Bank of America's plan to go it alone
The lender says it no longer needs government money, but analysts say its future depends on an economic recovery.
NEW YORK (Fortune) -- The curtain has been lifted: Bank of America must come up with $34 billion to meet the demands of its stress test by federal regulators. But the Federal Reserve's disclosure was followed by a far more surprising announcement from CEO Ken Lewis, who said that the bank would not, as some had speculated, convert the government's preferred stock into common equity.
"We do not need new government money, and we do not intend to convert the existing TARP money we have," said Lewis in a conference call with investors Tuesday. "In fact, our game plan is designed to help get the government out of our bank as quickly as possible." The CEO then unveiled his plan to raise money by selling common stock, converting private preferred shares, divesting some of the bank's assets, and producing greater profits.
The 19 banks evaluated by the Federal Reserve have until June 8 to submit their plans, and have until November 9 to meet their capital demands. Bank of America (BAC, Fortune 500) filed Thursday for permission to issue up to 1.25 billion shares of common stock.
A key measure of the bank's health, its tier one common capital ratio (the amount of common stock it has vs. its risk-weighted assets), is currently 4.49%, which the bank says is above guidelines. But the Fed says the bank must raise $34 billion more capital in case a predetermined "adverse scenario" arises - a situation in which the bank would be expected to generate losses of $137 billion.
Lewis was critical of that scenario, arguing that the government's forecast - a dire prediction of rising unemployment rates, massive loan losses, and widespread credit charge-offs - was "extreme."
Analysts speculated this week that Bank of America would buttress its capital by converting much of the $45 billion in preferred shares it issued to the government last fall to common stock. By doing so, the bank wouldn't have to raise new money, but it would dilute its current stock base, lessening the share of profits that each investor receives. As a major shareholder, the government would have a large hand in the bank's operations - anathema to investors, who earlier panicked over the threat of nationalization.
Instead, the bank's executives announced that they will raise the $34 billion using a variety of tactics, including issuing at-the-market stock and converting institutional investors' preferred shares into common equity, which would add up to $17 billion. The bank didn't elaborate on the mix between preferred and common - a smart move, says Stifel Nicolaus analyst Chris Mutascio. "By not giving specifics, they were lessening the potential impact of investors shorting the common stock," he says. "I think it's feasible that they could raise the capital on the market."
Bank of America also plans to sell several business units, including First Republic, the bank it acquired through its purchase of brokerage Merrill Lynch, and asset-manager Columbia Management, for $10 billion. Analysts speculated that the bank will also sell its stake in China Construction Bank, worth about $8 billion, but CFO Joe Price did not mention it in BofA's conference call. Those sales, coupled with earnings gains of about $7 billion, will add up to the $34 billion needed for its buffer, said Lewis.
Several analysts are bullish on Bank of America's stock, including David George of the Robert W. Baird firm. George wrote in a note Thursday that the bank's stock dilution would be manageable and that its core retail franchise was intact. "We believe that BAC is among the most profitable pre-provision banks in the industry, with significant earnings power, while possessing the industry's best deposit franchise," he wrote.
George has a "buy" rating on Bank of America's stock, as does JP Morgan banking analyst Vivek Juneja, who wrote Friday that the bank's estimate that it could raise $10 billion through asset sales was higher than he expected.
Mutascio, also bullish, noted however that his recommendation was based more on Bank of America's cheap market valuation than its immediate prospects for growth. "There's no bank that's more levered to an upturn than Bank of America," he says. "Their outlook really depends on the outlook for the economy."
Because Bank of America has a wide variety of business units, it's exposed to several variables. For example, if the current refinancing trend continues, its mortgage lending unit Countrywide will profit; if stocks continue to go up, wealth management unit Merrill Lynch will reap the benefits.
The downside, of course, is that those businesses will suffer if the real estate and stock markets tumble. Analysts are also wary of Bank of America's massive exposure to consumer leverage through its credit card division.
"Because the current crisis is now about household debt, anyone who's a retail bank should be concerned," says Columbia Business School professor David Beim. "It'll be terrific if they can raise the stress test money in the private markets, but they're not out of the woods yet." 
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