Bank capital structure in the year of FVAOL November 6, 2011 at 12:52 pm

I am sure you could make a case for pronouncing that ‘fvail’…

Dealbreaker points out a nice trick here. Note that:

  • Basel III is demanding banks increase the amount of equity they have (as opposed to total capital);
  • Some banks, like BofA, have seen large increases in their credit spread;
  • If you buy back your own debt at the market price, you can monetise that fair value gain.
  • So what has BofA done? Buy back subordinated debt and preferreds, and issue both equity and senior debt. It’s cute:

    Note first of all that you profit by “volatility in credit spread movements” by buying back the things with the longest duration: perpetual preferred and trust preferreds, which are trading at double-digit percentage discounts to where they were issued. You replace them with a thing that in some loose theoretical way looks similar from a duration and capital structure perspective: a mix of about half common stock (400mm shares = about $3bn on a good day) and half senior notes. It’s a regulatory capital improvement. And you’ll be paying out less cash going forward, since the senior debt should be cheaper than the preferred and, um, about those common dividends. Sure your common shareholders will be diluted, but not so much on an EPS basis, and they’ll be so thrilled with the juiced earnings this quarter that they won’t be too worried about the dilution.

    Update. I fixed a typo; thanks to Dennis for pointing that out.

7 Responses to “Bank capital structure in the year of FVAOL”

  1. […] FVOAL, verb [F-v-ail]: to buy back bank debt to issue […]

  2. Dealbreaker old chap, a wholly different kind of beast/

  3. Unless I’m mistaken, there is no preferred DVA. Still, if the price/book of the common is lower than the price of the preferreds (as a percent of par), an exchange can be immediately book value positive.

  4. Dblob

    The dealbreaker post is confusing; they use ‘DVA’ for both derivatives debt value adjustment and for the fair value adjustment on own liabilities. Most people only use it for the former. So yes, there is no DVA on the prefs, strictly, but there is FVAOL, which you can monetise by buying them back.

    Cheers

    D.

  5. Sorry – I was trying to make my note brief, but here’s what I meant…

    1) I am pretty sure the preferred line item on the balance sheet does not reflect fair value (as debt does), but instead reflects cost. Until the Berkshire transaction, BAC’s preferred line item was not changing from quarter to quarter. After the transaction it changed by $2.9bn – the portion of the proceeds that were due to the preferred ($2.1bn was attributed to the warrants).

    2) As a result, if preferreds trade at, say, 12 (for $25 face) and the stock trades @ 0.6x book – it is book value positive for the company to buy the $25 liability on your balance sheet back for anything less than $15.

    Ironically, this is almost the exact opposite of what the DealBreaker article was implying – this accounting trick does not require DVA – it requires DVA not be applied to preferreds.

  6. Sorry, I mean less than $15 worth of stock

  7. Ah, OK, thank you. That does make sense. I thought that they were trying to monetise a transient MTM gain that would go away if their credit spread declined, but your account is definitely more convincing…