How might the BofA stress test work

THERE ARE ALL SORTS OF THINGS WRONG WITH THIS POST.  BEST IGNORED.  LEFT FOR POSTERITY...

There is a joint press release from the Tim Geithner, Ben Bernanke, Sheila Bair (who I think really deserves to be in this company) and John Dugan (who is always wondering what he is doing in this company).  It outlines the stress test.  You can read it (word for word like me) if you are into self flagellation.

But here is the guts of it:

The bank must be able to have 4% tangible common equity and a 6% tier one ratio by year end 2010 in the adverse macro (that is stress) circumstance.  At bank of America there is plenty of preferred shares (both government and privately issued).  So the only constraint that matters is the 4% tangible common equity ratio.

The 19 Bank Holding Companies (including BofA) don’t need to meet the 4% test now – they only need to have enough capital now that they will in an adverse circumstance meet the 4 percent test later.  In other words when counting the losses that they might have in an adverse circumstance they are also allowed to count the earnings they will receive in the adverse circumstance.

That is good for a few banks.  Bank of America doesn’t meet a 4% tangible capital ratio now.  Not even close.  But its revenue is rising fast and it will be allowed to count three more quarters of revenue in its calculation. 

Unfortunately they are not allowed to count anticipated near term increases in revenue (they are having them and in adverse circumstances bank revenue typically goes up).  Presumably they are allowed to count revenue (net of “abnormal” trading gains and losses) at the run rate that they generated it in the first quarter – which is – as noted elsewhere on this blog – is a record.. 

There does not seem to be a provision against counting near term changes in pre-tax pre-provision earnings derived from cost changes.  That means that Bank of America should be able to count the cost synergies but not the revenue synergies from the Merrill Lynch merger.  That is about 6 billion per year – but probably only next year.
If a bank does not pass a stress test there are a few capital management options that are not open.  The most important is to shrink the lending book.  The stress test must be able to met whilst maintaining lending at prudent levels to keep the economy ticking along.  I guess the government doesn’t want to discourage a crash by forcing lending down.  They can however meet the tests by selling assets or raising third party capital or even (as is the shareholder’s greatest fear) by turning the preference shares that the government owns into new mandatory convertible preference shares as per the last Citigroup bailout.

Well everyone “knows” that the BofA shortfall is 33.9 billion.   That number has been leaked widely – and is so precise that it would be embarrassing for the journalist to get it wrong.

Anyway I want to have a little think about what that number means…

Here is the balance sheet of BofA

 

The company has a total balance sheet of 2,322.0 billion – but only 977.0 billion of loans (less after provisions).  By the time you add in an investment bank you get an awfully big number of assets (trading and other).  But 86.9 billion in goodwill and 13.7 billion is other intangibles.  The tangible assets are thus 2221.4 billion.  4% of this is 88.9 billion. 

The shareholder equity is 239.5 billion but you need to subtract off the same intangibles.  You then wind up with 138.9 billion in tangible equity.  There is a whack of preferreds (including TARP) and you have 65.6 billion of tangible common equity.  Prima facie the company has 65.6 billion in tangible common equity.  The bank is prima facie short 23.3 billion of capital.  I have put this in the following spreadsheet. 

 Summary

Balance sheet data in billions Total assets 2322.0 Goodwill 86.9 Other intangibles 13.7 Tangible total assets 2221.4 4% of this is  88.9 BofA shareholder equity 239.5 Goodwill 86.9 Other intangibles 13.7 Tangible equity 138.9 Preferred stock (including TARP) 73.3 Tangible common equity 65.6 Current tangible common equity ratio 3.0% Prima facie current shortfall 23.3

This number differs a little from the numbers in the last quarterly report.  Here they are.

This suggests that we have a 3.13 percent tangible common ratio – and the difference is tax assets and liabilities associated with the intangibles – see the footnote.  I am just going to accept the number.  Addition - main difference is the risk weighting of some of the off balancec sheet stuff...

Using that number we have 3.13 percent tangible capital, somewhat better than the 3.0 percent calculated above – and the shortfall is “only” 19.3 billion rather than 23.3 billion.  The widely mooted current shortfall is about 20 billion.

But it is not the current shortfall that matters.  It is the projected adverse circumstances shortfall at the end of next year that matters.

Now suppose that BofA has zero growth between now and the end of next year.  Then the required capital will not have changed – and the bank will have had some pre-tax, pre-provision earnings. 

It will in fact have had a lot of them.  Pre-tax, pre-provision earnings are running about 13 billion per quarter at the moment ($39 billion for the rest of this year plus another 52 billion next year for a total of 91 billion).  It will also have a further 6 billion in “earnings” from the Merrill Lynch synergies.* So they will have 97 billion in earnings before losses.

But lots of losses – an amount that none of us really know.  If they have 77 billion in losses they will still recover the 20 billion current shortfall and they will thus pass the stress test. 

Now is 77 billion possible?  Yes – but it is pretty bad if you think it has to come from the loan book.  The loan book is 977 billion and already has 29 billion of provisions against them.  The loan book might be that bad in an adverse circumstance – but frankly I doubt it.  The actual losses last quarter were way less than that rate – though the company provisioned considerably more than they charged off and they projected the losses would get worse.   Expost addition - the loss here is more or less what they think will happen in the stress test.  I happen to think the stress test loss estimate is just too high - but that is one of those things that people will differ about.

The non-loan book (and the off-balance sheet credit card book) could cause distress in the stress scenario.  The particular issue is the credit card book – and I would expect profits to go away – but this is MBNA not Metris – and my guess is that the book will hurt but not kill.  A credit card stress test here is solvable with 5mg of valium (a very small dose – read a mg for a billion dollars and you get it about right).

Far more problematic is the possibly they could blow up the (Merrill Lynch) trading book again.  Merrills – rather than anything else is the black box at BofA.  I suspect/hope that Bank of America has been steadfastly trying to de-risk the Merrill Lynch book.  Sure they shouldn’t have purchased it – but they have taken a whack of charges against it and the trading book is likely – at least in the next thirty days – to show some reverses.  After all –what were those year end charges about.  And they can sell good slabs of this book reducing total assets and hence required tangible common equity.  Still it is the trading book that is the black-box here and I have no idea how much valium is required to remove stress. 

The best thing though about the non-loan book is that it is easy to liquidate.  They can shrink it.

Indeed the easiest thing to shrink is the cash balance.  I have pointed out that the cash balance of BofA is enormous – and in the stupid rule of the week the 4% TCE ratio includes 4% of cash.  The rule is pretty clear – 4 percent on total assets including the huge excess cash balances BofA is holding.  Just by increasing risk (through shrinking cash balances) BofA can solve $6 billion of its shortfall.

But in the end it comes down to the trading book which should, after some run-off, be shrinkable.  The only question being how much do they lose by shrinking it?  And that depends where it is marked.  And to that – well I think you need to be an insider to know.

 

 

Disclosure: still long BAC.

 

 

John

 

*I think those earnings are as dodgy as they sound – but I think they can count them in working out stress test capital.