Several responses to the recent note which revisited the valuation case for Bank of America (BAC) focused on balance sheet risk. In addition, there was concern over buying a stock whose price has nearly doubled this year.
To recap briefly, the valuation analysis assumed an annual return-on-equity at BAC of 11% and noted that, since new purchasers of common stock can buy in at ~55% of book value, this translates into an annual return on investment of ~20%. The opportunity arises because, despite this year's strong performance, BAC's stock price stands at just over $11 against reported book value per share of $20.4.
This update makes the case that the 2012 rally reflected the stronger capital position of the bank, and hence reduced the chance of a capital-raise at distressed prices (even if there are negative surprises in the balance sheet or as a result of mortgage-related litigation). It argues that, notwithstanding the balance sheet risk innate to investing in financial institutions and particularly large, complex banks such as BAC, the stock will continue to be re-rated in 2013 as capital is returned more aggressively to shareholders.
Improved Capital Position Reduces "Dilution" Risk
The protection to bank investors from balance sheet risk, including litigation arising from the legacy mortgage business, is capital. BAC has done an extraordinary job of improving its capital position since Mr. Brian Moynihan became CEO in December 2009. For example, company reports show the Tier 1 capital ratio, calculated in accordance with today's regulatory regime, increased to 11.4%, presently from 7.8% at the end of 2009.
As a result, investor concerns that the bank did not have enough capital and would need to issue common stock at distressed prices, prevalent in August 2011 when Mr. Warren Buffet invested $5 billion in preferred shares, have abated. We believe the lower risk that current shareholders will be "diluted" by additional share issuance at low prices accounts for the recent strong performance of the stock.
Indeed, given we learned last March that BAC passed stress tests designed by regulators to assess capital adequacy (and, in particular, the ability to meet minimum regulatory capital requirements in the face of an "extremely adverse" economic scenario) we expect management to request the permission of the Federal Reserve to return capital to shareholders in 2013. If this permission is granted, and BAC is able to announce a stock buyback program possibly as soon as March 2013, it will provide some validation of the bank's balance sheet and a likely catalyst for the stock to trade higher towards book value.
Prospect for Return of Capital under Basel 3
In considering a request from BAC to return capital to shareholders, regulators will look at the bank's ability to meet capital standards agreed in the Third Basel Accord commonly referred to as "Basel 3." These global standards were to begin to take effect in the US on January 1st, 2013, and be fully phased-in by January 1st, 2019, but regulators recently delayed implementation.
To indicate the strength of BAC's capital position under Basel 3 standards, the table below shows the "Tier 1" capital and "risk-weighted" assets on a "fully phased-in" basis (which assumes the new calculation rules are in full force today rather than phasing-in over time). Together, these values generate the Basel 3 capital ratio which, for BAC, works out at 9% versus lower figures for JPMorgan Chase (JPM) and Citigroup (C).
|$bn||Tier 1 Capital||Risk-Weighted Assets||Tier 1 Ratio|
Under the Basel 3 standards, the Tier 1 capital ratio must exceed 7% by January 1st 2019 for all banks. In addition, systemically important financial institutions will be required to post additional capital, referred to as the "SIFI buffer," of 1.0-2.5%. Finally, the largest global institutions may face an additional capital requirement of 1% over and above the SIFI buffer as a disincentive against increasing systemic importance.
We do not believe this additional "global" requirement will be applied to BAC so that, even if the bank qualifies for the highest SIFI buffer of 2.5% (and is ultimately required to post a Basel 3 capital ratio of 9.5%), it appears to have adequate capital given the phasing-in over time of the Basel 3 requirements.
Balance Sheet Risk
A strong capital position can mitigate, but not eliminate, balance sheet risk. In the case of BAC, this risk is significant and arises from the inherent possibility of error in valuing bank assets and from litigation risk associated with the legacy mortgage business.
The accounting context is provided by a standard known as FASB 115 which states that the valuation methodology for bank assets depends on management intentions. Specifically, cost-basis accounting is used for assets designated as "hold-to-maturity" (such as the loan portfolio), and market-based accounting is used for assets designated as "available for sale" or in the trading account. Both approaches have pitfalls.
Cost-Basis Accounting: The book value for assets under cost-basis accounting can differ meaningfully from market value. Management has tools to address this through downwardly adjusting the book value from original cost via provision expenses (or "impairment" charges in the case of the "intangible" accounting items that can be generated when certain assets are acquired at a premium to book value), but investors take on trust the integrity of the associated processes for estimating possible losses.
In some cases, such as BAC's efforts to take provisions for the litigation risk arising out of claims that the bank and affiliates (including, in particular, Countrywide Financial) sold mortgages with faulty "representations and warranties," the possible loss is inherently unpredictable. Management is attempting to forecast the behavior of a few large claimants and the vagaries of the legal process. As a result, we have a situation where BAC has established reserves (being accumulated provisions less realized losses) against these claims of just over $16 billion and yet comments - on page 216 of the last quarterly report - that actual losses could exceed this amount by as much as $6 billion.
Market-based accounting: "Mark-to-market" accounting is no panacea. So-called "Level 1" assets are valued by reference to the market price of equivalent or similar actively-traded assets; even so, the approach may fail to take account of the "market impact" cost if a bank were to liquidate a portfolio of, say, mortgage securities that is large relative to usual trading volume of the reference asset.
Where there is no direct market benchmark, mark-to-market accounting becomes mark-to-model accounting which can be somewhat transparent for "Level 2" assets where inputs to a valuation model (such as, for example, interest rates and measures of volatility for derivative positions) are observable in the market. However, this transparency does not guarantee accuracy since model assumptions, such as the "normal" distribution of returns or measures of diversification across asset classes, can break down when markets are stressed. In hindsight, this so-called "model risk" was devastating to the credit agencies' rating of certain mortgage-backed securities before the financial crisis.
Finally, there are "Level 3" assets (such as long-dated or highly-structured derivatives, assets created from mortgage securitization, and private equity) where even the inputs to a valuation model cannot be reliably observed in the market. Even the best-faith valuation estimates for these assets can prove flawed and subject to negative revision. On page 145 of the last quarterly report, BAC designated $40 billion of assets as Level 3 representing nearly 20% of total equity.
The doubling of BAC's stock price in 2012 is likely because the "dilution" risk of a capital-raise at below-market prices has substantially diminished given the improvement in the bank's capital position to industry-leading levels.
Despite this rally, the stock trades at a price-to-book ratio of only 55% so that investors have the potential for an annual return on investment of 15-20% over time assuming BAC can deliver a more normal return-on-equity of 8-11%. A possible near-term catalyst for the stock to rally towards book value is the prospect the bank will announce a stock buyback program in 2013, possibly as early as March.
Investing in financial institutions, particularly large and complex banks, involves taking balance sheet risk because management's provisioning estimates under cost-based accounting and valuation inputs under mark-to-market accounting can prove optimistic. To give an idea of sensitivity for BAC, each $1 reduction in book value/share (equivalent to approximately $16 billion of pre-tax losses) reduces the annual investment return estimated in our analysis by approximately 1%.