Is B of A headed for a breakup?

By Jim Jubak

Bank of America (BAC, news, msgs) CEO Ken Lewis is betting his company that he can take hundreds of billions in government money and avoid the kind of government-engineered breakup now humbling Citigroup (C, news, msgs).

And he could be right. The big banks are so clearly on the edge of crisis -- again -- that it seems unlikely the government will use the power that comes with being the lender of last resort to break up Bank of America. That leaves Bank of America with a good shot at coming out of this crisis as the industry's next -- and only -- financial supermarket.

But is that a goal shareholders should want? The 10-year Citigroup experiment says no. Size doesn't bring enough of the expected benefits to offset the lack of control that has turned Citigroup into a lesson in the failure of risk management.

And shareholders should certainly question the risks that Bank of America is taking on in pursuit of that goal. There is a very real danger that the ground is shifting faster than Lewis and Bank of America realize. The incoming Obama administration is signaling -- if for no other reason than that Congress demands it -- that it will be a more active stakeholder in the big banks it is bailing out than the Bush administration was.

Strings attached

Citigroup is now on the hook to the U.S. government for so much money -- money it can't hope to raise anytime soon in the financial markets -- that it is facing at least de facto nationalization.

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By taking $20 billion more in government money and by accepting a government guarantee of $118 billion in assets, Bank of America has raised the odds that common shareholders will see the value of their equity reduced or perhaps wiped out if the government decides to fully exercise the control that comes with being the last source of capital standing. Already, the government has required Bank of America to cut its quarterly dividend to 1 cent a share from the prior 32 cents.

The U.S. Treasury and Federal Reserve, having pumped $45 billion into Citigroup and put taxpayers on the hook to guarantee up to $306 billion in troubled assets, forced the breakup of the 10-year old financial supermarket. The sale of a majority stake in Citigroup's Smith Barney brokerage house to Morgan Stanley (MS, news, msgs) on Jan. 14 was just the first step. The company's consumer-finance division, its private-label credit card operation and its proprietary trading unit are also on the block.

B of A chasing the money

Even before the blood from the first whack of the ax at Citigroup had started to cool, Bank of America was lobbying for -- and on Jan. 16 secured -- a $20 billion cash infusion from the Treasury. That was on top of the $25 billion the bank had received earlier. At the same time, the bank huddled with Treasury and Fed officials to work a government guarantee of $118 billion in troubled assets. The total package looks strikingly like the one that gave the government the power to force the breakup of Citibank.

Does Bank of America's Lewis have some kind of death wish? Well, no. He's making a calculated gamble that as bad as the books at Bank of America may get, the Treasury and Fed won't move to break up the financial supermarket he's building. In this calculation, the government really doesn't have another horse to ride, and the Treasury and Fed have to back Bank of America all the way.

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The crux of the matter is Bank of America's September decision to acquire Merrill Lynch. That deal, it now seems, was concluded in too much haste. It looks like Bank of America has once again, as in the case of its purchase of mortgage lender Countrywide Financial, underestimated the depth of the doo-doo at a company it was intent on acquiring. Merrill Lynch reported write-downs of $8.4 billion in the third quarter of 2008. And the value of Merrill's portfolio continued to collapse. In early December, a Citigroup banking analyst projected that Merrill would write down an additional $4.5 billion in the fourth quarter of 2008. By late December, analysts at Credit Suisse and Fox-Pitt Kelton Cochran Caronia Waller had raised their estimates for projected write-downs ranging from $8 billion to $8.6 billion for the quarter.

Tallying the losses

The final accounting for the quarter was even worse than those projections. On Jan. 16, Bank of America announced its fourth-quarter 2008 results: Merrill Lynch posted a loss of $15.3 billion.

Meanwhile, Bank of America's own business wasn't exactly throwing off cash. Going into the company's scheduled Jan. 20 earnings report, the Wall Street consensus was still predicting that the company would earn about 8 cents a share. That consensus included a huge range of estimates from a superoptimistic 49-cent-a-share profit to a massive loss of 75 cents a share.

The reality announced on Jan. 16 -- a loss of $1.79 billion, or 48 cents a share, which didn't include the losses at Merrill Lynch, since the acquisition wasn't formalized until Jan. 1 -- wasn't quite as bad as the worst of Wall Street's projections. Loan-loss provisions, money set aside for current and future bad loans, rose to $8.54 billion from $6.45 billion in the third quarter. The net charge-off rate, a measure of how fast troubled loans are becoming bad loans, soared to 2.36% in the quarter from 1.84% in the third quarter and 0.91% in the fourth quarter of 2007. Losses in the company's huge credit card division climbed to 7.16% from 4.75%.

More losses ahead

But the big problem is that after writing off its own losses from credit cards, commercial mortgages, residential mortgages and the rest of its portfolio, and the huge losses at Merrill Lynch, Bank of America won't have a balance sheet that can support the losses that are still in the pipeline or the huge expansion of its balance sheet still under way. The company certainly hadn't pulled back from lending in the fourth quarter, committing an additional $155 billion to new loans, which included $45 billion in mortgages.

Before the results were announced, Credit Suisse estimated that the company's tangible common equity ratio, a measure of capitalization, was just 2.7% even after the first $25 billion infusion from Washington. That's well below the 5% average at peers of roughly similar size, who aren't themselves in the best financial health.

Continued declines in the value of assets at Bank of America and Merrill Lynch have combined to create a capital crunch that the company couldn't meet except by asking for another infusion of cash and a huge government guarantee.

Continued: Few would-be buyers

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