I’m trying to figure out if I should be infuriated about the agreement allowing Bank of America to walk away from the asset guarantees it got as part of its January bailout in exchange for a payment of $425 million. I can piece together part of the story from The New York Times, Bloomberg, and NPR, but the complete story is a bit hazy.
The initial deal was that Treasury, the FDIC, and the Fed would guarantee losses on a $118 billion portfolio of assets; B of A would absorb the first $10 billion and 10% of any further losses, so the government’s maximum exposure would be about $97 billion. Part of that guarantee was a non-recourse loan commitment from the Fed, basically meaning that the Fed would loan money to B of A, take the assets as collateral, and agree to keep the assets in lieu of being paid back at B of A’s option. In exchange, the government would get:
(a) An annual fee of 20 basis points on the Fed’s loan commitment, even when undrawn (if B of A drew down the loan, which it didn’t, it would pay a real interest rate). The loan commitment could be interpreted to be only $97 billion, so this comes to $194 million per year.
(b) $4 billion of preferred stock with an 8% dividend. That’s a dividend of $320 million per year; B of A can buy back the preferred stock by paying $4 billion.
(c) Warrants on $400 million of B of A stock. B of A was at $7.18 the day the bailout was announced and yesterday it closed at $17.61, so if Treasury had gotten an exercise price of $7.18, those warrants would be worth about $580 million now.
Now, at this point I was furious, but then I found this provision in the term sheet:
“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.”
The question is, what does this mean? As far as the Fed loan commitment, it’s clear: Bank of America can walk away from that. Since they had the loan commitment for about nine months, their fee should be about 9/12 of $194 million, or $145 million. I’m fine with that.
But what about the preferred stock and the warrants? Is B of A getting all that back as part of the $465 million payment? The news stories aren’t specific on this point, but I’m pretty sure B of A is getting it back. I say that because all three stories refer to the government holding $45 billion of preferred stock in B of A. That $45 billion is quite clearly the $25 billion cash investment from October and the $20 billion cash investment from January – which implies that the $4 billion in preferred stock that Treasury got in exchange for the asset guarantee is gone.
B of A’s position must have been – actually, I’m having a hard time making their position in a reasonable way, because it’s so untenable – something like this: “In January, we all thought we would need that guarantee for a long time, and that’s why we gave you $4 billion in stock for it, but now it turns out we don’t need it, so let’s pretend we never gave you that stock.”
But this is clearly ludicrous. The deal was very clear. The government did something for B of A. In exchange, B of A gave the government $4 billion in stock. If the idea had been for the government to get, say $400 million in stock for each year the guarantee was in force, then that’s what they would have written into the term sheet. The economics of the deal were also very simple. B of A was in trouble; only the government was willing to give them an asset guarantee; that guarantee was worth at least $4 billion to B of A, and probably a lot more; so the government got $4 billion worth of stock.
So I’m still left wondering what this could mean: “the parties will negotiate in good faith as to an appropriate fee or rebate in connection with any permitted termination.” If I’m the government, I’m thinking: “I gave you something that was worth $4 billion at the time; you gave me $4 billion. Now you don’t want the thing I gave you; fine, throw it away. But what’s to negotiate? You already got something worth $4 billion.”
So the government negotiators should have been asking for $4 billion, plus nine months’ worth of dividends ($240 million), plus the value of the warrants ($580 million), plus nine months’ worth of the loan commitment fee ($145 million), for a total of $4.965 billion. But what did they ask for? According to an earlier (no longer available except in Google search results) version of the Bloomberg story, regulators were asking for “$300 million to $500 million.” And they got $425 million – which is basically the loan commitment fee plus one year of dividends on the preferred stock, meaning they got nothing, nada, zilch for the preferred stock or the warrants.
What possible explanation is there for this? Here are a few:
(1) B of A somehow convinced the government negotiators that the deal was really for $4 billion over some period of time, and hence the government didn’t have a right to it, no matter what the term sheet said.
(2) That “negotiate in good faith” clause was meant all along as a way for B of A to get out of the deal. That is, in January the government wanted to claim for PR purposes it was getting $4 billion in exchange for the guarantee, but nudged B of A and said that if things worked out, it wouldn’t actually be $4 billion.
(3) B of A threatened to go even more public with the claim that it only closed the Merrill Lynch acquisition under government pressure (remember, this asset guarantee was widely believed to be a quid pro quo for closing Merrill – see the Bloomberg headline, for example), and the government didn’t want that episode in the news again.
(4) As Bloomberg reports, “while the guarantee was announced in January, an agreement was never signed.” Wait a second. The deal was never signed? What? Why isn’t this a front-page scandal? Remember, the announcement of the guarantee bolstered confidence in B of A’s survival. (It may not have been good for the stock price because of the dilution, but it was a signal that the company would not be allowed to go bankrupt.) Even if nothing was ever signed, there is no way the government would have been able to back out after going public with the guarantee. So the taxpayer was committed. And somebody forgot to get B of A to sign the piece of paper? Or was this a conscious oversight to make it easier for B of A to get out of the deal later?
OK, now I’m infuriated. Shouldn’t you be?
Update: A Congressional source tells me that the deal was never closed because the parties could never agree on which assets to include in the pool to be guaranteed. This, of course, raises the question of why they couldn’t agree – after all, we did it with Bear Stearns, and we did it with AIG. (Did we do it with Citigroup or do we have another of these problems hanging out there?) The point is there’s no reason Treasury couldn’t have gotten this done. But B of A had no reason to want to close the deal – it got a benefit in the markets strictly from the announcement, and if it ever needed the guarantee there’s no way the government would refuse simply because nothing had been signed. So it was up to Treasury to close the deal and get the $4 billion in preferred stock.
My source also says the $425 million payment is supposed to represent the benefit that Bank of America got from the guarantee over the last nine months. But it doesn’t. A guarantee is insurance. Let’s say you pay $1,000 for a one-year insurance policy for your house. At the end of the year, can you go to your insurance company and ask for the $1,000 back because your house didn’t burn down? If B of A and Treasury agreed on a price of $4 billion, then that’s the price; it has nothing to do with what happens later. So even if the deal was never closed, the “regulators” should have been asking for a lot more than $300-500 million as the value that Bank of America got from the relationship. As StatsGuy points out below, they could have gone to court for it; as even a first-year law student knows, an agreement doesn’t have to be written down and signed to be binding (and I assume at least the term sheet was signed by both parties).
By James Kwak