Thinking the Impossible: Bank of America to Zero

Just about all of us recognize Bank of America’s (BAC) familiar red and blue flag logo.   Millions of Americans  have accounts there.  Bank of America, along with  Citigroup (C), and JP Morgan Chase (JPM) are arguably three largest banks in the US.  All have serious problems.
The thought of Bank of America’s common stock becoming worthless was unthinkable just a few weeks  ago.  Now, however,  the mega-banks are again in big trouble.  Most US and European banks have dropped to new lows within the last week or two.  Back in September, the month of the Merrill deal, Bank of America common was between 30 and 35.  On January 23 of this year it touched 5.2.  How could “America’s Bank” get in such dire straits?
Under normal conditions the index committee removes from the index a DJIA component which drops below $10.  These aren’t normal conditions.  So, Bank of America and Citigroup remain on the DJIA.   Removing two of the top banks ( not to mention General Motors ) from the DJIA  is politically undesirable at this time.  Maybe a reverse split?
Acquisitions of Countrywide Financial and Merrill Lynch were, at the time, thought to be advantageous to Bank of America.  Toxic assets held by these two companies, as the recession has deepened, are now found to be significantly larger than originally thought.  This week we have John Thain,  ousted Merrill chief, and Ken Lewis, Bank of America’s CEO, trading blame over the possible $50 billion mistake.
Nouriel Roubini (as re-published through John Mauldin) says the US banking system needs $1.4 trillion to recapitalize and in its current state is insolvent:

The US banking system is borderline insolvent in the aggregate and it will take a huge amount of public financial resources and complex and time-consuming work-out of insolvent institutions to restore its financial health and allow it to lend again in ways that support sustained economic growth. 

The US Dept. of Treasuries OCC’s  Quarterly Report (see page 23) shows just how deeply the mega-banks are into derivatives.  Bank of America has assets of $1.836 trillion and derivatives of $39.979 trillion, (mostly swaps).  With the demise of the Shadow Banking System ( non bank financial institutions), trading derivatives is much more difficult.  If marked to market, one wonders just how much of a loss would be realized in this $39.979 trillion portfolio.  Nobody, who will talk about it anyway, seems to know.   It wouldn’t take much to wipe out $1.8 trillion in assets.  Not surprisingly, there is a major confidence problem.   With a continually slumping housing market, commercial real estate problems accelerating, increasing credit card debt defaults and a deep recession that’s driving foreclosures to record levels, you can only guess.  Investors don’t like guessing.
Here is more of why Bank of America could go to zero.  If the bank is insolvent, the US government will have to use not only TARP2 but also a TARP3 and a TARP4.  Imagine the bickering in congress.  Someone, somewhere, somehow, sometime, has to own up to the toxic assets.  Only the US government (taxpayers) can do this (lucky us).  With government funding, dilution can wipe out the common stock holders.  With politicians calling the shots you can forget dividends and other “extravagances” such as bonuses, private jets etc.
The establishment of a “bad bank” to hold toxic assets is now being talked about, and Wall Street hails it as a  possible solution.  But how do  you determine the price to pay for the toxic assets?  Face value is a bad deal for tax payers while mark to market a bad deal for the banks.  Either way today’s common shares may not be worth much, if anything.
Eventually, the US government may “nationalize” the the mega-banks along with some of the regionals.  The Obama administration will have to keep the depositors happy and calm at all costs. They have to do this to avoid major social unrest, everything else is secondary.  The toxic assets end up in a bad bank worth who knows what.   The the mega-banks emerge somewhere down the line as recapitalized private entities.  The FDIC will keep depositors and some bond holders happy (we hope).  Everyone else: good luck and fasten your seat belts.

What is a "Black Swan" Event?

Perhaps you’ve heard the term.  Just what, however, is a “Black Swan Event”?   The term was popularized by Nassim Nicholas Taleb  in his 2007 book on probability, The Black Swan.    As an aside, Black Swans (Cygnus atratus) are found in southern Australia and though not endangered are not well known.  According to wikipedia A “Black Swan Event” has 3 components:

1. The event appears by complete surprise to most people, in a relatively short time.
2. The event has massive, often world wide, impact.
3. After the event has occurred, people attempt to explain it in hindsight.

Here are some examples of “Black Swan Events”:

1. World War I. — Who would have guessed that a relatively minor assassination would trigger a world war in which tens of millions would die.
2. The terrorist attacks of September 11, 2001. — No one saw it coming.
3. The Economic crisis that started in late 2008.  — Some saw economic problems but hardly anyone predicted the severity.
4. The Rise of the Internet. — People had all kinds of predictions of the future but somehow totally missed this.

Our current Economic Crisis  is an example of a “Black Swan Event”.  Almost no one (with a few notable exceptions) saw it coming.  It is having a major world wide impact.  Now, in hindsight, people are attempting to explain it.  Since this is still unfolding we don’t know yet how “black” this swan will be.

Systemic Risk

I read an article awhile back but can’t remember who wrote it or where I read it.  If I could, I would gladly give credit.  The article compared major banks to Mafia run booking houses.   Hmm!   Well, at this point, lets just say it is a metaphor.
In any case, it went like this:  If a gambler doesn’t make good on debts to his bookie he may very well get escorted to a dark ally and emerge with a broken leg or something of that nature.  If he doesn’t pay a second time he may end up wearing concrete boots at the bottom of the East River.  Problem solved, he never defaults again.  Better yet, word gets out to other potential non-payers. They may reconsider.
Why does the Mafia rigidly enforce this rule?   Are they nasty mean people?  Well, maybe, but it is mostly just good business.  If non-payers are treated leniently other debtors may not pay.  The bookie could fail.  If the bookie fails, other bookies (think counterparties)  could also fail.  The chain reaction goes on and the whole operation can come crashing down.
Likewise, if one bank does not get its payments from its counterparties (financial institutions),  they in turn cannot pay their counterparties.  One after another they fail.  That almost happened after Lehman Brothers went bankrupt.  Banks everywhere came close to not paying their counterparty obligations.  That, my friend, is Systemic Risk, a failure of major banks worldwide.   The US government will do practically anything to avoid that scenario, hence no more Lehmans and lots of bailouts.  We the taxpayers are keeping the banking system functioning with bail outs.  The question is can we continue to do it, as we most surely will have to.
What would have happened if we had allowed “Systemic Failure” last October?  I don’t know.  Maybe it would not have been worse than drawn out pain we are experiencing now.  Maybe taking the hit fast and quick is better than the slow torture of drawing it out.  It certainly would be easier on the tax payers.
Wikipedia’s definition of “Systemic Risk”:  Systemic risk is the risk of collapse of an entire system or entire market and not to any one individual entity or component of that system.

Worldwide Banks Plunge Again

Suddenly, banks are back in the news, and it is very bad news.  Two of the three largest US banks, Citigroup and Bank of America, despite huge bailouts 2-3 months ago are once again starting to fail.   How much the Obama administration will put in to keep them going is unknown.  However, cash injections will probably come with conditions not favorable to common stock owners.
Regional banks are faring no better, SunTrust, FifthThird, Regions Financial, Zions and many others are all off 70% or more for the last 52 months with common stock trading lower than last November.
Nouriel Roubini the famous New York University professor says the US Banking System is insolvent with another $3.6 Trillion in losses coming.  Yes, he is know as “Dr. Doom” but then again, he has been consistently right so far.
The fear is that financial institutions are nowhere done needing government help and the dilution of the equity will wipe out common share holders and threaten bond holders as the government takes preferred stock positions in front of everyone else.  There is talk again of actually buying the toxic assets (thought we dropped that as a “bad idea”).  Problem is, declining real estate values, both residential and now commercial, are causing more and more loans to go  toxic each day.  Credit card and consumer debt is also starting to go bad as deflation takes hold.
Banks are using government money to strengthen their balance sheets.  They are doing very little new lending, so cash injections are not helping Main Street.
The news from Europe is terrible also.   The Royal Bank of Scotland shares have plummeted.  Deutche Bank are Barclays are all down big time.  Talk of Nationalization is now heard in Europe.  On Tuesday January 20, 2009 Allied Irish Bank (AIB) was down 60% that day alone to $1.5 a share.  Allied Irish was as high as 47 within the last year.
How will it all end?  Who knows.  Perhaps a total reorganization of the banking system, certainly much more nationalation.  More tax payer money for sure will be put in, again increasing the deficit dramticly.  TARP2 isn’t near enough.  Worse case scenario: maybe a worldwide bank holiday (you can’t withdraw your money).

Owning Oil in Royalty Trusts

The price of oil is again dramatically down, with lots of volatility.  On January 13 WTI Crude dipped below $37 only to bounce back above $39 the next day. You can make — or lose — a great deal of  money fast by trading the relevant Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs).  See UCO, SCO, DXO and  DTO.  If this is your  cup of tea (I mean java),  you like lots of excitement and are a market timing whiz take this route.  Your brokerage firm will love it.
However, for those of us who like to sleep at night, there are alternatives.  Cash or the US dollar is a good safe place when oil prices seem high.  Or you can pick up at oil royalty trusts, when prices are down.   There are both Canadian and US trust available.  The trusts are obligated to pay out most of their earnings in dividends, 7-13% is typical.  The high dividends keep them from jumping up and down as much as the ETFs and oil stocks
Dividends track oil prices,  so today’s low oil prices may be a good time to purchase the trusts.   Keep in mind that trust income often comes from fields which are in decline, meaning every year they may produce less oil.  That is not a problem if unit price rises.  Most depletion schedules go out some 10-20 years.  Since all the action now is short term, I don’ look on depletion as a major concern.   Also, newer technology such as horizontal drilling coaxes more and more oil and gas from existing wells then ever before so potential reserves may rise.
As far as I know, world governments haven’t yet figured out how to print barrels of oil.  Oil royalty trust reserves are buried treasure which you don’t need a map for.  Again, while it is true that lower oil prices will bring lower dividends, you have a  proven asset.   These assets are valued in paper units — dollars — which may be printed in large quantities in the near future.  We will have more and more dollars chasing less and less oil.  You will want to hold the oil not the dollars.
Royalty trusts have special tax considerations and may do best in deferred tax retirement accounts so you consulting your CPA is a good idea.   Here are some some oil trusts to get you started: BP Prudhoe Bay Royalty Trust (BPT), Permian Basin Royalty Trust (PBT), San Juan Basin Royalty Trust (SJT) and Sabine Royalty Trust (SBR).