FBR Capital Analyst Paul Miller said last week that many banks are subject to lower mortgage origination performance than what the Street is expecting for the first quarter of 2013. Included in this group of banks to avoid prior to earnings reports were Bank of America (BAC), Wells Fargo (WFC), SunTrust (STI), US Bancorp (USB), Fifth Third Bancorp (FITB) and Flagstar Bancorp (FBC). Miller says his reasoning is based on conversations within the industry and that instead of the $482 billion the Mortgage Bankers Association is expecting in first quarter originations, he thinks the number will be closer to $400 billion.
While it is not necessarily news that the refinance boom that occurred in 2012 should be slowing down, the fundamental reasons behind the boom are still intact. The Federal Reserve's endless quantitative easing is still going strong, with unwavering support from the Chairman, Vice Chairman and others on the Federal Open Market Committee. In addition, the low interest rates created by the Fed's efforts have contributed to rapidly improving housing data, including new homes and existing homes.
Miller does make mention of the fact that he thinks you should avoid the origination-sensitive banks that are trading above book value but still includes BAC in his list. BAC's book value, however, is currently $20.24 per share, or roughly 66% higher than the current share price. Tangible book value, of course, is much lower, but Miller doesn't make mention of tangible book value and BAC is still below tangible book value as well. Wells Fargo, another name on Miller's list of banks to avoid currently trades at 1.34 times book value, compared to BAC's 0.60.
We all know that BAC has its share of mortgage related issues after its ill-fated, hastily completed acquisition of Countrywide during the financial crisis. However, BAC has been settling litigation related to Countrywide, downsizing the business and preparing Countrywide as a profit center for the future instead of just an expensive acquisition. As a result, Miller is correct that BAC is origination-heavy in its mortgage business and may suffer in 2013 in comparison to the effortless refinance boom that occurred last year. However, it is worth considering that maybe BAC is ahead of schedule and that the risk is to the upside instead of the dire scenario where mortgage income is evaporating in 2013.
Miller has the right idea in terms of avoiding the origination heavy names that are already expensive relative to book value but what I can't understand is why he included BAC in this list. Wells Fargo shareholders should perhaps be concerned with its origination business as WFC is the largest player in residential real estate in this country. In addition, we saw that WFC's price to book ratio is over double that of Bank of America's, offering little relative upside if you are playing a booming housing market.
The bottom line is that I will respectfully disagree with Miller's assessment that BAC shareholders are in trouble going into first quarter earnings based on its origination business. Miller is forecasting a pretty significant downside to the MBA's assessment of mortgage originations in the first quarter of this year and if he is right, those banks that are more expensive relative to book value may be punished as a result. I would certainly be more concerned in this light for WFC shareholders than BAC shareholders as WFC's price to book is more than double that of BAC's. I believe that any material weakness in the mortgage market is already reflected in BAC's still-depressed share valuation relative to book value. While some other major banks like WFC have come out of the financial crisis with strong valuations, BAC is still trading very cheaply relative to its historic norms by many metrics. Therefore, I believe the mortgage related downside relative to Miller's prediction is the lowest for BAC out of the major banks. If there is weakness after the first quarter earnings report, consider it an opportunity to pick up cheap shares.
If you are worried about weakness in the shares and are inclined to use options, you could cover your shares with short calls into the earnings report. For instance, you could sell the June 12 call with the stock trading at $11.96 for $0.64, or a whopping 5.4% absolute return in three months. If you think there is more than $1 per share of upside to BAC shares between now and June, the 13 call can be sold for $0.28, offering 2.3% of protection to the downside while still offering the premium and potentially $1.04 of capital appreciation on the upside before your shares would be called away. Since BAC pays a meaningless dividend, selling at the money or out of the money call options can be a great way to protect your position and generate some income at the same time. Given what Paul Miller said about mortgage origination heavy banks, perhaps now is a good time to play it on the safe side even if I think he's overly pessimistic.