Continued Problems In Housing Mean Trouble For Bank of America

| About: Bank of (BAC)

Similar to the rest of the financial sector, Bank of America (NYSE:BAC) has been one of the hardest hit stocks in the market during 2011. Due to structural problems within the global financial system itself, its place as the weakest positioned of the "too big to fail" banks, and deteriorating financial fundamentals, I believe that Bank of America is still an excellent short opportunity.

In terms of European exposure, Bank of America has less exposure than competitors such as Citigroup (NYSE:C). Despite Bank of America’s more domestic focus, they still have a significant amount of international investments in both government debt and European corporate bonds. Net exposure totals $485 million ($470 sovereign) in Greece, $2.7 billion in Ireland ($27 million sovereign), $6.5 billion ($1.5 sovereign) in Italy, $362 million in Portugal ($326 sovereign), and $4.4 billion in Spanish debt (less than 1% sovereign). Bank of America does not disclose any direct holdings in debt of the troubled countries of France and Belgium. With a total equity amount of $228 billion dollars, a 50% write down of European sovereign debt would cost Bank of America at least $2.5 billion. This number constitutes less of than one percent of the banks equity, so sovereign risk is not a huge threat to the bank on its own.

Even though Europe is a not a big problem for Bank of America, their biggest macroeconomic driver, the American housing market, is a severe risk . The housing market is expected to continue to weaken and hurt Bank of America’s bottom line. With the 2007 acquisition of Countrywide, Bank of America is on the hook for billions of dollars of toxic delinquent mortgages. In 2010 alone Bank of America’s home lending department lost $8.9 billion. These losses should continue as the US housing market is expected to enter a second major wave of foreclosures. Ten million new subprime mortgages reset in September, and many will continue to reset every month until May 2012. In fact November 2011, was the first month since 2009 to have loan delinquencies increase.

As a result, delinquent loans will continue to generate losses for Bank of America. Currently, Bank of America’s mortgage default rate sits at 4.71%. Its total mortgage debt is $258 billion dollars and its home equity loans total $138 billion. These amounts exclude off balance sheet liabilities related to countrywide. An increase in adjustable rate mortgage resets will increase default rates and the amount of write-downs on the value of mortgage assets. Just a 2% rise in defaults will equal at least an additional $7.9 billion in losses (excluding any additional countrywide damages). This won’t cause Bank of America to go bankrupt, but it dents their total equity by at least 3% annually. However, continued weakness in the American economy will slowly erode the company's equity and stock price.

Bank of America is desperately seeking to raise capital to ward off future housing losses. Selling off strong assets such as their holdings of the Chinese Construction Bank, profitable asset management departments, and their unfavorable deal to sell equity to Warren Buffett show that Bank of America faces a severe capital shortage and is scrambling to support crumbling balance sheets to maintain positive equity. The gains from these sales also artificially boosted the company’s net income into positive territory of 56 cents per share covering up what otherwise would have been losses. The sale of their remaining stake Chinese Construction Bank will skew earnings again, but does not make up for the fact that the bank is selling off their strongest assets to compensate for the continued weakness of bad mortgage debt and holdings such as Countrywide. Competitors such as Citigroup have strategically divested risky and unrelated assets to the company’s core competencies such as Smith Barney, toxic portions of Citi Holdings, and reducing the investment banking side of its business. This has resulted in lower risk for Citigroup while creating a stable company based on solid revenue drivers and specialty in global commercial banking and corporate lending.

The remaining departments of the bank are profitable, but not growing fast enough to compensate for its losses in mortgage debt. Its sales and trading department’s revenues were down 17% over the past year. With investors growing cautious of the markets due to the European debt crisis, trading volume has decreased as a whole in 2011, which will continue the decline in trading revenues. The wealth management division added $1 billion in net income and commercial lending added $3.2 billion dollars in net income for 2010. The earnings from these divisions are not enough to compensate for losses in the mortgage lending business, which will lose anywhere between $7-20 billion per year until adjustment rate mortgages resets expire in 2013 and if housing manage to stop falling. This prevents Bank of America from achieving any semblance of profitability over the next few years.

Overall, Bank of America faces severe risk to movements in the financial markets and the macro economy. Unfortunately, the primary driver of their risk is within the American housing market, which will pull down the fortunes of Bank of America with it for the foreseeable future.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.