I’m serious, why even try? Human beings often feel they can achieve control over an unpredictable situation by quantifying it to death. Perhaps that explains why analysts are still trying to determine fair value for Bank of America (BAC). In reality, you might as well be trying to determine the future path of a smoke molecule as trying to figure out what fair value for Bank of America might be. (Note that for the purposes of this article I am using Bank of America as the poster child for shaky, too-big-to-fail banks, but there are at least a dozen other highly levered US and European banks I could have chosen).
Pity the poor investment analyst whose job it is to value a bank in B of A’s situation. The first problem the analyst will encounter is that thanks to the FASB, there is no way of valuing banks’ distressed assets based on current market realities. The Financial Accounting Standards Board is a private, not-for-profit organization, which has no accountability to the public, yet has been deemed by the SEC to be the body responsible for setting accounting standards for public companies in the United States.
In 2009, the FASB bowed to political and bank industry pressure and suspended mark to market accounting, replacing it with a methodology where banks can choose to amortize the value of their assets based on the price the banks initially paid for them. A lot of these assets are so called toxic assets that prior to the housing crash were rated AAA and were bought at ridiculously inflated prices. Therefore, this new accounting methodology is regarded in some quarters as “mark to fiction”. While the FASB’s 2009 shift in “standards” played a big part in preventing an all-out financial collapse, firms like Bank of America are now paying a big price for this lack of transparency.
Bank investors, spooked by the prospect of another recession, are left with no real price discovery mechanism and are therefore selling first and asking questions later. These investors are particularly concerned that those banks that have relatively low capital adequacy ratios may have their equity completely wiped out by even a relatively small percentage decline in the value of their assets. This is especially the case for banks that are perceived to be highly leveraged to weak housing markets or sovereign debt crises.
Putting aside mark to market accounting concerns, there is always going to be difficulty in valuing an important segment of every major investment bank’s holdings – their derivatives book. It is one thing for an investment bank to claim their derivatives book is hedged, but a hedge only works if your counterparty for the trade actually survives to make good on your bet with them. While the US authorities made sure a bailed-out AIG made good on the credit default swaps it wrote for Goldman (GS) and other banks, there is no guarantee that Belgian, French or German authorities will do the same if say, a Dexia or a Soc Gen or a Commerzbank fails due to the European sovereign debt crisis (events the market is pricing in with greater probability as each week passes).
As an aside, whatever happened to the entirely sensible idea of having plain vanilla derivatives traded on an exchange so they could be transparently valued on a mark to market basis? I guess that plan made too much sense for the politicians and bank lobbyists to follow through on, even though most of them were in agreement, in the wake of TARP, that it was necessary.
Getting back to our now frazzled bank analyst, there is also the extreme litigation risk that Bank of America now faces due to allegations of widespread mortgage fraud. We are talking about several billions in potential payouts that may ultimately be decided by a court ruling that could go one way or the other, or by a Congress that votes to rewrite the rules so that the big banks don’t go the way of the tobacco companies. These regulation risk scenarios are certainly not going to be easy for the analyst to predict with any accuracy.
I think what would be refreshing is that rather than have analysts pick a fair value number out of thin air in a process akin to a monkey throwing darts blindfolded, they came up with a chart like meteorologists show to predict a range of potential paths for a hurricane. Everyone takes the analyst seriously when they say he has an $18 price target on a bank, yet you would never find a weatherperson saying they are predicting that a tornado that is now somewhere south of Puerto Rico will cross right over Camden, New Jersey.
People would laugh at them if they dared to predict the trajectory with such accuracy. The analyst should really be telling us that there might be only a 30% probability the stock price will fall within a $15 to $21 range in the future, a 50% chance it will fall between $0 and $15 and a 20% probability it will rise above $21.
click to enlarge
B of A’s future price path probability range looks something like this, although it's likely to be much less predictable.
Even if the analyst was some kind of supercomputer that was somehow able to exactly determine fair value in the face of on an almost infinite number of variables, the fair value target wouldn’t mean anything if others ignored his or her projections. In a fractional banking system, faith in the viability of a bank can be eroded almost overnight. One day other banks don’t want to lend to you in the repo market and poof, there goes the value of your bank. A number of French banks are facing this scenario right now. Bear Stearns didn’t go from $85 to $2 overnight because its “fair value” changed suddenly, it went to $2 because there was a chaotic run on the bank that fed on itself in a nonlinear, circular fashion.
So there you have it, valuing Bank of America is a complete exercise in futility. Even Warren Buffett, perhaps the most accurate “fair value” guesstimator of our time, didn’t bother trying to value Bank of America common equity. Instead he wisely decided to invest in preferred shares, knowing the probability distribution range for the future income stream of preferred shares is much narrower than that for common equity.
So what is a Bank of America shareholder to act given all this chaos and uncertainty? The Fair Weather Investor is well aware that research shows that historically, it hasn’t generally paid off from an absolute return or risk-adjusted perspective to continue to a broad stock index once the index’s 50 day moving average is below its 200 day moving average.
The Financial Select Sector Spider (XLF) saw its 50 day moving average cross below its 200 day back in June. While a trend-based system such as Fair Weather Investing doesn’t work as well on individual stocks as on broader stock indices, the price action of the XLF would indicate that investors should stay well away from this sector for now.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
