Opportunities in Bank Bonds, Part 2

Thinking about Citigroup and Bank of America — Given to Finacorp Clients 3/4/09

When the government gets involved in business, the rules of the game change. Creditworthiness becomes less of an “analyze the metrics” affair, and more of a “how strong of a guarantee” affair. What would it take to make the US Government change the way that it is behaving?

But first, how have the US Government, Citigroup and Bank of America been behaving? I’m going to begin this with timelines for Citigroup and Bank of America. Things have happened fast, so a review of how we got to this stage in the crisis could be instructive in where things might go from here.

Citigroup Timeline

1. 9/29/08 – C agrees to buy WB’s banking business. WFC offers more, but C’s offer is backed by FDIC. (Share Price prior to news ~ $20, afterwards $18.)

2. 10/9/08 – C abandons bid to buy WB’s banking business. (Share Price prior to news ~ $13, afterwards $14.)

3. 10/14/08 – C receives $25 billion in TARP money. (Share Price prior to news ~ $16, afterwards $19.)

4. 10/16/08 – C reports 3Q net loss of $2.8B. (Share Price prior to news $9.52, afterwards $8.89.)

5. 11/17/08 – C announces plan to lay off 52,000 workers. (Share Price prior to news $8.89, afterwards $8.36.)

6. 11/18/08 – Mike Mayo predicts that C could lose money in 2009. (Share Price prior to news $8.36, afterwards $6.40.)

7. 11/19/08 – C forced to take SIVs back on balance sheet after $3.3B losses. (Share Price prior to news $6.40, afterwards $4.71.)

8. 11/23/08 – US Government invest $20B in C, and guarantees $306B of their liabilities. Fitch downgrades rating to A+. (Share Price prior to news $3.77, afterwards $5.95.)

9. 12/2/08 – C sells $5.5B of FDIC-backed debt. (Share Price prior to news $6.45, afterwards $7.22.)

10. 12/19/08 – S&P cuts C’s rating by two notches to A. Moody’s cuts C’s rating by two notches to A2.

11. 1/13/09 – C sells brokerage unit for $2.7B to MS. Most C units are rumored to be up for sale. (Share Price prior to news $5.60, afterwards $5.90.)

12. 1/16/09 – C reports $8.3B loss, announces plan to split in two. (Share Price prior to news $3.83, afterwards $3.50.)

13. 1/20/09 – C slashes dividend to .01/share. (Share Price prior to news $3.50, afterwards $2.80.)

14. 1/23/09 – C is effectively nationalized, argues Bloomberg. Increasingly, as a ward of the US Government, C increases lending, and home loan modifications.

15. 2/27/09 – C announces a goodwill writedown of $9.6B, adding $9B to the losses of 4Q08. US Government enters a deal to convert $25B of preferred stake to common, pari with private institutional investors, increasing C’s tangible capital, and raising US ownership to 36%. Moody’s cuts C’s rating by two notches to A3. (Share Price prior to news $2.46, afterwards $1.50.)

Bank of America Timeline

1. 1/11/08 – BAC agrees to buy CFC. Regulators offer BAC capital relief, letting them lend more to their broker-dealer subsidiary. (39.41 — 38.50)

2. 1/24/08 – No capital will need to be raised after a $12B sale of preferred stock. (36.83 – 40.57)

3. 3/10/08 – Allegations of fraud and growing mortgage losses swirl around CFC. BAC affirms that the purchase will go through. (37.13 – 35.31)

4. 4/21/08 – BAC misses earnings as bad debt gets written down $6B. Moody’s cuts ratings of BAC to Aa2. (37.79 – 37.61)

5. 5/15/08 – CEO Ken Lewis criticizes the bailouts of Wall Street firms. (Sorry, couldn’t resist.) Aside from Bear, at that time, it was mostly Fed lending programs. (36.88 – 36.71)

6. 5/21/08 – BAC sells $2.7B of preferred stock. (35.40 – 34.63)

7. 6/2/08 – CEO Lewis calls the CFC deal compelling. (33.84 – 33.58)

8. 6/19/08 – Price of CFC deal adjusted down. (28.46 – 28.14)

9. 7/1/08 – CFC deal closes. (23.31 – 23.81)

10. 7/8/08 – CEO Lewis announces that the dividend will be maintained, and there is no need to raise more capital. (21.56 – 23.54)

11. 7/16/08 – Fitch cuts BAC rating two notches to A+. (19.45 – 22.67)

12. 7/21/08 – BAC beats estimates for 2Q08. Also announces that it does not plan to guarantee the debts of CFC. (27.85 – 32.35)

13. 9/10/08 – KBW cuts BAC to underperform, citing constrained capital. (32.97 – 32.40)

14. 9/15/08 – BAC agrees to buy MER for $44B as Lehman goes into Chapter 11. S&P cuts BAC’s rating to AA-. (28.23 – 26.55)

15. 10/6/08 – BAC misses 3Q estimates, cuts the dividend, and announces an offering of common stock. (29.65 – 23.77)

16. 10/8/08 – BAC raises $10B through selling common stock. (23.33 – 19.63)

17. 10/16/08 – MER announces fifth straight quarterly loss of $5.1B. (24.41 — 24.25)

18. 10/30/08 – BAC announces a $15B issue of preferred stock to the US Government under the TARP program. $10B for Merrill (23.31 – 22.78)

19. 11/18/08 – CEO Lewis says MER acquisition is on track. (15.17 – 15.19)

20. 12/5/08 – BAC sells $9B of FDIC-backed debt. (13.90 – 15.24)

21. 12/11/08 – BAC announces job cuts of 35,000. (16.33 – 14.91)

22. 12/19/08 — S&P cuts BAC’s rating to A+. (14.07 – 13.80)

23. 1/2/09 – BAC closes MER deal. (13.92 – 14.33)

24. 1/7/09—BAC sells $2.8B of China Construction Bank stock. (14.11 – 13.71)

25. 1/8/09 – Moody’s cuts ratings of BAC to Aa3. (13.82 – 13.54)

26. 1/16/09 — $138B lifeline extended by the US Government — $20B more of preferred stock, and guarantees on assets and derivatives equal to $118B. BAC cuts dividend to 1 cent/share. (7.18 – 5.10)

27. 1/23/09 – John Thain fired as Merrill loses $15.4B for 4Q08. (5.37 – 6.24)

28. 2/20/09 – CEO Lewis says that the finances of BAC are fine, and they don’t need additional help. (3.61 – 3.79)

29. 2/24/09 – CEO Lewis says that BAC is stronger than rivals. (4.03 – 4.73)

30. 2/25/09 – CEO Lewis says that Countrywide and Merrill will be stars in 2009. (You can’t make these up.) (4.81 – 5.16)

31. 3/3/08 — S&P cuts BAC’s rating to A. (3.95 – 3.65)

I bolded the cases where government actions were taken. What common factors can be found in the actions of the government?

  • Unwillingness to harm bondholders. Common and preferred stock can be diluted/destroyed, but not unsecured debtholders, not even junior ones.
  • The US Government is willing to give up protections for taxpayers if it would save institutions that they deem “too big to fail.”
  • They are willing to give the money to the holding companies, rather than protecting operating banks and other regulated financials.
  • The US Government is willing to do it in pieces, with grumbling, but they will keep doing it until the US economy either normalizes, or falls apart.
  • The economic incentives of the banks become muddled with the goals of the government. More money is available to those that support the goals of the government, rather than only profits.

I think that the government’s actions encourage the laziness of bankers – why sell assets when you can finance them? Why try to eke out profits when the government feeds additional liquidity to those that do their bidding?

As I said in my last article, there is some political pressure to make the bondholders of some of the holding companies share in the pain. I don’t think that will be effective in the short run for two reasons:

  • Inertia – DC is slow to change even strategies that seem not to be working.
  • Large bond managers (e.g., PIMCO, BlackRock) that are providing many services to the US Treasury regarding the TARP have large holdings of senior debt, and they will do all they can to tell policymakers that it is a bad idea to have senior debt be compromised. It would have large systemic risk implications! Possibly, there is regulatory capture going on in the boldest way ever. Bond managers, representing the bond market, tell the US Treasury what they should do. Shades of the Clinton Administration.

Personally, I don’t think that the balance sheet of the US Government is big enough to handle all of the liabilities that they will be asked to absorb, equitize, or guarantee. Bondholders need to watch for stresses and strains that will appear in the currency and Treasury security markets, and be prepared for the day when the US Government says, “No more. We can no longer afford this largesse. No one is too big to fail. Chapter 11 and RTC 2 for all failed financial companies.”

That is the main risk here, but it should not appear for a while. Gauge your own willingness to play in the bonds of firms like Citigroup and Bank of America. Without continued help from the US Government, they are insolvent; current prices factor in support for some time, but if that help should evaporate, prices will drop considerably. Dancing near the edge of a cliff is rarely advisable, even if you get paid to do it. Play this carefully.