Judging by Monday's gains in shares of most big banks, investors must have missed a certain New York Times article over the weekend.
The piece cited a confidential Bank of America (NYSE: BAC ) bailout proposal the bank presented to members of Congress. In its plea for help from the federal government, the Times reported, the document "warns that up to $739 billion in mortgages are at 'moderate to high risk' of defaulting over the next five years and that millions of families could lose their homes."
$739 billion? With a "b"? Numbers this huge demand a moment to pause for reflection. Total losses to date from this crisis throughout the global finance sector amount to $200 billion. Apparently, Bank of America not only foresees that total rising by 370%, but also warns that the trouble may drag on for half a decade. The sum is nearly five times the $150 billion total of the fiscal stimulus package that Congress approved earlier this month, representing nearly 5% of U.S. GDP.
What does this mean for Bank of America?
If Bank of America has adopted forecasts that quantify the potential cumulative industrywide losses from the mortgage crisis, has the bank conveyed its projected portion of those losses to shareholders within the company's recent earnings report?
Bank of America's 2007 annual report revealed $8.18 billion in remaining exposure to mortgage-related CDOs after writedowns, which sounded like a lot until this news. Although B of A did report an eyebrow-raising $104 billion in "special purpose entities liquidity exposure," it's clear that the market didn't think the company would actually lose that much. With Bank of America now becoming the largest mortgage lender, the company's share of a $739 billion loss would be substantial indeed.
How does it affect the Countrywide merger?
This revelation raises questions about Bank of America's acquisition of Countrywide Financial (NYSE: CFC ) , announced last month. After initially reading the move as CEO Ken Lewis' giant gamble that the U.S. slowdown would be less severe and shorter than many anticipated, I now wonder whether it was an entirely different sort of bet.
The Federal Reserve and the Bush Administration have drawn their lines in the sand with respect to the U.S. markets, indicating that they will consider any measures to stave off massive equity losses. Within this context, they can ill afford to let any of the enormous banks go under.
Was the Countrywide merger a strategic gamble that the resulting size of the company would exert even greater pressure on those in power to guarantee the company's survival? What did Ken Lewis know, and when did he know it? These are all questions that shareholders will undoubtedly be asking as these losses unfold.
With the merger priced at an 80% discount to Countrywide's 52-week highs above $40, though, it is entirely plausible that Bank of America perceived long-term value at $8 per share. At least one Countrywide stakeholder agrees.
Will Bank of America be the only victim?
Hardly. Major mortgage-lending competitors Wells Fargo (NYSE: WFC ) , JPMorgan Chase (NYSE: JPM ) , Washington Mutual (NYSE: WM ) , and Citigroup (NYSE: C ) will presumably face their share of losses as well. Across the pond, too, European banks with significant exposures to mortgage-backed securities, such as UBS (NYSE: UBS ) and Deutsche Bank, are sure to join the fray. The results for European markets and the euro itself could be similarly painful.
What's the bottom line for investors and consumers?
If the losses spur the type of bailout for which Bank of America is lobbying, consumers will foot the bill through tax increases and/or inflation. If the government leaves the markets alone, a reversal from recent actions, we'll face plummeting equity markets and a continued credit crunch, matched with severe home devaluation and overall stagflation.
In either case, investors can expect further spillover from mortgage defaults into losses on credit card debt, auto and student loans, commercial real estate, etc. Somehow, I suspect that even this $739 billion number will not be the banks' final answer.
For me, the light at the end of the tunnel was extinguished this weekend. For anyone who owns a major mortgage lender, this is your last call to run, not walk, to the nearest exit.