Why Did Bank of America Pay Back the Money?

Everybody knows by now that Bank of America is buying back the $45 billion of preferred stock that the government currently owns. While the reason why they are doing this is obvious, I’m going to pretend it isn’t for a few paragraphs.

Buying back stock costs money — real cash money. Why would a company ever do such a thing? The textbook answer is that a company should do it if it doesn’t have investment opportunities that yield more than its cost of capital. The cash in its bank account, in some sense, belongs to its shareholders, who expect a certain return. If the bank can’t earn that return with the cash, it should return it to the shareholders. In this case, though, the interest rate on the preferred shares is only 5%, which is far lower than usual cost of equity. In fact, Bank of America just issued $19 billion of new stock in order to help buy back the government’s preferred stock. The cost of that new equity (in corporate finance terms) is certainly higher than 5%. In other words, Bank of America just threw money away.

In practice, companies buy back stock in order to increase their earnings per share. Fewer shares outstanding and the same earnings mean higher earnings per share and a higher stock price. In theory, this shouldn’t work: the benefit of having fewer shares should be exactly balanced by the fact that the company is now worth less (because it has, say, $45 billion less cash than it had yesterday). But in practice, it seems to work, probably because of signaling. But that doesn’t make sense in this case, either, since these are preferred shares that Bank of America is buying back, which have no claim on earnings. In effect, Bank of America is paying off cheap (5%) debt it doesn’t have to pay off — and to do that, it’s issuing new common shares, which will dilute existing shareholders.

Paying back its TARP money also has the effect of making Bank of America weaker. From a liquidity perspective, it now has about $20-25 billion ($45 billion minus $19 billion raised from new equity minus a few billion from other asset sales) less cash than it did before paying the money back. From a capital perspective, using cash to buy back preferred shares reduces your Tier 1 capital ratio. (I know there is disagreement about this, but the term sheet explicitly said that Treasury’s preferred shares counted as Tier 1 capital.)

So why?

The answer … which most of you know already … is to avoid executive compensation caps. From the Times article:

“It is a particularly delicate time for Bank of America, which has struggled to find a replacement for Mr. Lewis. By paying back the money that it received under the Troubled Asset Relief Program, or TARP, Bank of America will free itself from exceptional federal oversight of its executives’ pay — a thorny issue in recruiting a new chief executive.”

In retrospect, the executive compensation caps inserted by Congress into the stimulus bill back in February are having a perverse effect. Because the caps applied only to financial institutions that took TARP money — and they applied much more heavily to institutions that received “exceptional assistance,” like Citigroup and Bank of America — it tilted the paying field even more heavily against them. This gives them an incentive to take steps that weaken their financial condition, even as conditions in the real economy (to which Bank of America is highly exposed) remain bleak.

I support restrictions on the form of compensation in financial institutions, such as requiring them to be distributed in restricted stock that vests over several years (which is already standard practice at some banks, such as Goldman Sachs) and making bonuses in good years subject to clawbacks in bad years. But those restrictions have to apply to all financial institutions, not just some of them; otherwise, you get this situation where Bank of America is making a silly financial decision because it has to in order to hire a new CEO. (The fact that nobody will be CEO of America’s largest bank because of executive comp restrictions is another issue, but there’s not much we can do about that. I would do it, but I don’t want to move to Charlotte.)

Update: Ted K. pointed out to me that Wells Fargo, which is generally considered less of a basket case than Bank of America, is not paying back its TARP money yet.

By James Kwak

36 thoughts on “Why Did Bank of America Pay Back the Money?

  1. One of my usual minor nitpicks…

    In theory, this shouldn’t work: the benefit of having fewer shares should be exactly balanced by the fact that the company is now worth less

    This depends entirely on the market price of the shares at the time of the repurchase. If the shares are undervalued, then a repurchase increases the per-share value of the company; if the shares are overvalued, then a repurchase decreases the per-share value of the company.

    Your statement would only be true in a world where the market price of the shares always equals their value (“efficient” markets).

    If BofA’s transaction signals anything, it is that their shares are overpriced (because they are selling new ones) and that they see no opportunities for investment yielding more than 5% (because that is the cost of the preferreds they are retiring). This is a possible explanation, although I like yours better.

    Either way, I do not see why anybody would want to buy stock in such a company. Oh, right, free taxpayer money; almost forgot.

  2. Thanks for the insights. I saw the share announcements on Bloomberg and was surprised but … not really.

    Money in the bank is not the same as money in the pockets of bank executives. In this instance, BofA executives are ‘voting with their pocketbooks’ on the future value of the bank’s business. They are taking the cash in hand, thank you.

    Tomorrow – and shareholder interest -will take care of itself.

    I see this same process taking place throughout finance as insiders grab as much liquid cash as possible, usually by dumping junk securities on dumb money or onto the Federal Reserve balance sheet. Not exactly a vote of confidence …

  3. it doesn’t dilute existing shareholders much if at all. the new shares from this issue (and a probably comparable amount of shares from deferred compensation) bring in new equity cash, raising the equity the has company by $15/share.

  4. B of A isn’t making a silly financial decision at all – they are playing by the pre-TARP rules that the U.S. has yet to really revise. out in the market, there’s no down side to this decision – afterall over-leverage got them huge profits the last time . . . .

  5. Summing it up:

    They are now brazenly engaging in Akerloff’s looting, intentionally weakening the balance sheet in order to literally steal the money on a personal basis, doing it directly contrary to the proclaimed purpose of the bailouts, and doing it in plain sight with the full blessing of the government and MSM.

    Got it.

  6. In theory, this shouldn’t work: the benefit of having fewer shares should be exactly balanced by the fact that the company is now worth less.

    This assumes that equity value is asset based. If equity value is discounted cash flow based, and the company has excess cash sitting on its balance sheet, repurchasing shares should raise share price since fewer shares will have claims on future earnings.

  7. I agree, because I think that in general buying or selling shares shouldn’t affect the value of shares. But most market watchers tend to focus on this whole earnings-per-share issue. New shares do dilute EPS, but theoretically the cash you get by selling the shares makes it balance out.

  8. Since I’m taking a test on this tomorrow, I’ll do a quick elaboration.

    One of the ways to get cost of equity is the equation

    (Risk free rate) + Beta(Market Risk Premium)

    If you take that equation and slice it about any way possible, you’re going to end up with an equity cost of capital above 5% which is very close to the risk free treasury rate. Another way to look at it is that equity capital is more expensive than debt capital, so check the rates on BofA debt, I’m willing to bet they are decently above 5% as well. Executive compensation is about the only restriction on the Government preferred shares so removing that restriction is the only reason to pay it back right now as far as I can see.

  9. no mention of the $3b+ in dividends that will not be paid to uncle sam? the market loves this payback. the only people who don’t really are those still holding on to the view that bac is “insolvent”…

  10. Compensation. Quite possibly.

    Nonetheless, there is also:

    1. The stigma of gross incompetence associated with being a TARP recipient. It seems to me that anyone that has received a TARP bailout has put up a huge sign that says: “My management is so incompetent that I had to run hat in hand to the government to get bailed out.”

    2. BoFA has claimed they were essentially forced to take TARP money by Henry Paulson. Well…maybe.

    3. It is quite possible that TARP money was forced onto some banks in an effort to hide the poor state of Goldman Sachs.

    4. One can argue that one can manage one’s bank better in the long run than the government, so one should buy out the government asap, rather than suffer the fate of General Motors with a new CEO every two months.

    Just some thoughts.


  11. In my opinion it still dilutes value to the current common shareholder, not just in EPS. Of course we’re talking about “new issues” of shares. It depends on the size and type of the new issue. Of course the larger the “new issue” of shares sold is, the more the current common shareholder gets screwed. I think you have SOMEWHAT of a point though, if it keeps the company solvent it could help current shareholders long-term.

    But see this is why Buffet is so sharp, and accounts for a large degree of his success. He injects capital into companies that need/want capital and then he negotiates an extremely high dividend on those preferred B shares. He wins BOTH ways. Buffet gets a much higher interest rate (dividend) than common shareholders who sometimes have invested in the company longer than he has, and if the company goes bankrupt, Buffet gets paid off before the common shareholders.

  12. I have run across internet sites like American Banking News in the past two weeks that claim the Federal Reserve is pressuring Bank of America and others to submit TARP repayment plans.

    Certainly these banks have current funds in their reserve accounts at their Federal Reserve Bank that are all but idle. How much of these essentially frozen funds are being used by B of A to redeem the government stock position.

    I certainly makes sense that the Obama Administration would want to recover the TARP funds as soon as they can.

    Is not B of A looking out for number one here? So too are the managers in the bonus pool. Around $26 bn of the total funds used in the government take out are earning next to nothing interest. At least the portion of the $26 bn at the Fed used in the redemption is earning a pittance against a Preferred Stock requirement.

    Do both sides desire this redemption? It makes good sense for both sides or all three sides if you include those participating in the bonus pool. The politicians, the bank and the management are all looking out for number one using “idle assets” for most of the transaction. The inability to pin this down directly is just what all parties to a redemption would desire under the circumstances.

  13. It DOES dilute value. People nowadays put their money in mutual funds, most of them are not active stakeholders. They’re busy checking to see if they can find the international space station in the night sky with their naked eye while Blankfein, Dimon, Pandit, etc. are trying to figure out if they will label the capital injection a salary or a bonus.

  14. An alternative interpretation would be that you actually can hire someone quite adequate to run BoA (and who’s willing to move to Charlotte), even given the caps/restrictions, but that the Board and management are in sufficiently captured/self-interested such that they would rather weaken BoA’s financial position and give away stockholders’ money rather than pay themselves less.

  15. I enjoyed you and your daughter’s video Bruce. We can feel the real sincere emotions in your video. The struggle of the common man is very much part of the American story, like Arthur Miller’s “Death of a Salesman” and last years Academy Award nominated “The Wrestler” directed by Darren Aronofsky. We keep struggling and will CONTINUE to struggle and fight for the American Dream, because that is the American character. Persistence and determination.

    Someday the Ken Lewises, James Caynes, and Joe Cassanos of the world will see justice. Maybe we won’t get to see them receive justice, but they will receive justice.

  16. James, you are right re executive compensation. The announcement also happened to coincide (neatly) with Mr. Bernanke’s testimony. Of course, I’m not suggesting anything…

  17. Yesterday’s Federal Reserve H 4.1 Balance Sheet of the Federal Reserve Banks certainly adds fuel to the fire that the big banks are starting to assign funds from their reserve accounts to the reserve account of the US Treasury to redeem their Tarp capitalizations. Member Bank Reserve Demand Deposit Accounts declined $47 bn over the preceding week while the US Treasury Demand Deposit Account increased $47 bn.

    Has the Bank of America redemption closed yet? But banks are transferring money to the account of the Treasury.

    On the asset side there was near nil asset activity other than the announced asset acquisition from AIG and the pay down of the AIG loan.

  18. From a balance sheet analysis perspective it is quite easy to see a very interesting full cycle set of transactions emerging. Those institutions with a Reserve Demand Deposit Account at their Federal Reserve Bank sold Fannie and Freddie guaranteed mortgage backed securities to the FRB’s aggregating far more than the TARP investments and simply let the proceeds of sale credit remain in their account for six to nine months until now. The credit was not drawn down. Any draw down of sufficient size for all depositors is quite limited in scope. But there is one set of transactions where the accounts are drawn down. That exception is redeeming out the Treasury by assigning their redemption payment value to the Treasury from their Reserve Demand Deposit Account.

    What a coup. The big banks pay to take out the USG investment in their institution effectively using assets they could sell to no one else. Assets they sold at 100 to the FRB and not at market value.

    Now the Treasury is paid off with a static investment at the FRB. Since the cash flow of the MBE’s also effectively winds up credited to the Treasury Since Fed profits almost totally go to the Treasury they also receive a decent return. If not, the FRB’s may sell of Treasuries and Agencies to allow the Treasury to take down their account. Thus, the MBE’s remaining are become backing for currency at some future time.

    The whole sequence of moves to counter the bank runs of a year ago and allow recovery to the Treasury seems well worked out. So utterly simple too ! With all the bonus hoopla few will even notice.
    Anyway, the foregoing seems readily doable and also well underway.

    The bank runs were contained and the Treasury will be made whole at a decent profit. The FRB balance sheet will shrink up to a point too. The price will be currency backed by MBS’s in part which is quite academic. It will take some time but the first tranche will be big banks settling things out first.

  19. Although I am a BOA customer (they’re the closest bank and I really keep almost nothing there), I am rooting for them and the other TBTF’s to fail. Whatever they can do to cut off their noses to spite their faces in the name of executive compensation sounds good to me. I just hope they understand that there won’t be a TARP again, and it seems as though they and the others will need a “fix” sooner or later (greed addiction and gambling need hand-outs when their luck runs dry).

    But, I also must say that I’m glad we, the taxpayers, got the money back. It’s better than having it at BOA gathering dust in order to prop up their balance sheet. I just wonder what kind of superexec they can hire now that they are just a pinprick away from another catastrophe.

  20. “The answer … is to avoid executive compensation “

    If true, this is another example of how the big banks game the regulatory system, and why regulation is such a weak hand in enforcement.

    Speaking of “weak hands”, President Obama says that since taxpayers rescued the banks, the banks need to lend more, according to NBC nightly news reporter Chuck Todd (December 4). The Obama statement appears to be in response to polls showing President Obama is perceived to be too closely aligned with the banks, according to Todd.

    In summary, the Administration continues to try and put a positive spin on the failed policy of bank bailouts. Moreover, either by design or happenstance, the Obama mindset appears to accept the “trickle down” policy of bailouts.

    I would suggest that the Administration admit their mistake, and reclaim the high moral ground ,by breaking up banks deemed too-big-to-fail.

  21. Agree with article that this was not the time to repay tarp. From a shareholder perspective, raising common equity is obviously dilutive. However, it also obviously improves the banks capital position. It doesn’t matter that preferred is Tier 1. We all know the capital standards measures are flawed. The preferred has indeed eaten up a material portion of BofA’s net profit – real cash out its door. So common doesn’t eat up cash. If bank of America could have paid off all of TARP with $45 billion of new equity, it would have hurt shareholders, but been defensible in terms of resolving the government ownership while strengthening the BofA balance sheet. In any case, the fact is that the bank did use a mother lode of cash in addition to the common equity proceeds at a bad time. No doubt the executive compensation issue, particularly as BofA seeks to hire a new CEO was a key factor in the bank’s decision to move forward. What is worst about the current move is that the bank is using the cash at a time where it is not close to being profitable based oon stable recurring revenues. A seemingly endless flow of new problem loans as well a boatload of securities deeply in the red, but not marked to market (about $7 billion at 3rd quarter end) are also a concern. In short, one can surely argue this was a bad idea from a shareholder perspective. I find it even more worrisomne, however, that the bank is looking to stabd on it’s own two feet before it has gotten up off its knees.

    Joseph Tibman
    Author, The Murder of Lehman Brothers, An Insider’s Look at the Global Meltdown
    Amazon: cut & past: http://urlPass.com/4gq7

  22. The viewpoints expressed here point out the deep divide created by highly defective US state policy. The state must produce policy decisions that keep financial companies on an even keel where they do not damage the financial system or the polity and hopefully positively reinforce both.

    A bank simply cannot wear the hats of both banking and merchant at the same time. It should not matter if a banking business marks to market on receivables in any form since banking loans to term. The merchant business buys and sells at market.

    Making things worse is the fact of life that most participants in business consider the state minions to be incompetents to be manipulated to their ends. That fact of life has been heavily in place now for decades.

    The state needs people that decide and make it stick as to policy in a society as complex as ours. Such a statement is inimicible to the mythology of the society.

    A lot of problems would have been solved with seizure of B of A and the total disenfranchisement of all shareholders. Under the circumstances the common shareholders loss of profits to the Preferred Shareholder are a bitter pill to save them from a total loss. Since no decisive act was taken by the state all parties are advancing their self interest. All ideologues are vehemently crowing their ideological position.

    The state should have wielded the sword on the matter but is itself incapable of doing so because of the inability of Congress to decide anything itself from ideological disease. Throw in the ever present lobbyist for all positions possible and we are in the worst of all positions. That is no decision that works is really possible in the required time frame.

    What a mess. But, every party with a lot of personal wealth and power at risk that is able to enter the fray to pursue their own benefit will do so. Our system is adversarial and only works when their are clear decisions made by winner over loser. That in itself is inimicible to survival of the idea of democracy.

    A dozen years ago Jacques Attali wrote an great article on this subject for Foreign Policy. ” The Crash of Western Civilization:The Limits of the Market and Democracy”


    Are we beyond effective state solutions?

  23. James, I agree with your analysis except for your conclusion that imposing pay caps was counterproductive because it influences banks’ decision-making in a manner that doesn’t maximize solvency (tier 1 ratios).

    The function of TARP was emergency public support for the bondholders (and secondarily the stockholders and employees) of the banks involved in the face of a severe liquidity crisis and spreading financial contraction. The banks were insolvent then and they are insolvent now if their full liabilities and assets are marked to market (which includes the probability of getting back the investment in the assets). The Fed’s programs of loans and guarantees and parking a trillion dollars in excess reserves and paying interest on that money was the real method for creating the illusion of solvency that everyone so desperately sought in the short/medium term. Now we can pretend that their is no banking crisis.

    The restrictions on executive pay in TARP were entirely political (as was the TARP program itself), and their function was to publicly pressure the banks to pay the funds back so the Treasury Dept could say it wasn’t a give-away. The “let’s punish the evil executives” interpretation is popular in the financial community and press, but incorrect, as is the interpretation that the pay caps would somehow affect risk-taking or any other operational process in banking itself.

    In sum, the pay caps are working exactly as intended:
    Now that the immediate crisis is over the investment houses/banks are paying the money back to regain freedom where it matters to their egos, the Treasury Dept can say it’s getting back the money it promised it would.

  24. Hey, as a member of the tax-paying public, we’ll take it. BoA is done anyway, no way they can overcome SIV debt, just to mention one white elephant. The govt did well on this one, made it thru the pyramid-scam — can they get clawbacked after the bank blows up? — so why is everyone crying about a broke bank paying back the people? The real question is: Why would anyone who isn’t a speculator own the stock?

  25. The silver lining is that BAC is now closer to its richly deserved bankruptcy, which will help hasten the demise of TBTF.

  26. It really is a sad statement that they believe that no one who would be subject to compensation caps could be worth hiring. It really is delusions of grandeur.

    I mean come on, the compensation is still phenomenal. You’re (not you, but them really) telling me that you can’t find some hot shit person willing to work for a simple million or something.

    I’ve worked in management in big business long enough to know that CEOs, while requiring a certain talent, are hardly so special that there aren’t gobs of people who could actually do the job if they (those hiring) were able to get past worrying about what are essentially pointless qualifications of exclusivity.

    These aren’t simply the “best and the brightest” except in the deluded cliques of hyper-oligarchy.

  27. James says, “you get this situation where Bank of America is making a silly financial decision because it has to in order to hire a new CEO.”

    Btraven says: It “has to”?

    And he continues in parens, “The fact that nobody will be CEO of America’s largest bank because of executive comp restrictions is another issue..”

    Btraven sayd: “Nobody”?

    James, have you been drinking the kool-aid? The assertions and assumptions you’ve made are nonsensical and complete fallacies — unless you believe the next CEO has to come from “The Bankster Brotherhood.”


    I am confident there are hundreds, if not thousands, of people who could fill the CEO position and do an adequate job, and probably most of them would do a far better job than Lewis.

  28. “I am confident there are hundreds, if not thousands, of people who could fill the CEO position and do an adequate job, and probably most of them would do a far better job than Lewis.”

    As so many have said before, “I could drive that company into bankruptcy for much less!”

    Sure, there’s probably a lot of good experienced managers who could do well in that job. But the CEO class doesn’t really want to believe that; they want to believe that they have special talents that are really worth lots and lots of money, even when they are obviously failing.

    Since I didn’t believe the banks should have gotten the TARP money in the first place, I’m not unhappy if they give it back. If they fail now, maybe we’ll do what we should have done in the first place, break them up and put them out of our misery.

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