BofA Not Quite Out of Options

Updated from Tuesday, April 28

It should come as little surprise that federal regulators believe Bank of America ( BAC) needs more capital to survive the recession, unless you take as gospel the recent public declarations of top executives.

BofA shares closed down 9% to $8.12 Tuesday on concern that federal officials were pushing the company and battered rival Citigroup ( C) to build their capital cushions in the wake of government stress tests. The report comes at a particularly bad time for BofA, which is hosting its annual meeting of investors in Charlotte, N.C. Wednesday, at which many will be calling for CEO Ken Lewis' head.

Unfortunately for investors who would like some clarity on the situation, Bank of America has mostly remained mum about its plans to shore up its balance sheet -- except to issue bold assertions of its adequate capital levels and financial strength.

Lewis asserted he was "confident we'll pass the stress test" in a March speech. He followed that up on a conference call to discuss the firm's first-quarter profit beat last week by saying "we absolutely don't think we need additional capital," adding the caveat that "we think we are fine, but again, this is in the hands of the regulators at the moment."

What should investors tell Bank of America Chairman and CEO Ken Lewis?

Keep up the good work.
Resign as chairman, stay as CEO.
Thanks for the memories.

If the government's stress tests do uncover capital gaps, management rhetoric may be seen as honest, but flawed. Or it may seem like flagellation and denial aboard a rudderless ship.

One obvious alternative for BofA is to offer new stock or convert some of the government's $45 billion worth of preferred holdings into common shares, but that option would dilute existing shareholders. The firm could also make a rights offering, notes Jonathan Finger, managing partner of Finger Interests, which has launched a campaign to unseat Lewis and some board members. Such a move would allow existing shareholders to participate without diluting their stakes, or to sell rights in the open market.

Luckily, a bank with the size and scope of BofA has more options than a stock or rights offering. For instance, Bank of America booked a $1.9 billion gain during the first quarter by selling its stake in China Construction Bank. BofA still holds 13.5 billion in preferred shares of the bank, worth about $30 billion. It also received quite a few divestible assets through its acquisition of Merrill Lynch.

With three of its own wealth management businesses -- U.S. Trust, Columbia Management and Global Wealth Advisors -- in addition to Merrill, there has been speculation that BofA may rid itself of some of those legacy divisions. It has been widely rumored that First Republic Bank, a private bank operated by Merrill, is on the auction block. Merrill bought First Republic for $1.8 billion in 2007, though it's unclear how much the asset would sell for today.

Bank of America also acquired a 50% stake in BlackRock ( BLK) through the Merrill deal, largely in the form of preferred shares. With BlackRock's market cap standing at about $19.25 billion, a divestment of all or part of that stake could easily afford BofA some cash.

A spokesman said BofA would have no comment for this article.

Bank of America has worked to assure investors and depositors that it isn't Citigroup ( C) or American International Group ( AIG), whose troubles brought those companies to near-collapse before the government stepped in with emergency assistance. But BofA may want to take a page from the Citi-AIG playbook in terms of handling the hue and cry more effectively, and showing investors that there is a clear strategy to handle worst-case scenarios, with a road map back toward steady profits.

AIG has disclosed hundreds of millions of dollars worth of asset sales, including AIG Private Bank, 21st Century Insurance, a few foreign banking subsidiaries and commodities businesses. Meanwhile, the giant insurer has accelerated the separation of its core property and casualty business into a separate entity, called AIU Holdings.

Citi has sold off its German banking division, as well as a majority stake in Smith Barney and some ancillary units, as part of a plan to rid itself of $400 billion in assets over the next few years. There are also reports that it may be divesting its Japanese banking division, Nikko Cordial.

Some of those assets represent huge, profitable jewels in a complex crown. It is unclear, according to The Wall Street Journal, whether regulators will consider Citi's pending assets sales as capital that address capital shortfalls. However, the divestitures showed that both Citi and AIG were actively working to raise cash and get back to basics by unwinding the financial supermarket models they employ.

Whether Bank of America has similar intentions, or entirely different ones, the firm might be better served letting investors know what, exactly, it plans to do.

" Shares are already pricing in a large common equity raise ... so the key question is how much will they need, where do they get it from and at what price," writes Matt O'Connor, an analyst with Deutsche Bank ( DB).

He initiated BofA with a hold rating on Monday, noting that under his own stress test, the bank's ratio of tangible common equity to risk-adjusted assets plunged to 1.8% from 4.1% as currently reported. O'Connor assumes regulators are targeting at least 3%, implying a significant shortfall.

O'Connor asserts that "it's unclear to us whether BofA will be able to raise capital without government help," and some other analysts agree. Goldman Sachs' ( GS) Richard Ramsden said he "would not be surprised" if the bank converted preferred equity into common to make up for "insufficient" TCE ratios. And Morgan Stanley's ( MS) Betsy Graseck, who rates BofA underweight, cited a full conversion of all preferred shares into common as her "bottom-of-cycle, bear-case" scenario, with a price target of $4.

However, others, like Citigroup's Keith Horowitz, are more optimistic.

While Horowitz believes BofA will need $5 billion in additional capital, he called potential dilution "relatively small" at 10% to 15% and noted "significant options available" to plug in balance-sheet gaps. Among those are its remaining China Construction Bank stake, along with divestible assets like First Republic and Columbia, and $30 billion in private preferred shares that could be transferred into common.

"Bottom line: if BofA is deemed to need more capital ...we see a very low likelihood that it will need to go to the government, since it has many other resources," writes Horowitz. He later adds that "on a normalized EPS base of $4, we believe there still is large upside in the stock."

Of course BofA is not the only bank whose investors worry about a capital shortfall -- Wells Fargo ( WFC), Fifth Third ( FITB) and Regions Financial ( RF) are among those cited by analysts and commentators as potentially needing additional funds. But several high-profile investors like CalPERS, Jonathan and father Jerry Finger, CtW Investment Group and others are fed up with what they consider to be irresponsible management decisions and a lack of communication on a clear path forward. They have launched campaigns to unseat Lewis and other board members, hoping that a change in management will lead to a new direction for the firm and its share price.

As a slew of angry shareholders prepare to convene for Bank of America's annual meeting on Wednesday, one can only hope the firm has something to say.

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