Bank of Merrillwide

I sometimes forget that not only did Bank of America (BAC) buy Merrill Lynch, which was inexplicably on the verge of an utter meltdown in the fall of 2008, but that it also took own the absolutely toxic Countrywide Financial.  In recent months, it seems to have inherited the same sick death spiral that both of those constituent companies had in the months leading up to their demises.

The mystique of former Bank of America CEO Ken Lewis always baffled me.  Bank of America was rarely a stellar performer, even among the ordinarily demure commercial banking sector (at least it appeared demure prior to 2007).  He made some significant acquisitions of companies such as FleetBoston and MBNA, but to say that those purchases alone made him some financial services management genius would be a little bit of a stretch.  Like many of the CEOs in the commercial banking sector, I think that he envied the apparent success of the investment banks, especially Goldman Sachs (GS), during the mid-2000s.  Indeed, traditional banking business units were often looked at with a measure of disdain during those years since they had declining margins and simply weren't as attractive as hedge funds, private equity, and any number of other newer businesses.

Some banks, like Wachovia, Citigroup (C), and Bank of America bet recklessly on the housing bubble in order to attempt to get attractive rates of growth.  They paid the price for it.  Wachovia nearly died and had to be bought by Wells Fargo (WFC) while Citigroup and Bank of America had close calls.  In the midst of all of it, Ken Lewis thought he would be something between the shrewdest value investor in history and the savior of the financial system by buying up Countrywide Financial and Merrill Lynch when both were on the brink.  Had both not been so terribly flawed, he might have been onto something.  As it was, he created a great big lumbering, wounded giant.

Lewis was booted (well, not really, but you know how this all works), but the legacy of his misdeeds still haunts Bank of America to this day.  Over the past year, the stock has atrophied horribly and now has plunged to devastating lows of less than $5 a share:

While no particular news has come out other than the constant drumbeat of bad news out of Europe, the implicit news that the market seems to have priced into the share price is that Bank of America will have to issue more shares to increase its capital ratios.  After all, it supposedly trades at just 5.5x next year's earnings according to current analyst estimates.  Since the overall market is not utterly panicked at the moment, it stands to reason that there might be something to this expectation.

With headlines like this one swirling around, it might be dangerous to speculate on the unknown here: http://www.marketwatch.com/story/draft-big-bank-capital-rules-expected-soon-2011-12-19

I should caution that while Bank of America has one of the lowest prices you'll see in a major financial stock, it's hardly unique this year.  Look at Goldman Sachs:

The two declines are not qualitatively different.

The Strangest Financial Crisis

So, when I looked at the early quotes on ten year treasuries on Friday afternoon, when word of the looming S&P downgrade began to surface, quotes suggested a rise in rates to about 2.55%-2.60%. I thought that was a fairly reasonable reaction since the loss of a grade might be worth a dozen or so basis points in higher yield.

What I did not expect was that rates would plunge today to the lowest levels since the worst of the 2008 panic. This is why I call it the strangest financial crisis. Under most, or all, circumstances the fears surrounding a country's sovereign debt cause the two following reactions:

1. Interest rates spike like mad
2. The currency collapses
3. The equity markets collapse

Well, one of those happened. The other two did not. Hell, the dollar actually rose slightly: http://www.bloomberg.com/apps/quote?ticker=UUP:US

Normally, when people are told there is a bomb in the building, they run out of it for the refuge of other structures. That did not hold today, not one bit. Instead, what seems to have happened is that the markets fear the consequences for economic growth more than they do the downgrade itself. Normally, the channels affecting economic growth would be a spike in real interest rates and a collapse in the integrity of financial markets. In this case, the concern appears to be that our current rate of economic growth is as good as it's going to get because the downgrade has precluded any possibility of stimulative action by the government. Further, the ripple effect of downgrades to private and municipal issuers is likely part of what is at work here as well.

It is also possible that markets are anticipating a major hit to consumer confidence as people pull in their horns in anticipation of future interest rate increases, which I will point out is not a rational behavior. Much like someone prone to panic attacks can induce one due to the fear of one coming on, the markets can collectively do the same thing. The fear of future consumer... fear probably motivated some of the indiscriminate selling today, and it was indiscriminate.

A further mechanical cause is the incredible plunge in oil. It's down almost 20% in a few weeks. This has caused mass liquidations by hedge funds, who have to liquidate virtually everything, including shares in damn good names. I am struck by a plunge like this in United Technologies (UTX), one of the best run companies in the world with a tremendous track record of strong earnings growth and healthy dividends:

Hell, even a company like Church and Dwight (CHD), which is basically immune to recessions and will benefit from the plunge in petroleum prices, has taken a clipping:

The banks got slaughtered, which is understandable. If indeed U.S. interest rates are heading higher, banks' margins will get squeezed. Fair enough. Also, Bank of America (BAC) is one sick puppy these days. Seeing a collapse of this magnitude in a premier financial stock is not reassuring:

Still, the basic theme to take away is simple. The market has rapidly priced in a significant reduction in economic growth prospects and the related effect on earnings growth. This is not principally a U.S. debt crisis and should not be labeled as such. If it were, money would not have sought out U.S. treasuries in such massive quantities today. We are faced with a market that is rapidly pricing in deflation due to a weak economy, which explains the dual decline in stock prices and bond yields. Concerns about inflation are radically misplaced at this time. All of the inflation of the past several months has been driven by food and energy. Those are dead now. Their declines will be seen in CPI over the next few months and year over year inflation will vanish.

At this point, continue to hold cash for the moment. A bounce back, possible a big one (+500 pts or so) or two will happen in the next week or so, but that will probably be greeted with a fresh low sometime thereafter. These things never go straight down then straight up. Even 1998 with LTCM, which is the closest to that trajectory, did not follow that pattern. Stabilization was followed by new lows before a solid bottom was formed. The opportunity will come, but it isn't here quite yet.

Bank of America to Customers: We Don't Ever Want to See You

This is an interesting trend in banking. Bank of America (BAC) is giving you a strong financial incentive never to set foot in one of their branches. Really, that is what they are doing. Even to me, with as short a time as I've been on the earth, this is hard to fathom, but I suspect that over the next five years this will be much more common than not. It's amazing to think that as recently as a decade ago, banks were still trying hard to increase their number of physical branches. That seems a quaint idea now.