September 19, 2008

Bank of America & Merrill: Brilliant or Dissaster in the making

As you may have heard BofA is buying Mother Merrill. What to think of this move?

Well, I am not enthusiastic. In the best of times large acquisitions like this have high probability of failure so I am not quite sure what is the situation in a troubled time like this. However this is far better than buying Lehman I must say.

I bought the shares of BofA because it is a retail bank with no exposure to investment banking, not a big one anyways. Now BofA is building an empire to reach all corners of US finance. I do not like the business of empire building. Just look at Citi business model of being a banking supermarket. It did not work. It was too difficult to manage and hid risks away from management.

BofA management are good and they have solid experience in integrating acquisitions. But this is an investment bank where its true assets and core competencies lie in its people and the relationship they build with clients. It is very different than a retail bank, which is about processes and customer service.Investment banking encourages the superstar while retail emphasize the system. It is a big culture clash.

I am mulling my position in BofA as I am not sure I can track it or follow it now due to the added complexity. I have not decided to sell yet, so I will keep running scenarios to the merit of the business.

Below is a good article about the marriage between BofA and Merrill that differ from all the typical media stance cheering the deal and celebrating Ken Lewis acumen of deal making.

The big question: In agreeing to buy Merrill Lynch, is Bank of America saddling itself with an unmanageable pile of toxic assets? While the potential long-term benefits for both firms are compelling, the short-term risks of doing such an enormous deal in the middle of a financial panic could end up being too much for BofA to handle.

If there were no credit crisis, the deal would appear to be a steal. For a mere $40 billion or so — the deal value has declined, along with BofA’s stock, from the initial $50 billion — BofA will be able to combine its giant retail-banking network with Merrill’s extensive network of personal financial experts. The cross-selling opportunities and the expected $7 billion in annual cost savings virtually pay for the deal.

Nevertheless, the price that BofA paid and the savings it promises to reap could take a back seat to its ability to support Merrill’s assets on its balance sheet.

BofA cannot use its large depository capital base to back up much of Merrill’s riskier assets, so it needs to be stocked and ready with cash. If BofA does not have the required amounts of capital to absorb these assets, some of which are particularly radioactive, it could find itself in the same boat as its broker-dealer rivals, begging for cash at a time when the world’s wallets are closed.

To complicate things, BofA is still in the process of absorbing the troubled mortgage lender Countrywide Financial, which it bought earlier this year. That deal will force it to put $172 billion worth of risky mortgage assets on its books. Countrywide is still hemorrhaging money and more write-downs are expected. About 35 percent of Countrywide’s subprime mortgages are said to be in default, and it could get worse.

Merrill Lynch still has $5.6 billion in subprime assets on its books, according to analysts at Oppenheimer & Company. That would combine with Bank of America’s $5.2 billion for a total of $11.5 billion in sludge. That is more subprime exposure than UBS, Morgan Stanley, Goldman Sachs and Wachovia — combined.

BofA says that the combination of Merrill and Countrywide’s assets on its balance sheet is expected to bring its Tier 1 capital ratio — a key measure of financial strength — down to about 7.4 percent. That would be the lowest of all the major financial institutions and not too far from the 6 percent mandatory level required by the government.

It could be worse: David Trone, an analyst Fox-Pitt Kelton, says he believes that BofA may have been using marks that overvalue some of its assets. He estimates that BofA’s Tier 1 capital ratio, after the acquisition, would be more like 6.65 percent if Merrill’s portfolio is marked to current market prices.

That would leave a thin margin for error, and there could be a rough road ahead.

Bank of America has billions in personal loans, credit card debt and car loans outstanding. If the economy continues to head south, more people will start defaulting on their commitments. That would burn through BofA’s loan-loss provisions and eat away at its profits. The result could be a tumbling stock price, which might require BofA to raise capital to fill the gap in its common equity. BofA could raise capital by cutting its dividend, but that would cause its stock to fall as well and send a negative signal to the market.

While other banks are deleveraging and selling their troubled assets, BofA is going the opposite direction and taking on more. If the credit crunch ends today, BofA could cross the finish line and make out like a bandit. But if it continues or gets worse, the nation’s largest bank could regret its impulsive wedding.

1 comment:

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