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2. Capital return plans face scrutiny

Bank of America (NYSE:BAC) inked a deal in 2011 with a host of big-named mortgage holders requiring it to fork over $8.5 billion to settle a host of misrepresentation and warranty issues. The deal has been in the news ever since.

The settlement was originally hailed as a massive victory for Bank of America, until other bond holders decided to fight an accord that they say allows the bank to settle for just pennies on the dollar, giving short shrift to the losses many mortgage holders have swallowed.

ProPublica has weighed in on the issue, recasting the controversy in terms of a Bank of America capital strategy. The idea here is that by relying on the $8.5 billion settlement, the bank has set aside too little in reserves to cover the future costs of litigation. If the $8.5 billion is a drastically low figure, it stands to reason that the bank will need billions more to cover the litigation costs. Analyst Mike Mayo has suggested the more likely costs will be in the $25 billion to $30 billion range.

A day of reckoning looms, the article notes, in the form of the Bank of America stress tests, the results of which will soon be announced by the Federal Reserve Board.

"A look at Bank of America's estimates for how much it will have to pay for its mortgage liability is telling. It has gone up steadily each year. In 2009, the bank had a reserve of $3.5 billion. By last year, it had jumped to $19 billion, with an estimate of additional loss of up to another $4 billion."

It notes also that, "Bank of America seems to have been consistently underestimating its legal exposure. (And it has other, undisclosed legal reserves for different cases. The incentives to lowball those are much greater, because the public cannot scrutinize them.)"

The question of course is how the Fed will view this situation. If it agrees that the bank has low-balled its reserve needs, the bank will likely be required to hike its reserves, which would deal a big blow to the bank's desire to aggressively return capital to investors this year. It would take a bite out of earnings as well.

The pressure is on as this moment of truth looms.

For more:
- here's the article

Read more about: Bank of America, mortgages
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By Jim Kim

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3. Michael Dell on the hot seat

It's stress test season on Wall Street.

This week, 18 top banks will learn the results of the latest round of tests administrated by the Federal Reserve Board. Bank investors will learn next week whether the Fed has approved individual bank plans to return capital to shareholders.

Winning the right to boost dividends or buy back shares as detailed in applications is not a sure shot. Bank of America (NYSE:BAC) and Citigroup (NYSE:C) have learned some humiliating lessons in that area over the past two years. And once again, stocks could be in for short-term turbulence.

That said, there's plenty of optimism that banks will fare very well this year, given that most of the largest banks made progress on the capital ratio front last year.

Bloomberg predicts that big lenders will buy back $26.4 billion in shares, up from $23.8 billion last year, and will pay out $14.5 billion will be paid in dividends, up from $11.1 billion last year.

The Fed began annual stress tests in 2009 and two years later "adopted an approach known as Comprehensive Capital Analysis and Review, or CCAR, which focused on lenders' capital plans, assessing how dividend or share-buyback increases would affect them. This year it's also conducting a separate review, as mandated by the 2010 Dodd-Frank Act."

The point is to model how banks would react given a severe financial shock or economic stress. The 2013 scenarios include: an economic contraction that lasts six quarters accompanied by inflation and interest rates spikes and a surge in the unemployment rate to above 12 percent accompanied by a 52 percent drop in equities prices.

The new wrinkle this year is that banks will be given a chance to revise their capital return plans based on early results of the tests. A few banks in previous years submitted too-rosy plans for dividends and buybacks and saw those plans rejected outright, even though more modest plans would have been approved will little controversy.

For more:
- here's the article

Read more about: banks, Stress Tests
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By Jim Kim

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4. Wall Street eyes collateral transformation

Michael Dell is in the hot burning center of the universe when it comes to the proposed leveraged buyout of his computer company.

By dint of his massive ownership stake in the company he founded while still in college, a more lucrative deal is not likely to emerge. This will come despite the best efforts of Evercore, which has been retained by the special committee to seek out alternatives in the go shop period. Even if a competitive deal were to emerge, Dell would likely find a way to up his offer. He's not going to give up his company.

But he's in a tough spot because his stewardship of the company has not been without complaints. The awkward truth is that in the view of some, the company might be better off without someone else leading the Dell reboot.

It would be unwise for the Dell board to ignore this line of thinking completely. Fortune puts the issue in blunt terms:

"The one person we really haven't heard much from, however, is Michael Dell himself. Save for a few milquetoast statements in the official announcement, the company's CEO has been absent from the public eye. This needs to change," it notes.

"Often when a company is taken private, the transition is accompanied by a management change. But that won't be the case here, as Silver Lake Partners wouldn't have enough clout to fire Michael Dell if it wanted to (something that scared off another potential bidder)," according to Fortune.

That's fairly harsh and perhaps a tad unfair. There's plenty Michael Dell could do with a private company that would be hard as public company, like run up massive short-term losses in pursuit of long-term gains. But the point here is that Dell needs to address the issue. And the longer he remains silent on the issues, the more the skepticism will grow.

I'm sure the board has discussed this. Most likely, they have developed a communications plan with this in mind.

For more:
- here's the item

Read more about: lbo, Dell
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By Jim Kim

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5. Brokerage loans and the return of advisor conflicts

The magic of securitization lives on.

No one really doubted that it would ever go away, despite the implosion of so many residential MBSs and the many securities and derivatives that were built on top of them. The reality is that there are some really good reasons to package together groups of bonds to achieve certain goals, such as higher credit ratings or enhanced income flow, though the financial crisis highlighted some of the excesses of the practice.

Another test case may be coming in the form of the nascent "collateral transformation" market, which is breathing to life as Wall Street banks sense demand from financial services institutions that for higher quality capital in order to satisfy new regulatory demands from the likes of Dodd Frank, EMIR and Basel III.

As described by the Financial Times, "In a typical deal, an insurance company might come to a bank with a portfolio of lower-rated assets such as junk bonds. The bank would lend the bonds out in the repo market – typically to another big bank – in exchange for government bonds or cash. The government debt or cash can then be used as collateral to back the insurer's centrally cleared derivatives trades."

It also noted that, "Like the CCPs, banks providing the service will charge fees and take a slice of security from their clients in exchange for the transformation. The collateral comes in the form of a "haircut", or a clipped portion of the asset's market value…."

Finally, it noted that, "For riskier collateral, such as junk bonds, banks would be expected to hold back a bigger slice of the asset being transformed. If the value of the bonds were to fall, the bank would be able to resort to its own collateral to make the trade whole."

Is this financial engineering all too similar to the type aptly symbolized by synthetic CDOs, at least the ones that imploded in the financial crisis? Some are warnings as much.

"The risk is that the new business could create longer and more complicated chains of collateral, which are more susceptible to vicious feedback loops when market values start to slide," the FT notes.

Indeed, if the core securities of these products sour en masse, the carnage would likely be severe. Do not be surprised if some people trot out the case study of Greece, which relied on swaps to mask its true deficit position to comply with Maastrict Treaty.

This would only confirm the recent view that higher regulatory capital requirements could easily backfire, as banks take more risks to goose margins in the face of more stringent capital ratio rules.

For more:
- here's the article

Related articles:
Collateral at issue with swap rules

Read more about: shadow banking, Securitization
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By Jim Kim

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