Market Rout Continues as Bank of America Deathwatch Begins

The global economy is caught between a rock and a hard place.

Political sentiment continues to favor austerity, assuming - hopefully but perhaps vainly - that the markets will respond positively to evidence of fiscal probity. At the same time, the markets are awakening to the reality that even if stimulus were possible, the central bankers have shot their wad. The chronic European debt crises on top of the US Fed's solo quantitative easings in the absence of traditional stimuli have left the cupboard nearly bare.

Meanwhile, the too-big-to-fail banks have realized that much of their own financial prosperity depended on pliant governments, who have reached the end of their own practical ability to help - to say nothing of their citizenry's willingness to enable any further wealth transfers from the middle to the financial classes.

An overriding problem is that you can not cut your way to prosperity. Markets demand growth prospects. Without government stimulus, hope rests on corporate spending. But in an economy which depends on consumers for 70% of GDP, the lack of jobs and plateauing of income stifles incentives for investment. John Maynard Keynes may be out of favor, but the alternatives appear less than encouraging. JL

Yves Smith comments in Naked Capitalism:

There is plenty of evidence of rattled nerves. Commodities took a hit, another sign that deflationary expectations are taking hold. But perhaps the biggest change in attitude is lost faith that central bankers can or will intervene successfully. Bond purchases by the ECB did little to calm markets (a recovery in Italian and Spanish bonds quickly reversed).

The Fed seems bizarrely preoccupied with inflation although the real problem is that what the US needs is fiscal stimulus to offset consumer deleveraging and failure of businesses to invest. We actually need more bankruptcies and asset writedowns in combination with more aggressive spending. In Euroland, the scope of the sovereign debt crisis has now reached the too big to fail Italy, and one of my German press reading contacts said that finance minister Wolfgang Schauble nixed yesterday the notion of enlarging rescue facilities.
It is clear that the Charlotte bank has too much in the way of legal liability that it will not be able to shed and yet-to-be-taken writedowns on balance sheet items (for instance, roughly $125 billion of home equity loans and junior liens on residential real estate as of end of last year) for it not to be at risk of a death spiral. Its stock was down 7.44% yesterday, which puts its market cap at $89.5 billion, which is a mere 41.6% of common equity (total equity less book value of preferred) of $215 billion. That means if the bank is under pressure to raise its capital levels, it will be so dilutive as to be problematic, particularly if the stock market weakens further and banks continue to take it on the chin. And the entire mortgage industrial complex is coming under stress. Number three mortgage insured PMI posted yet another loss and fell short of regulatory standards. Although mortgage insurer woes are mainly a Fannie-Freddie issue, problems in tightly-coupled systems can ricochet in unexpected ways.

The death spiral dynamic kicked in during the crisis as a result of funding stress: as interbank markets dried up and short term funding costs rose, CDS spreads also rose and banks faced risk in terms of both cost and availability of funding. Rating agencies downgrades exacerbated the spiral. Some of these conditions would appear not to be operative now, with banks having tons of reserves parked at the Fed. But BofA in particular has been suffering a slow bleed of deposits as angry consumers vote with their feet, making it more dependent on market funding than before.

The other way for BofA to shore up its capital level would be for it to sell assets. But it already dispose of the Merrill Lynch stake in Blackrock. Merrill would seem to be the most logical sale candidate, but who would buy it when the logical buyers, other TBTF banks, are now under stress thanks to financial market upheaval? It would seem nuts to allow any of the US TBTF banks to double up on market risk. Citi has been under regulatory pressure to skinny down. JPM is less sound that its PR would have you believe (there is a ton of risk sitting in its derivatives clearing business) but Dimon loves to be the government’s subsidized buyer if things got that far. Morgan Stanley? A sale of a stake to a sovereign wealth fund (the notion that this is a “buy low” in an entity not exposed to mortgage liability?)

The meltdown in the financial markets obscured an important development on the mortgage front, namely, that New York state attorney general Eric Schneiderman filed a motion to intervene in the proposed $8.5 billion settlement between Bank of America and the Bank of New York acting as trustee of 530 Countrywide residential mortgage securitizations.

We said when the deal was announced that it was not a done deal and it stank to high heaven, so we are glad to see confirmation of our dim view. In keeping, the motion charges Bank of New York with “fraudulent and deceptive conduct”. As we will see, the allegations that Schneiderman has made against Bank of New York opens up a whole new front of mortgage securitization liability, that of the trustees failing to live up to their contractual duties and worse, making ongoing certifications that they had. This is an area we’ve discussed at some length before and have been surprised hasn’t been taken up until now.

By way of background, the proposed settlement purportedly had Bank of New York acting on behalf of investors, although it conferred with only 22 and did not even go through the motions of consultation with the rest. In addition, we indicated, many of that 22, such as the New York Fed, had reason to support Bank of America getting a sweetheart deal if it alleviated questions about the bank’s solvency. Moreover, as we pointed out, Bank of New York itself had substantial conflicts of interest in entering into this deal. BofA represented nearly 2/3s of Bank of New York’s trustee business, and as Adam Levitin had noted prior to the settlement being filed that Bank of New York would “inevitably have to be deferential” to Bank of America.

But the biggest problem with the deal were the broad releases that went well beyond the matter at hand, which were breaches of representations and warranties (in simple terms, that investors were promised that the mortgages would meet certain standards and those promises were violated). One was effectively a payoff: that Bank of America gave Bank of New York indemnification that looked to be too good an offer to refuse.

Bank of American and Citigroup both had near death experiences in early 2009. Citigroup was forced by the FDIC to trim its operations considerably. Bank of America was not required to make any serious overhaul. The mortgage mess has exposed the weakness of the bank’s foundations. Perhaps it will manage to muddle through again ex extraordinary official measures, but I would not bet on it.