I have been optimistic about the prospects of the banking sector and the results of the recent stress test have augmented my optimism. At the moment, the majority of the banks look in a far better shape than four years ago. The Federal Reserve has allowed a number of banks to give dividends or buy back shares. Bank of America (NYSE:BAC) has also announced to increase its quarterly dividend to $0.05 per share from $0.01, along with a share repurchase plan of $4 billion. In my last article, I talked about the quantitative aspect of the stress test and how the major banks did in that test. In the most recent round, the Federal Reserve have reviewed the capital plans of the banks and the only major casualty was the Citigroup (NYSE:C); Federal Reserve rejected Citigroup's capital plan. However, in this article, I will only talk about Bank of America.
The approval of the capital plan was not the only good news for the bank; it also announced a settlement agreement to pay off claims regarding Fannie Mae and Freddie Mac. According to the settlement agreement, the bank will pay $6.3 billion in cash and buy securities worth around $3.2 billion at the fair market value from the two entities. In total, the bank will pay around $9.5 billion. The settlement will have a dual impact on the bank: First, in the short term, the profitability of the bank will affected. Specifically, the earnings for the first quarter will be reduced by about $3.7 billion (pre-tax), or $0.21 per share (after-tax). Earnings per share for the first quarter of last year were just $0.10 per share. However, the short-term pressure on the profitability should not concern the long-term investors as the pressure is not related to the core business of the company, instead it is coming from a litigation event.
The bigger impact will be in the long term, and that will be positive. The settlement means that the bank has resolved almost 88% of the mortgage-backed securities principal amount. The bank might not be completely out of the litigation issues; however, this settlement takes it closer to getting over the MBS debacle, and the lawsuits that it brought. In my previous articles, I have been saying that the bank should try to settle these issues quietly and as soon as possible like its peer JPMorgan (NYSE:JPM) did and it should get on with the business. I have also said this before that it is time for the investors to start valuing banks on the prospects of their businesses, and it is time for the discount attached to these stocks due to the litigation issues to go away. This settlement will go a long way in convincing the market that Bank of America is ready to put its litigation issues behind it, and we will see the stock take off.
The approval of the capital plan and the increase in dividends will take the stock higher. In isolation, the per share annual dividend of $0.20 will not make Bank of America one of the highest yielding stocks (based on the current price the yield will be close to 1.1%, even after a 400% increase in the quarterly dividend), and for income investors, there are many other more attractive options. However, for Bank of America and its shareholders, it is more than just a dividend hike - it is the trust in the operations and the business of the bank that this capital plan shows.
The reason behind the restrictions on dividend and share buybacks was that the Federal Reserve did not see enough strength in the business as well as the financial positions of these banks to cope with adverse economic conditions. The financial position of the bank was determined to be strong through the first phase of the stress test. However, the decision to allow the increase in dividends shows that the central bank also believes in the business prospects of the bank. If there were doubts about the ability to operate or maintain the dividends; the Federal Reserve would not have allowed these banks to raise dividend. Companies also do not like to cut dividends, so the increase in the dividends shows that the company will be able to generate enough cash flows to meet its current level of dividends. As I have analyzed the profitability of the bank in my previous articles, I believe the bank is more than capable of paying the dividends and retaining cash for operations.
Banking sector is ready to take off, in my opinion. The economic environment is favorable and the shackles are slowly coming off. Solution of the litigation issues, increase in dividend and continued growth in the bottom line will take Bank of America's stock over $20 over the next few weeks, in my opinion. This is a very good time to establish or enhance a long-term position in this stock as I believe the upside potential is huge.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.