We have a deal. You, the US taxpayer, have generously provided to Bank of America the following: one Treasury-FDIC guarantee “against the possibility of unusually large losses” on a pool of assets taken over from Merrill Lynch to the tune of $118 billion, and a further Fed backstop if the Treasury-FDIC piece is not enough. In return we receive $4 billion of preferred shares and a small amount of warrants “as a fee.” There is a $10 billion “deductible,” i.e., Banks of America pays the first $10 billion in losses. Then remaining losses are paid 90 percent by the government and 10 percent by Bank of America.
We are also investing $20 billion in preferred equity, with an 8 percent dividend. There will be constraints on executive compensation and Bank of America will implement a mortgage loan modification program. Essentially, this is the same deal that Citigroup received just before Thanksgiving, known as Citigroup II, which was generous to bank shareholders but not a good value for the taxpayer.
This is more of the same incoherent Policy By Deal that has failed to stabilize the financial system, while also greatly annoying pretty much everyone on Capitol Hill. Hopefully, it is the last gasp of the Paulson strategy. The Obama team will shortly unveil a more systematic approach to bank recapitalization; it would be a major mistake to continue in the Citigroup II/Bank of America II vein.
In addition, you might ponder the following issues raised by the term sheet:
- The $118 billion contains assets with a current book value of up to $37 billion plus derivatives with a maximum future loss of up to $81 billion. This is more detail than we got in the Citigroup deal, so there is evidently greater sensitivity to calls for transparency. But the maximum future loss is based on “valuations agreed between institution and USG.” What is the exact basis for these valuations? From the term sheet, it sounds like we are talking mostly about derivatives that reference underlying residential mortgages. Absent any other information, my guess is that they could easily lose more than $81 billion, depending on how the macroeconomy and housing market turn out.
- What is the strike price of the warrants? This was controversial in the Citigroup II deal (because it was unreasonably high), but at least it was quite explicit up front. The announcement is suspiciously quiet on this point, perhaps due to the recent spotlight on warrant pricing terms.
- What kind of reporting will there be by Bank of America to Treasury and what will be disclosed to Congress in terms of the exact securities covered by this guarantee and how they perform? The lack of information is a big reason why the Troubled Asset Relief Program (TARP) became discredited and Capitol Hill is so concerned to see more transparency going forward. There is nothing in the term sheet that reveals the true governance mechanisms that will be put in place or how information will be shared with the people whose money is at stake (you and me, or our elected representatives). I understand there is market-sensitive information present, but there are obviously well-established ways to share confidential information with members of Congress.
Overall, it feels like the latest (and hopefully the last) in a long line of ad hoc deals, which have done very little to help the economy turn the corner. The new fiscal stimulus needs to be supported by a proper bank recapitalization program as well as by a large scale initiative on housing.
Also posted on Simon Johnson’s blog,