A week ago, I made a quick post about bank solvency after hearing FDIC Chair Sheila Bair say that “98% of banks” are well-capitalized by the regulatory definition of Tier 1 capital (6% or greater).

How well has this definition functioned in the real world? Consider the following from a recent Bank of America (BAC) SEC filing:

Bank of America ended 2008 with a Tier 1 capital ratio of 9.15 percent.

But there is another part to the story that makes the above statement stand out.

In view of the continuing severe conditions in the markets and economy, the U.S. government agreed to assist in the Merrill acquisition by making a further investment in Bank of America of $20 billion in preferred stock carrying an 8 percent dividend rate.
In addition, the government has agreed to provide protection against further losses on $118 billion in selected capital markets exposure, primarily from the former Merrill Lynch portfolio. Under the agreement, Bank of America would cover the first $10 billion in losses and the government would cover 90 percent of any subsequent losses. Bank of America would pay a premium of 3.4 percent of those assets for this program.
On a pro forma basis this would boost the company’s Tier 1 capital ratio to approximately 10.70 percent.

So, it seems that Tier 1 capital can signal everything is fine, while in reality a bank could be tens of billions of dollars short of what it needs to keep running. Fantastic; this is the empirical evidence the regulators trot out anecdotally to assure us things are alright.

The second part of this is something I’ve been curious about for a while, but only fully pieced together today. Yesterday, CNBC had an interview with John Thain to get his side of what’s happened/happening with BoA/Merrill Lynch (video here). Thain claimed that the top people at Bank of America were fully aware of what “legacy assets” Merrill had, but that the value of those assets deteriorated further during December.

This is curious because a check of the Markit credit protection indices that a whole host of asset classes rallied in December.

First, the high-volatility, investment-grade CDX:

Next, the crossover CDX:

And your AAA/Aaa subprime assets:

Finally, the commercial real estate CDX.

In other words, asset prices were improving in December. So what was really happening at Merrill – they owned all the wrong assets, or they had them marked at a level the auditors would not have signed off on?

Jim Chanos believes it is the latter. The video below (hat tip, Todd Sullivan) covers more topics that just that, but he voices the opinion that the existing level of write-downs does not yet reflect what those assets are worth. Given what the news flow has implied, his world view seems to be a more accurate reflection of reality.

Topping it off, Fannie (FNM) and Freddie (FRE) are back for more money. And, what they are asking for is more than expected – the story of the crisis, it seems. Once again, debts continue to be transferred to or subsidized by the U.S. government, rather than removed from the system. With the current policies in place, it could be a very long and difficult road for equity investors – one reason I continue to sit on my hands in terms of committing new funds.

Subscribe to our feed using your favorite service: