So much bad news has come out on Bank of America (BAC) that I wanted to take a look to see if it was cheap enough to initiate a position. I have heard the common refrain that BAC could generate $2 in EPS once its mortgage woes are behind it, and obviously a 10 multiple on that gets a $20 stock. Good upside when it is trading around $7.00 a share. Warren Buffett is behind this behemoth now, perhaps the worst is over.
First of all, you have to understand that no bank is an income statement play. Truth is it can make the income statement look like anything it wants. Loss reserves are highly subjective, and loan quality and leverage are impossible to gauge on an income statement.
So that brings me to the balance sheet. BAC's common equity is 18x levered. This is high, and with continued mortgage losses and liabilities, the firm's ROE has been pretty much nil since 2008. Small percentage hits to their assets will affect the equity in a magnified way given the leverage. A well run bank will generate decent ROEs even in bad times, having provisioned properly for bad loans when made in good times. Obviously the Countrywide deal was a colossal failure. At least management won't be making acquisitions for a long time. They were terrible at it.
I also read last week that BAC is trading at 1/3 of book value. Not true. First of all, if you are buying common equity, then you care about its COMMON TANGIBLE equity book value. Unless you believe that intangible assets somehow have a lot of value. My belief with B of A is that its intangibles are worthless. Its brand and reputation are something, but not enough to be meaningful. Nobody paid anything for Lehman’s name, and it was a venerable investment bank for decades.
As of June 2011, Bank of America’s Tier 1 tangible common equity was $115BB (10Q page 66). It also had 10.1BB shares outstanding, therefore a book value per share of $11.35. So is this cheap at $7.00?
Downside
First of all, let’s look at the downside case. The stock is down by almost half over the past year, and confidence does seem to be wavering. The Fed is now asking BAC to provide contingency plans if economic conditions worsen. One idea BAC provided was that it might sell some Merrill Lynch stock, one of its businesses that is performing fairly decently right now. I am sure ML employees are quite irate that their business is performing, and they are getting dragged down by legacy Countrywide mortgage assets. Perhaps there is something that they could do here, or perhaps they could sell more China Construction Bank stock, worth around $8BB after selling that much CCB stock last month.
But net net, it wouldn’t take much to see Bank of America needing to raise $40-70BB more of capital. It has $2.4 Trillion of assets, and a mere 2% hit to those assets gets you to $47BB of further losses. This excludes additional legal and regulatory claims. Those could easily be another $25BB. See below on how I get that number. This is simplistic I know, but simply noting how small changes in asset values can severely hurt this stock. It is still too highly levered in my opinion.
Any number over say $40BB in losses and therefore needed capital would spell certain death to current shareholders. Only the government could rescue BAC then, and an AIG-type takeover would ensue. Current BAC equity holders best case would get $1-3 a share.
That is the downside, the disaster case. Understand banks are really confidence games. If there is panic, then unfortunately B of A is going to be the first one to go. The Fed won’t let it fail ala Lehman, it will instead get nationalized. But that is never good for equity holders.
Reps & Warranty Claims
The upside case in BAC stock requires a fair number of conservative assumptions regarding the bank’s balance sheet.
First, let’s look at Rep & Warranty liabilities. Bank of America has settled several big cases. They reserved $1.6BB for its Assured Guaranty (AGO) Agreement, $8.6BB for its BNY Mellon (BK) settlement, $2.8BB with the GSEs back in December. In total BAC has reserved $17.8BB for R&W liabilities. There is more unfortunately. One unreserved area, quoted from their June 10Q is:
So I would add $5BB for further accruals on the Non-GSE R&W liabilities.
On the liabilities of lending and foreclosure practices, state attorneys general are seeking $20BB in total from a variety mortgage servicers including BAC. I would probably add another $5BB for the state attorneys’ general suits. There are some reports today that state AG’s are close to settling these claims, we will see what the amount for B of A will be.
Lastly, the Federal Housing Finance Agency’s (FHFA) suits against 17 banks, filed this weekend, are seeking to recoup $196BB in total from mortgage backed securities (MBS) bought by Fannie Mae (FNMA.OB) and Freddie Mac (FMCC.OB). That includes $57.4BB against BAC. I have read that the statute of limitations was due to expire next week, and therefore FHFA wanted to at least file its complaints to preserve its rights. Given that FNMA and FMCC lost roughly $30BB on these BAC mortgages (according to the NY Times), I suspect that BAC will share in 30% of the losses, plus some punitive damages that could increase that by a big amount. So, for the sake of argument, lets assume 30% of $30BB = $9BB of damages, plus another $3BB for penalties. The market cap of BAC fell almost $8BB on Friday, before the suits were filed but after they were announced. Probably not too far from where the liabilities will end up.
Let’s not forget the AIG suit of $10BB filed last month too. It will face something here, call it $1-2BB to settle.
That totals unreserved amounts of $5BB (non-GSE liabilities), $5BB from state attorneys general, 1.5BB from AIG, and $12BB for the FHFA claims. That is approximately $25BB. Sure these are guesses based somewhat on prior settlements, but some estimates are required.
So, where does that leave tangible BV/share? Roughly $9.00. So, at $7.00/share, BAC is trading roughly at 80% of Book Value. Somewhat cheap, not compellingly cheap.
Quick Note on Buffett's Preferred Investment
Buffett's purchase of $5BB of preferred stock and warrants does nothing to convince me that he believes the equity is cheap. He gets free options on 700mm shares of equity, and if it’s worthless, he knows that similar to AIG and the GSEs, creditors will do fine in a nationalization. His downside on the preferred is pretty low. He gets all his capital back plus 5% even if the stock tanks.
Upside Potential
To be fair, Bank of America has actually written off $91BB in loan losses since the beginning of 2008, and even with that kind of headwind, has only lost $10BB in cumulative P&L. The card business, global wealth management division, and commercial bank still generate nice returns on equity. BAC announced it is actually exiting the mortgage lending business entirely. Selling stakes in China construction bank, its Balboa insurance subsidiary are generating cash and getting the Bank out of non-core businesses. With normalized loan losses, earnings power is high.
I am not going to even attempt to sum of the parts analysis. BAC is just too large, and too unlikely to ever be broken up. But if it earned $0.33 in EPS last quarter excluding the mortgage settlements, then clearly EPS potential is in the $1.30 per share range, which should equate to an $11-$12 stock. The litigation overhang however may be a dark cloud over this stock for a while.
Loan Losses
I have some quibbles over how it has recently booked provisions for loan losses. I prefer to see provisions at least as high as charge-offs, and that has historically been the case. Until 2011 that is. Perhaps it is managing loan losses to show better earnings given the bad news of the mortgage claim settlements. Or perhaps loan losses really are expected to decline. But in the six months ended June 30, 2011, BAC only added $7BB in provisions for loan losses, despite actually charging off $12BB of loans. If things are not really improving, then this $5BB difference will show up again in losses. That’s 50 cents a share. A future earnings drag. I somehow doubt that it has over-provisioned in the past.
Here is a summary of BAC's loan losses over the past 5 years. Generally it does seem reasonably well reserved for future loan losses. $’s in Billions.
6 Months | |||||||||
Jun-11 | 2010 | 2009 | 2008 | 2007 | 2006 | ||||
Tang Common BV | $ 115 | 130.9 | 118.6 | 50.7 | 56.4 | 59.1 | |||
Shares | 10.10 | 10.085 | 9.936 | 5.017 | 4.438 | 4.458 | |||
BV/sh | $ 11.35 | $ 12.98 | $ 11.94 | $ 10.11 | $ 12.71 | $ 13.26 | |||
Net income (losses) | (6.8) | (3.6) | (2.2) | 2.6 | |||||
Loan/lease chargeoffs | -12 | (37.4) | (35.5) | (17.7) | (7.7) | (5.9) | |||
As % of loans | -1.2% | -3.9% | -3.8% | -2.0% | -1.0% | -0.9% | |||
Provision for loan/lease losses | 7 | 34.3 | 33.7 | 16.2 | 6.5 | 4.5 | |||
Total allowance | 37.3 | 43.1 | 38.7 | 23.5 | 12.1 | 9.4 | |||
Avg loans outsd | 939 | 954.3 | 941.9 | 905.9 | 773.1 | 652.4 | |||
As % of loans | 4.0% | 4.5% | 4.1% | 2.6% | 1.6% | 1.4% | |||
Conclusion
I am a buyer at $5. From $5, I can lose $2-$3, or make $6-$7 a share. The likely scenario to me is that the government and various buyers of mortgage paper created by BAC will continue to litigate over losses that aren’t really getting any better. The GSEs are getting more aggressive in litigating, according to BAC’s recent 10Q. And, in fact, national mortgage default/delinquency rates are still at a very high 12+% and actually increased slightly last quarter. The government will make BAC continue to pay, not so much as to put it out of business, but enough so that there will be limited profitability for some time.
The stock is probably oversold technically, and could bounce back to $10. But it could just as easily fall to $5-$6. It doesn’t seem like an investment, but more of a spec play. I suggest this one is quite difficult to analyze. Had I a constructive view on housing or the economy or European banks, I would probably say it’s worth owning some. But with such a dismal macro backdrop, this one is tough to like.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
