Bank of America Is Too Big To Fail

Warren Buffett has come to the rescue of Bank of America by investing $5 billion in the beleaguered financial institution. The deal came together at lightning speed over the past few days; but it wasn’t cheap. The bank’s preferred stock purchased by Buffett will pay a $300 million annual dividend (6% rate) and can only be retired early if BofA pays a 5% penalty ($250 million). Additionally, Buffett received warrants to buy 700 million shares of BofA at a price of $7.14, a price that is lower than the current trading price of the company. The latter arrangement affords Buffett an opportunity to earn a significant amount of money if the bank’s stock price increases ($700 million for each point increase of BofA’s stock price over the deal price).

The health of our banking system is of great importance, especially banks like BofA that cater to so many individual customers for home mortgages, personal loans, and auto loans. BofA also is a huge institutional organization that funds large and small companies and conducts business with thousands of counterparties throughout the world. The demise of such a large institution would be such a gigantic blow to the global financial system, and so the bank must be saved.

BofA is the largest bank in the country with assets of $1.4 trillion and has 53 million customers. The mortgage crisis, its acquisition of Countrywide Financial and alleged securities and banking violations are a huge cloud hanging over the bank. Penalties, judgments, and future losses emanating from these problems could result in huge capital deficiencies. Buffett’s cash infusion is a drop in the bucket compared to BofA’s potential capital needs under the darkest scenarios.

Talk about “too big to fail,” BofA has 288,000 employees$771 billion of debt and so much more. A failure of the bank would be beyond catastrophic and make the Lehman Brother’s bankruptcy seem like a non-event. Conclusion: There is no chance that the federal government will allow BofA to fail. The bank is significantly larger than Lehman. Its bankruptcy is often cited as one of the major causes of the current financial crisis. It is highly unlikely that the federal government would mishandle a BofA problem in the same manner.

If the financial markets refuse to do business with BofA, making it impossible for the bank to meet its cash needs, Uncle Sam would have to step in. But guess who is applying pressure on BofA? It is the 50 Attorneys General, who are suing U.S. mortgage servicers (BofA being the largest), and investors in mortgage deals originated by BofA. It is a litigation bonanza.

Assuming things get dire, one possible alternative to a bailout by the federal government could be cessation or tempering of lawsuits against BofA by federal, state, and local agencies. Then, if the economy accelerates and the mortgage industry improves (or at least does not worsen), BofA may get through this mess. And, Buffett will make good money on his investment.

It makes no sense for one part of government, whether it be federal, state or local, to be increasing the risk of default of a company if another part of government will have to bail the company out. Maybe the government bureaucrats should start communicating with each other.

Photo CreditWikimedia Commons