"Ring Fencing" Bank of America

from www.federalreserve.gov

January 15, 2009

Summary of Terms

Eligible Asset Guarantee

Eligible Assets: A pool of financial instruments consisting of securities
backed by residential and commercial real estate loans and
corporate debt, derivative transactions that reference such
securities, loans, and associated hedges, as agreed, and
such other financial instruments as the U.S. government
(USG) has agreed to guarantee or lend against (the Pool).
Each specific financial instrument in the Pool must be
identified on signing of the guarantee agreement. Financial
instruments in the Pool will remain on the books of
institution but will be appropriately “ring‐fenced.”

The following financial instruments will be excluded from
the Pool: (i) foreign assets (definition to be provided by
USG); (ii) assets originated or issued on or after March 14,
2008; (iii) equity securities; and (iv) any other assets that
USG deems necessary to exclude.

Size: The Pool contains up to $118 billion of financial
instruments. More specifically, the Pool includes cash
assets with a current book (i.e., carrying) value of up to
$37 billion and a derivatives portfolio with maximum
potential future losses of up to $81 billion (based on
valuations agreed between institution and USG).

Term and Coverage of Guarantee:

Guarantee is in place for 10 years for residential assets and
5 years for non‐residential assets. Residential assets will
include loans secured solely by 1‐4 family residential real
estate, securities predominately collateralized by such
loans, and derivatives that predominately reference such
securities. Institution has the right to terminate the
guarantee at any time (with the consent of USG), and the
parties will negotiate in good faith as to an appropriate fee
or rebate in connection with any permitted termination. If
institution terminates the guarantee, it must prepay any
January 15, 2009 outstanding Federal Reserve loan (described below) in full.

Guarantee covers Eligible Losses on the Pool. Eligible
Losses are the aggregate incurred credit losses (net of any
gains and recoveries) on the Pool during the term of the
guarantee, beyond the January 15, 2009, marks and credit
valuation adjustments for the Pool (as agreed between
institution and USG). Eligible Losses do not include
unrealized mark‐to‐market losses but do include realized
losses from a sale permitted under the asset management
template (described below).
Deductible: Institution absorbs all Eligible Losses in the Pool up to
$10 billion.

USG (UST/FDIC) will share Eligible Losses in the Pool in
excess of that amount, up to $10 billion. All Eligible Losses
beyond the institution’s deductible will be shared USG
(90%) and institution (10%).

Financing: Federal Reserve will provide a non‐recourse loan facility to
institution, subject to institution’s 10% loss sharing.
Federal Reserve loan commitment will terminate (and any
loans thereunder will mature) on the termination dates of
USG guarantee. Institution has the right to terminate the
Federal Reserve loan commitment and prepay any Federal
Reserve loans at any time (with consent of Federal
Reserve).

Federal Reserve will charge a fee on undrawn amounts of
20 bp per annum and a floating interest rate on drawn
amounts of OIS plus 300 bp per annum. Interest and fee
payments will be with recourse to the institution.

Institution may draw on Federal Reserve loan facility if and
when additional mark‐to‐market and incurred credit losses
on the Pool reach $18 billion.

January 15, 2009
Fee for Guarantee – Preferred Stock and Warrants:

Institution will issue to USG (UST/FDIC) (i) $4 billion of
preferred stock with an 8% dividend rate (under terms
described below); and (ii) warrants with an aggregate
exercise value of 10% of the total amount of preferred
issued. The fee may be adjusted, as necessary, based on
the results of an actuarial analysis of the final composition
of the Pool, as required under section 102(c) of the
Emergency Economic Stabilization Act of 2008.

Management of Assets:
Institution generally will manage the financial instruments
in the Pool in accordance with its ordinary business
practices, but will be required to comply with an asset
management template provided by USG. This template will
require institution, among other things, to obtain USG
approval (not to be unreasonably withheld) before any
Material Disposition. A Material Disposition is a disposition
of financial instruments in the Pool that creates an Eligible
Loss that, combined with other dispositions of Pool
instruments in the same year, exceeds 1% of the Pool size
at the beginning of the year. This template also will
include, among other things, a foreclosure mitigation policy
acceptable to USG.

Revenues and Risk Weighting:
Institution will retain the income stream from the Pool.
Risk weighting for the financial instruments in the Pool will
be 20%.

Dividends: Institution is prohibited from paying common stock
dividends in excess of $.01 per share per quarter for three
years without USG consent. A factor taken into account for
consideration of USG consent is the ability to complete a
common stock offering of appropriate size.

Executive Compensation:
An executive compensation plan, including bonuses, that
rewards long‐term performance and profitability, with
appropriate limitations, must be submitted to, and
January 15, 2009
approved by, USG. Executive compensation requirements
will be consistent with the terms of the preferred stock
purchase agreement between USG and institution.

Corporate Governance:
Other matters as specified, consistent with the terms of the
preferred stock purchase agreement between USG and
institution.

The foregoing is accepted and agreed
by and among the following as of
January 15, 2009:

DEPARTMENT OF THE TREASURY
FEDERAL RESERVE BOARD
BANK OF AMERICA CORPORATION
FEDERAL DEPOSIT INSURANCE CORP



So we now have the playbook on how the government will ring-fence (nationalize? I guess its a matter of semantics at this point) the big banks. None of the systematically important big banks will be allowed to fail. The government will provide guarantees on bad assets. It might be better to actually remove these assets from the balance sheets and create a bad bank. This will provide the banks will more confidence to lend. But this shouldnt be done without mechanisms for appropriate oversight. This move is important and is a good move. It begins to restore confidence in the financials. Transparency is still missing but hopefully the new administration will be able to provide that in the future. The tackling of insolvency has begun in the first quarter and overall this is very positive news. There are still other institutions out there. We need to get those under control asap as well. This slow bleed - Countrywide, Merill, Wachovia, Freddie / Fannie, AIG, Bank of America is unfortunate. There are others with bad assets - those should all be dealt with speedily and in this quarter!

Whitney on the 300B TARP Funds

via FT



Whitney: TARP funds go down the downgrade drainPosted by Sam Jones on Jan 07 14:43.


La lutte continue.


Forget the short-lived buzz of $300bn in TARP stimulus, pain for the banks is far from over. Real deleveraging is only just beginning to gather speed; the world economy has yet to enter its worst months, and there are certainly more writedowns to come.


Oppenheimer’s Meredith Whitney is - when it comes to banks’ capital positions - the analyst to turn to. And fortunately, she has a note out today:We now believe that, at a minimum, capital ratios will be meaningfully lower in the fourth quarter versus post TARP pro forma levels. Aside from the greater than $40 billion in writedowns and provisions we expect for the group of bank stocks under our coverage, and earnings pressure related to chronic negative operating leverage, we also expect capital strains to become apparent from ratings change pressures. Accordingly, we maintain our cautious stance on our group.


The thrust of Whitney’s note is nothing new: she reiterates her “ring of fire” position, whereby ratings downgrades on securities owned by the banks punch huge holes in banks’ balance sheets thanks to onerous regulatory capital requirements. Lower rated securities require larger amounts of regulatory capital in reserve.


And for anyone sceptical as to the significance of that relationship…
The interesting part of the latest note comes in quantifying the scale of the rating agency downgrades so far - and more importantly, demonstrating that the worst of them have only just worked through:


Clearly, Q4 of 2008 was the worst period so far in terms of security downgrades by a country mile:


The effect of those Q4 downgrades, estimates Whitney, will be to more or less drain all TARP money pumped into the system so far. Expressed below as Opco analysts on upcoming writedowns for Wall Steet’s finest:


(Click on the image for a larger version)

Insolvency!

from paul.kedrosky.com


October 23, 2008
The Bank Capital Mirage
The following more or less supports what some have been saying for a while -– that major banks in the U.S. and the U.K. will end up being entirely nationalized before this crisis is over –- but it's still a striking way of looking at the data. The gist: Government recapitalization and other fund-raising has largely been in service of banks' prior subprime losses, while corporate and consumer loans are just starting to hit bank balance sheets. It won't take much to tip banks over into insolvency again.









[via Bloomberg]


Also from ftalphaville.ft.com


This is a singularly arresting chart (same as the one posted above):
It’s Bloomberg’s chart of the day and has been reproduced by Paul Kedrosky on his blog, Infectious Greed.







Kedrosky writes:
The following more or less supports what some have been saying for a while — that major banks in the U.S. and the U.K. will end up being entirely nationalized before this crisis is over — but it’s still a striking way of looking at the data. The gist: Government recapitalization and other fund-raising has largely been in service of banks’ prior subprime losses, while corporate and consumer loans are just starting to hit bank balance sheets. It won’t take much to tip banks over into insolvency again.


This is frightening stuff. Not least because the Fed’s own balance sheet is not looking healthy. Via Brad Setser at the CFR, here’s Paul Swartz’s latest graph:






The balance sheet is likely to grow further too. Jan Hatzius, Goldman’s chief economist has pointed out that during the Japanese credit crisis of the 1990s, the Bank of Japan ended up with a balance sheet equivalent to 30 per cent of GDP. The Fed’s is currently 12 per cent. And on Wednesday the Fed made this announcement:


The Federal Reserve Board on Wednesday announced that it will alter the formula used to determine the interest rate paid to depository institutions on excess balances.
Previously, the rate on excess balances had been set as the lowest federal funds rate target established by the Federal Open Market Committee (FOMC) in effect during the reserve maintenance period minus 75 basis points. Under the new formula, the rate on excess balances will be set equal to the lowest FOMC target rate in effect during the reserve maintenance period less 35 basis points. This change will become effective for the maintenance periods beginning Thursday, October 23.


Which is an admission, basically, that the Fed lost control of the Federal Funds Rate. And if that needed proving, take a look at the graph from the New York Fed:

Lastly a nice picture courtesy of http://www.ridingthedax.com/

http://www.ridingthedax.com/2008/10/23/bubble-banks-revisited/

I have been harping for a while about insolvency issues. Looks like many others are catching on. The is one of the first issues that needs to be tackled. Unfortunately President Bush has made it clear that Nationalization wont happen on his watch. Volcker mentioned that banks have been "effectively" nationalized either overtly or through other lines by the Fed. But this is lack of clarity as many of these banks have market capitalizations well in excess of their balance sheet worthiness. What we vitally need right now is clarity (read the end of the insolvency issues) and then an INTELLIGENT strategy to combat the simultaneous develeraging of both banking and consumer levels -(regulating derivatives, debt restructuring of consumers, creation more jobs in the creation of tangible goods in the US, simultaneous creation of incentives for savings and increasing money velocity) etc.

How the Swedes Did It

from nytimes.com
September 23, 2008
Stopping a Financial Crisis, the Swedish Way
By CARTER DOUGHERTY

A banking system in crisis after the collapse of a housing bubble. An economy hemorrhaging jobs. A market-oriented government struggling to stem the panic. Sound familiar?
It does to Sweden. The country was so far in the hole in 1992 — after years of imprudent regulation, short-sighted economic policy and the end of its property boom — that its banking system was, for all practical purposes, insolvent.

But Sweden took a different course than the one now being proposed by the United States Treasury. And Swedish officials say there are lessons from their own nightmare that Washington may be missing.

Sweden did not just bail out its financial institutions by having the government take over the bad debts. It extracted pounds of flesh from bank shareholders before writing checks. Banks had to write down losses and issue warrants to the government.

That strategy held banks responsible and turned the government into an owner. When distressed assets were sold, the profits flowed to taxpayers, and the government was able to recoup more money later by selling its shares in the companies as well.

“If I go into a bank,” said Bo Lundgren, who was Sweden’s finance minister at the time, “I’d rather get equity so that there is some upside for the taxpayer.”

Sweden spent 4 percent of its gross domestic product, or 65 billion kronor, the equivalent of $11.7 billion at the time, or $18.3 billion in today’s dollars, to rescue ailing banks. That is slightly less, proportionate to the national economy, than the $700 billion, or roughly 5 percent of gross domestic product, that the Bush administration estimates its own move will cost in the United States.

But the final cost to Sweden ended up being less than 2 percent of its G.D.P. Some officials say they believe it was closer to zero, depending on how certain rates of return are calculated.
The tumultuous events of the last few weeks have produced a lot of tight-lipped nods in Stockholm. Mr. Lundgren even made the rounds in New York in early September, explaining what the country did in the early 1990s.

A few American commentators have proposed that the United States government extract equity from banks as a price for their rescue. But it does not seem to be under serious consideration yet in the Bush administration or Congress.

The reason is not quite clear. The government has already swapped its sovereign guarantee for equity in Fannie Mae and Freddie Mac, the mortgage finance institutions, and the American International Group, the global insurance giant.

Putting taxpayers on the hook without anything in return could be a mistake, said Urban Backstrom, a senior Swedish finance ministry official at the time. “The public will not support a plan if you leave the former shareholders with anything,” he said.

The Swedish crisis had strikingly similar origins to the American one, and its neighbors, Norway and Finland, were hobbled to the point of needing a government bailout to escape the morass as well.

Financial deregulation in the 1980s fed a frenzy of real estate lending by Sweden’s banks, which did not worry enough about whether the value of their collateral might evaporate in tougher times.

Property prices imploded. The bubble deflated fast in 1991 and 1992. A vain effort to defend Sweden’s currency, the krona, caused overnight interest rates to spike at one point to 500 percent. The Swedish economy contracted for two consecutive years after a long expansion, and unemployment, at 3 percent in 1990, quadrupled in three years.

After a series of bank failures and ad hoc solutions, the moment of truth arrived in September 1992, when the government of Prime Minister Carl Bildt decided it was time to clear the decks.
Standing shoulder-to-shoulder with the opposition center-left, Mr. Bildt’s conservative government announced that the Swedish state would guarantee all bank deposits and creditors of the nation’s 114 banks. Sweden formed a new agency to supervise institutions that needed recapitalization, and another that sold off the assets, mainly real estate, that the banks held as collateral.

Sweden told its banks to write down their losses promptly before coming to the state for recapitalization. Facing its own problem later in the decade, Japan made the mistake of dragging this process out, delaying a solution for years.

Then came the imperative to bleed shareholders first. Mr. Lundgren recalls a conversation with Peter Wallenberg, at the time chairman of SEB, Sweden’s largest bank. Mr. Wallenberg, the scion of the country’s most famous family and steward of large chunks of its economy, heard that there would be no sacred cows.

The Wallenbergs turned around and arranged a recapitalization on their own, obviating the need for a bailout. SEB turned a profit the following year, 1993.

“For every krona we put into the bank, we wanted the same influence,” Mr. Lundgren said. “That ensured that we did not have to go into certain banks at all.”

By the end of the crisis, the Swedish government had seized a vast portion of the banking sector, and the agency had mostly fulfilled its hard-nosed mandate to drain share capital before injecting cash. When markets stabilized, the Swedish state then reaped the benefits by taking the banks public again.

More money may yet come into official coffers. The government still owns 19.9 percent of Nordea, a Stockholm bank that was fully nationalized and is now a highly regarded giant in Scandinavia and the Baltic Sea region.

The politics of Sweden’s crisis management were similarly tough-minded, though much quieter.
Soon after the plan was announced, the Swedish government found that international confidence returned more quickly than expected, easing pressure on its currency and bringing money back into the country. The center-left opposition, while wary that the government might yet let the banks off the hook, made its points about penalizing shareholders privately.

“The only thing that held back an avalanche was the hope that the system was holding,” said Leif Pagrotzky, a senior member of the opposition at the time. “In public we stuck together 100 percent, but we fought behind the scenes.”