In the past week, Bank of America (NYSE:BAC) has suffered a huge price drop partially due to the public fear that Bank of America will have to issue more stock, causing share dilution, to raise equity capital because of recent lawsuits, potential Countrywide legacy charge-offs, and the implementation of Basel III. Analysts, news anchors, hedge fund managers, and individual investors are asking themselves if Brian Moynihan will have to renege on his promise, and issue more common shares in order to raise more capital. Barring an economic meltdown on par with the Great Recession, I do not think it will happen. After reading through the second quarter 10-Q, I have serious doubts that Bank of America will have to issue common stock to comply with regulations, or offset losses.
Implementation of Basel III:
Here are some main points pertaining to Basel III
Banks need to have a Total Capital Ratio of 8% (the same as Basel II)
Of that 8%, 6% needs to be Tier 1 capital (previously 4%)
Of that Tier 1 capital, 4.5% (previously 2%) needs to come from Common Equity (APIC, RE, and some OCI)
There will also be a capital conservation buffer requirement that will be made up of an additional 2.5% in common equity.
During times of high credit growth, governments can impose a counter-cyclical buffer that can be upwards of 2.5% of Tier 1 common equity. During this time,this buffer will be used to make credit more expensive, and once the cycle is over the buffer will be lowered leaving credit less expensive.
Some banks that may pose systemic risk will be required to add an additional percentage to their common equity ratio, anywhere from 1-2.5%. This is called the SIFI surcharge, and specifics will be released late 2011, or early 2012.
Basel III also places new restrictions on what can be classified as Tier 1 common equity, additional Tier 1 capital, Tier 2 capital, and completely abolishes Tier 3 capital.
Basel III phases in Tier 1 common equity classification restrictions over the course of 10 years.
Basel III is a gradual process with new guidelines being implemented January 1, 2013, and total compliance expected by January 1, 2019.
Banks will need to be at the Tier 1 capital requirements by 2015 (4.5% common equity), and at that point the capital conservation buffer starts getting evenly phased in over the next four years.
There is still some uncertainty over how much of Basel III regulators will implement, and if they will adopt it in its entirety.
As of June 30, 2011, Bank of America had $114.7 billion in Tier 1 common equity and $1.393 trillion in risk weighted assets, a Basel II compliant common equity ratio of 8.23%. According to Brian Moynihan, Bank of America's CEO, Bank of America will have a fully compliant Basel III Tier 1 common equity ratio (using common equity classification inputs from 2019) of 6.75% to 7% by the end of 2012. This means that the bank is likely to be at the required 2019 common equity ratio of 7% by 2012. This gives Bank of America six years to increase its Tier 1 common equity ratio by however much federal regulators assign it for being "too big to fail."
In the following exaggerated scenario, let's assume that regulators want Bank of America to add 2.5% to the common equity ratio by 2019, due to the systemic risk that an insolvent Bank of America poses. Let's keep risk weighted assets constant ($1.393 trillion) and we will say that Bank of America's Basel III common equity ratio is on the low-end of Brian Moynihan's estimate, 6.75%, at the end of 2012. That would mean that Bank of America has total Tier 1 common equity of $94 billion (Basel III compliant). In order to meet the additional capital requirements (9.5%) Bank of America will have to come up with $38.34 billion between 2013 and 2019, roughly $6.4 billion per year in additional common equity.
Here are some reasons I believe Bank of America can reach this number without issuing more common stock.
Bank of America is committed to reducing its risk weighted assets by selling off non-core businesses and reducing non-performing loans. In this year alone, it has decreased its RWA by $85.5 billion. Note: If Tier 1 common equity stays the same, every $100 billion decrease in RWA increases the common equity ratio by 50 basis points.
With expected net income of $15.3 billion in 2012, and net income expected to grow year after year, Bank of America will be able to put huge amounts of profit back into retained earnings year after year, increasing Tier 1 common equity.
According to the most recent 10-Q, pages 129 and 151 respectively, Bank of America currently has $37.3 billion in allowances for loan and lease losses. It also currently has $61 billion in total past due 30+ days consumer and commercial loans. The worst-case scenario would be that Bank of America would have to write down all of these past due loans today, with no recovery amount for any of these loans (impossible). This would reduce common equity by $23.7 billion, but would also decrease RWA by around $55 billion as well. Bank of America would still have a Tier 1 common equity ratio of 5.25%, well above the ratio required in 2013 (3.5%). However, it is highly unlikely that this worst-case scenario could ever happen. Bank of America will continue to gradually decrease its non-performing loans, while recovering some of its losses.
Bank of America currently has a host of legal issues. It is being sued by AIG for $10.8 billion dollars, Blackrock and T. Rowe Price for an unknown figure, and is being investigated by state and federal regulators for questionable foreclosure practices. Bank of America has set aside $17.8 billion for future litigation and legal costs. $8.5 billion is expected to go to the Countrywide settlement that happened in late June 2011, $5.3 billion is expected to go to Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC), due to an expected increase in repurchase rates. That leaves a $5 billion cushion before BAC will have to tap into common equity. In my opinion, it is unlikely AIG will receive the full $10.8 billion that it is demanding. I find it hard to believe that a jury would award a company, that is mostly owned by the U.S. Treasury, money as a result of its own investment mistakes. Blackrock and T. Rowe Price opted out of a $624 million settlement last year, and they are suing Bank of America because they feel as if they can maximize their returns in a jury trial. I don't think state and federal investigators will file suit against Bank of America, once it agrees to reduce balances on troubled mortgages. Due to the extended time period that it takes to get anything done in our court system these costs will be recognized over a period of years, not quarters. Even then, I would bet that Bank of America will probably only need to cough up at least $5+ billion for legal costs.
Bank of America CEO, Brian Moynihan, has said on multiple occasions there will not be a new stock issuance. With his career and his reputation on the line, I think Mr. Moynihan will exhaust all other options (such as selling China Construction Bank stake) rather than issuing more common stock. He has stated over and over again that Bank of America will raise capital and reduce risk weighted assets by selling non-core assets and strengthening their core businesses, not issuing more stock.
Overall, I think that the public fear regarding Bank of America's need to raise more capital through new stock issuance is unfounded and exacerbated by media headlines. At this price range, and Bank of America's current fundamentals, I think BAC has a lot of upside potential over the long term.
Disclosure: I am long BAC.