot risk another loss of confidence," and will likely "continue the sale of non-core assets," while also reducing "risk taking in core businesses amid a deeper restructuring."

Under the Basel III standards, Bank of America needs to achieve a Tier 1 common equity ratio of at least 9.5 percent—including a 2.5 percent capital conservation buffer and another 2.5 percent required for "Global Systemically Important Financial Institutions"—by January 2009. And while Staite says the bank is "technically correct" in estimating it will have a Tier 1 common ratio of 9.6 percent at the end of 2014, "this is not sufficient" as the company "needs strong ratios to keep funding costs low and keep the confidence of counterparties."

Market confidence is particularly important for Bank of America "during a period of macro uncertainty and when BAC is still exposed to considerable mortgage risk," which is why Staite believes "investors would like to see BAC closer to meeting full Basel III requirements by the end of 2012." Otherwise, according to the analyst, Bank of America will face rising funding costs and lower net interest margins, "making it less competitive."

Staite added that Bank of America's continued moves to reduce risk and shore up the balance sheet leave Wells Fargo and JPMorgan Chase as "the two banks that are best placed to increase market share. The analyst has "Overweight" or "buy" ratings on Wells Fargo and JPMorgan, with a neutral rating for Bank of America.

In hindsight, Moynihan's earlier plan to begin returning capital to investors in the second half of 2011 was a pipedream, and the Federal Reserve probably didn't agonize too much over its decision to reject the company's capital plan.

For the second quarter, Bank of America posted a net loss of $8.8 billion, with its Consumer Real Estate Services unit losing $14.5 billion, mainly from the subsequently-contested $8.5 billion settlement of Countrywide mortgage putback claims with a group of institutional investors. Meanwhile, the company's Global Wealth & Investment Management unit contributed total revenue of $4.5 billion, including $3.5 billion from the Merrill Lynch Global Wealth Management group.

The bank's mortgage putback risk is the "great unknown," as the lawsuits continue, and out of $384.8 billion in one-to-four family residential mortgage loans serviced for others (excluding home equity lines) as of June 30, $148.8 billion, or 39 percent, were past due 90 days or more, according to the company's regulatory filing with the Federal Reserve. Another $22.6 billion, or 6 percent, of the loans serviced for others were past due 30 to 89 days.

Bank of America also reported that $131 billion, or 34 percent, of the one-to-four family mortgage loans (again excluding home equity lines) serviced for others, were in some phase of the foreclosure process, as of June 31.

Those are devastating numbers, in the midst of all the putback claims by institutional investors.

Moynihan's strategy of fully integrating the Merrill Lynch operations is understandable, of course, in light of the unit's continued profitability and lack of credit and mortgage putback overhang that Bank of America faces as the company continues to choke on former CEO Ken Lewis's disastrous decision to buy Countrywide in 2008.

But the company's consideration of a possible capital raise by issuing tracking stock for Merrill Lynch, investors' possible lukewarm reaction to a tracking stock, Bank of America's unknown level of mortgage putback risk as even the federal government piles-on, and the possibility of a double-dip recession, put an eventual Merrill spinoff on the table. ______________________________

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