Friday, August 12, 2011

The Death Spiral beckons ...

Bloomberg reported that as of August 10, 2011, 186 US-based financial services companies traded for less than 60 percent of their book value, or common shareholder equity, including Bank of America, Citigroup Inc., Morgan Stanley, AIG and SunTrust Banks Inc. Together, they had a market capitalization of $300.5 billion, compared with $686.4 billion of book value. This means that a fall in their share prices to this extent (40%) is well nigh inevitable. 
How likely? These banks are very, very vulnerable. For example, earlier this week, AIG filed a suit accusing Bank of America of securities fraud; demanding damages of $10Bn. This sent the BofA stock down 20%, in addition to the bloodbath that the Dow Jones has experienced in the week after August 2, and the S&P downgrade. Its market cap stood reduced to $68.6Bn. Compare this with just one year-end intangible item on its 2010 Balance Sheet: Goodwill is shown at $73.8Bn (see p.130, Table XIII. See also Footnote 1 below)  – forget the rest of its balance sheet, BofA would have the world believe that this intangible item alone, built up from excess over book value paid for its past acquisitions, is worth more than the entire BofA is worth on Wall Street. How many will believe this, and for how long? There will always be the small boy who shouts, “The Emperor is not wearing any clothes!”. After reading Page 114-115 of its 2010 Annual Report, any accountant will understand that BofA will have to write down goodwill significantly (it wrote down $12.4Bn in 2010) - and to keep the shareholders' equity intact after this write-down, it would need to raise more equity. The dilution this would almost certainly drag the share price lower. Which will require them to raise more equity at even lower prices ... leading to a death spiral.
What about the demand for financial sector shares? All but non-existent. Retail interest was never very visible in the US in equities; now it has disappeared. Institutional investors are worried about what write-down of such intangibles would do to the Balance Sheet – and will stay away from any further issues in sufficient number as to make a public issue a very big gamble that could very easily fail. So the only solution – a government bailout wherein the financial institutions that still bear the TBTF tag (Too Big To Fail) are partly nationalized. Expect this to happen in the not too distant future, when the pressure of reporting numbers that have no relation to stock market prices forces them to look for ways of raising their net worth to blunt the edge of the writedowns that are inevitable already. 
What if the US Government finds it politically unpalatable or impossible to rescue these firms with a QE3? Refer to the title of this post! 

Footnote 1 referred to above
Table XIII on p.130, and Table XII and Table XIV before and after it, were the result of BofA's attempt to dress up their Income Statement and Balance Sheet, and the justifications for using these were on page 40. If they had followed GAAP alone, the Tables and the explanation on p.40 would be unnecessary. They used "non-GAAP measures" - euphemism for accounting legerdemain to make accounts smell sweeter, euphemism for which is "additional clarity". The footnote to Table XIII reads: Presents reconciliations of non-GAAP measures to GAAP financial measures. We believe the use of these non-GAAP measures provides additional clarity in assessing the results of the Corporation. Other companies may define or calculate non-GAAP measures differently.

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