Legacy Entity Sleight of Hand at Bank of America

photo: Leo Reynolds via Flickr

Dr. Philip Neches has an analysis at the Huffington Post of the Bank of America (BAC) announcement that they will separate 1.3 million of their mortgages into a new “legacy asset” entity. This is a “good bank / bad bank” strategy. He notes that the announcement was exceedingly low key.

Bank of America (NYSE: BAC) announced last Friday that they were creating a new subsidiary, Legacy Asset Servicing, to handle their 1.3 million troubled mortgages. They hoped that their announcement would get buried under the snow — and news about Egypt and the Super Bowl. Their wish seems to have come true.

Neches also points out that the TARP process was like a bankruptcy court process, but with an inherent weakness:

The TARP process was the equivalent of Chapter 11, with the Federal Reserve and the Treasury acting as both the “debtor in possession” lender and the bankruptcy judge. When put that way, the flaw in the idea becomes immediately obvious: the roles of lender and supervisor are inherently in conflict with each other. The lender, seeking to minimize its risks, pushes for strict controls over the operation of the bankrupt party; the supervisor has to balance the demands of all parties, including other creditors, employees, customers, and public.

TARP clearly succeeded at one of the three goals of Chapter 11: stabilize operations. It did not, however, achieve the other two goals: fix the problems and reposition for the future.

Bank of America will now try to resolve the loans that it places in the bad bank at low impact on its own balance sheet. I wonder how it is going to do this. Currently since during the crisis the Treasury and Federal Reserve Bank convinced the Accounting Standards board to end ‘mark-to-market’ requirements on bank assets most of these bad loans are on the books of the bank at their pre-crash highs. As long as they are NOT resolved the bank looks to have more assets than it really does. The shadow hanging over the banking sectors is: What are these assets really worth? Bank of America may seek some hedge fund to take equity in the unit to minimize the effect of the balance sheet hit. Neches says:

This means that they are preparing to separate the Legacy Asset Servicing business from the BAC holding company at some future date. The bet is that some investor or group of investors will buy the “bad bank”, even if it’s just for $1. The benefit for the remaining “good bank” is obvious: it now has clearly positive net worth and is better positioned for the future.

. . .
I don’t see the logic of this. If BAC sells the asset pool which has a book value of say $260 billion for $1 it will have to realize the loss on its books of the whole enchilada. They can’t by sleight of hand magically make the loss disappear. IF the entity becomes separate from BAC they could take out a short on it though… or they could securitize the entity in tranches and sell off the more toxic stuff to some idiots. If they could buy a AAA from some supine rating firm, then they could get a good price for the securities. Does this sound familiar? Hmmm.

As Neches points out the resolution of the loans at a loss has the potential to eat up ALL of Bank of America’s capital:

Here’s a back-of-the-envelope analysis. Suppose that the average balance of the 1.3 million troubled loans is $200,000. Suppose that the best that can be done is to realize 50% of the nominal value of the loan. Suppose that every one of the remaining 13 million mortgages is perfectly good. Do the math, and that comes to a loss of $130 billion, just a whisker short of BAC’s $144 billion market capitalization.

This last point is exactly why Treasury and the Fed wanted to do away with the mark to market requirement. If the assets of the largest banks in the the US were marked to market, they would need massive new injections of fresh capital to be solvent, or they would fail. This has not yet been resolved and has the whole market doing some strange things — posting new highs while knowing that the financial edifice is incredibly under capitalized and needs to recognize the losses and get on with life.

(Cross posted at www.petraitis.us)

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