Last Wednesday I wrote a highly critical post about the agreement between Bank of America(BAC) and the government (Treasury, the Fed, and the FDIC) to terminate BAC’s asset guarantee agreement in exchange for a payment of $425 million. I’ve learned some more about this and I think I can reconstruct the government’s perspective on this issue, with the help of someone knowledgeable about the transaction.
A good place to start is Schedule A of the Termination Agreement. A few relevant facts:
- BAC requested the termination on May 6. Note that this is the day after the stress test results were released, although I’m not sure how much of a factor that was. Apparently at this point BAC felt comfortable going without the guarantee. It took an additional four months to work out the terms, but Treasury and BAC decided to use January 16-May 6 as the period that the guarantee was in effect. You could argue that the guarantee was really in effect until the Termination Agreement was signed, because BAC could have changed its mind, but I don’t think using May 6 as an end date is too unreasonable.
- The $118 billion pool of assets was identified in advance of the announcement, but not down to the level of individual securities. Because the assets were mainly or entirely from Merrill Lynch, the vast majority of them were already marked to market. One of the things the government had to do was verify BAC’s marks. Another thing they had to do was verify that the assets did not violate any of the conditions of EESA, the bill that governed the usage of TARP money. This is one reason that negotiations on the initial deal took time.
- By May 6, the parties had already agreed to exclude $14 billion of assets, and disagreed about another $42 billion. For purposes of calculation, then, they assumed that they would have excluded half of that $42 billion, or another $21 billion. This brought the “covered pool” down to $83 billion. (This is a bit of a fiction since the final pool was never identified, but the only purpose of the fiction was to calculate the termination fee.)
If you accept those assumptions, the calculations on Schedule A for the Fed’s loan commitment fee ($57 million) and the foregone dividends ($69 million) more or less make sense. The calculation for the warrants also seems right. They used a strike price of $13.30 and the market price on May 6, pro-rated for the reduction in the asset pool from $118 billion to $83 billion, and came up with a warrant value of $140 million.
I have two quibbles with this so far. The first is this practice of using a preceding 20-day average stock price for the exercise price. Given that most banks are coming to the government when their stocks have just fallen precipitously, this seems like a surefire way to set your exercise price too high. But given that this has been standard practice since early in the bailouts, that has nothing to do with this deal in particular.
The second is pro-rating the amount of preferred stock and warrants by the size of the asset pool. On January 15, when they agreed on $118 billion as the size of the asset pool, both sides knew that the pool had to be verified, and they probably knew that the pool would likely get smaller. In that case, since they both knew that the pool would be adjusted when they agreed on $4 billion as the premium, $4 billion was the appropriate premium for the post-adjustment pool, not the pre-adjustment pool; the adjustment was already priced in.* But that’s a relatively small issue.
The big issue is that BAC and the government pro-rated the $4 billion in preferred stock by the effective term of the guarantee – 4 months, while the original term was 5-10 years, depending on the type of security. Because they came up with a weighted average term of 5.4 years (which I don’t dispute) this reduced the premium for the insurance from $4 billion to about $230 million (pro-rating by the size of the post-adjustment pool brings it down to $159 million).
The government’s argument for this is, roughly, that if you prepay the annual premium on your homeowner’s insurance at the beginning of the year, but then you sell it after four months, you get a rebate for the last eight months. Put another way, if $4 billion is the right price for 5.4 years’ worth of insurance, then $230 million is the right price for four months’ worth. (BAC’s argument, presumably, is that since no definitive agreement was signed they shouldn’t have to pay anything.)
My argument, on the other hand, is that it’s more like buying a homeowner’s policy when there’s a 50% chance that your house has asbestos (which would increase your liability premiums). Four months into your policy period, you get your house inspected and find out there’s no asbestos. Now you can’t get a rebate from your insurer, because in this conceptual example the insurer already priced in a 50% chance of asbestos. A similar example would be someone buying health insurance (in the individual market) at the moment that he has a 50% likelihood of having cancer. In either case, there are two possible states of the world, and you are buying insurance against the bad state of the world. When the good state occurs, you can’t get your money back.
Another way to think of this is as an option. If BAC had bought an asset guarantee for four months, I agree that the premium would have been a lot less than $4 billion because these assets could take many years to deteriorate. (However, you could also argue that since these assets are marked to market, their values deteriorate as soon as expectations of default increase; you don’t need to wait for the actual defaults). But even though BAC only used the guarantee for four months, they got more than that: they got four months of insurance, plus an option to buy another five years of insurance if they found themselves in the bad state of the world.** If the first four months were worth $230 million, then the option was worth a lot more than $230 million.
The other thing that can be said in defense of the Termination Agreement is that to get more, the government would have had to go to court to enforce a term sheet that was largely performed but never finalized as a definitive agreement, and that’s not what the government should be doing with its time these days. I’d say that’s a matter of opinion.
* Alternatively, perhaps the working assumption was that as assets got disqualified from the pool, other assets would be added. In that case, had things gone badly, BAC would have been pushing to replace the assets that got disqualified with new assets, and the effective coverage would have been $118 billion. That is, the fact that the pool only got smaller already reflected the fact that things got better for BAC after January 16, not worse, and therefore that fact should not be used when estimating the value of the guarantee.
** Actually, it’s more complicated and slightly better for BAC, because for some reasonable amount of time (six months?) they had short-term insurance and they had the right to exercise the option on long-term insurance by signing a definitive agreement. Furthermore, if you accept the underlying logic of the Termination Agreement and the metaphor of selling your house and getting an insurance rebate, even after signing the definitive agreement BAC still had the option to terminate the agreement and get a rebate. Refundable level premiums make sense when the risk of loss is uniformly distributed and unchanging over time; when the risk of loss changes over time and the buyer of insurance can see how it changes, then they are an invitation to moral hazard. Come to think of it, if you live in the fire zone of the Oakland Hills and you buy your insurance policy on July 1, should you get a 50% rebate if you cancel it on January 1 after fire season is over?
By James Kwak
17 thoughts on “More on Bank of America”
I would reverse the argument. If the government had declared publicly “under no circumstances will we intervene to help BAC,” the company would have failed in March.
The government’s intervention was worth the ENTIRE equity value of the company; indeed, the bonds would have been impaired.
The crime here is that the government never negotiated a commercially reasonable return for the incredible value it was bringing to the table. Why not demand eighty percent of the equity, or any other number? Why not demand the immediate issuance of the shares, in advance of any agreement on the pool, to put the onus on the petitioning bank to cooperate?
Every dollar that we do not collect is, in essence, a dollar we the taxpayer have provided to bank shareholders – the very group least deserving of government charity. http://tauntermedia.com/2009/07/25/bad-math-worse-investors/
Without the Government’s guarantee, Bank of America would have faced a liquidity squeeze; ended up in Bankruptcy; and its shareholders would have been wiped out. Their rescue was surely worth the entire fee that was agreed to up front.
The Bailout was sold on the idea that the government would get much of its money back when things stabilized. To do so it needs to receive full payment on its guarantees from those institutions and portfolio’s that survive to offset its losses on those that do not.
By letting Bank of America off so easily, the treasury &/or fed have subverted an essential element of the Bailout legislation and representations made to congress and the American people.
In my view, this settlement should be challenged in court as beyond the authority of those in charge since it is directly contrary to how the program was sold!
James, I thought you presented a nice discussion. Using your logic, the way to value the guarantee would not to prorate the insurance. Instead, the government should have done the following calculation:
(Value of Insurance on 1/15/09) – (Value of Insurance on 5/6/09) = (Fee to Exit the Insurance).
The Value of the Insurance on 1/15/09 was worth more than $4 billion, according to the term sheet. If the Value of the Insurance on 5/6/09 > $3.575 billion, then taxpayers were shortchanged. I suspect they were.
Thanks. You’re right – that’s the way to value it.
I think your inequality sign is backwards.
I hope Mr. Kwak will excuse me, this is not directly related to the topic, but in a very broad way it touches on the issue. Professor Joseph Stiglitz gave an interview with James Surowiecki of “The New Yorker” magazine. Professor Stiglitz drops many pearls of wisdom here.
This is really just another way of saying what Linus said, but you could make this very clear via your put option analogy.
The government sold BAC a several year put option at a time when expected volatility of the underlying was very high. (One also might argue that at those times and given the not-widely-traded underlying, such a put option would have been directionally expensive, as the market anticipated bad news that was not reflected in BAC’s marks, but that it could not arbitrage away. But pointing to volatility is more orthodox, and is sufficient to tell our tale.)
BAC asked the government to repurchase the option, and negotiated a price that arguably compensated the government for the time value of the option lost.
However, the option would have lost value not only, or primarily given its long expiration, due to time. If we take the option as being pretty near the money, the option’s value would have fallen much more due to the drop in volatility expectations. The government was very gentleman-like with BAC (but not with taxpayers) in deciding to hold expected volatility constant for the purpose of buying back the option, even though those volatility expectations have collapsed.
With measured brevity, you are right on!!
If the Value of the Insurance on 5/6/09 < $3.575 billion, then taxpayers were shortchanged.
Thanks for spotting the error!
the question of what volatility to use is far from cut and dried. there is no market for ‘volatility expectations’ on several-year BAC puts. generally one would use a long term average vol (something like a 90 or 180 day moving average). i don’t have a bloomberg terminal up right now, but i’d imagine that the difference is less than you think it is.
on the other hand, the value of the underlier is i would imagine much higher, making the put option worth a lot less valuable now than in december or march.
Just imagine a bank named after your own country, which doesn’t even know how to carry assets on it’s balance sheet. Don’t you think most 3rd year University business students could manage that much??? But not Bank of America http://www.businessinsider.com/bank-of-america-admits-its-asset-values-are-lies-2009-3
Then after Bank of America is rescued by Obama and the taxpayers, show absolutely no gratitude at all.
In essence what you have with Ken Lewis and Bank of America is a large fat baby that urinated and dumped in it’s diaper. And after Mommy (Obama and the taxpayer) changed their diaper and gave them a new diaper, Baby (BAC) cried because the new diaper wasn’t comfortable enough.
Better get that i in interfluidity. Remember self-promotion is the name of the game. COME ON Bro!!! If you worry too much about America’s economic future and moral sense you’re going to miss the gravy train!!! (haha)
The even worse crime is that every person involved in all the bad decisions and every bankster involved in taking the money won’t be poor, destitute, or imprisoned when this is all said and done. They’ll be well off, employed, or at least employable at obscenely high salaries.
All I can say is, considering the vile travesty that the TARP and bank bailouts (guarantees, etc.) are, isn’t there some way the the government can hold BOA’s feet to the fire to get us taxpayers more skin? It looks to me like they are walking away much too inexpensively. But this is a moral issue for me and for most taxpayers. We’ve suffered for years from the abuse foisted upon us by the financial oligarchy, and we want our pount of flesh, anywhere we can find it.
i think the underlying here is BAC’s guaranteed assets, not BAC itself. (BAC historical stock price understates its asset volatility precisely because of state guarantees, written and implied.) so i treated the price as constant (on the presumption that BAC hasn’t remarked the assets since the deal was inked), and let “volatility” cover all changes. but you’re fundamentally right — it may be a matter less of volatility than that the expected value of the assets has shifted from well below BAC marks to something somewhere close to the marks. but since there’s no analogous situation with widely traded, constantly marked assets, and i wanted to keep my parallel orthodox, i let “volatility” cover the case, on the theory that the marks represented a zero-point and the range of everyone else’s expectations capture valuation uncertainty. if you let the “real” market value of the underlying change despite the formal marks remaining constant, than its much more straightforward to think of this in terms of a change on in-the-moneyness.
the core point is that the value of the put option has changed in a manner that far exceeds the loss of time value. whether you attribute it to a change in volatility from marks or value of the underlying is in a sense definitional.
Well we watched the movie of Simon and Larry Fish (great name!). As we munched popcorn and tried to read between the lines, we kept wondering — where is Simon from? Yorkshire? Throw us a bone here. Also, regarding the use of “we” in the video – Simon says “we” again when talking about our issues with the financial system, but is he American? Just here for a extended visit on her majesty’s secret service like he was back in the USSR?
Noticed also what nice things he had to say about the quixotic Jaime Caruana LaCorte (whose ancestors founded the first banks in Malta and Valencia).
This is so well reasoned & thought through from both perspectives, as you would expect from a first-rate legal mind. Thanks for the update.
I harped on this several times, and on a lot of forums also.
Here’s a couple of bits from Feb:
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