Strategy To Short Bank Of America

Dec. 7.11 | About: Bank of (BAC)

The recent rally in the financial sector has increased my bearish outlook on Bank of America. Fundamentally, Bank of America (NYSE:BAC) is continuing to deteriorate. The sale of its NYSE market making business to GETCO reflects that B of A still is in desperate need to sell off quality assets raise capital. Market making was one of Bank of America’s more profitable sectors and reducing it to cover Countrywide losses is a strong sign of weakness. S&P also downgraded all of the major US financial institutions last week as well. BAC's credit rating specifically fell from A to A- with a negative outlook (a generous rating for the company’s current position).

A resolution in Europe has little, if any, impact on Bank of America since 90% of its revenues are US based. Unlike internationally diversified competitors such as JP Morgan, Barclays, and Citigroup, Bank of America’s main credit and off balance sheet risk is tied to the US housing market. Despite higher recent home sales numbers, the Case-Shiller index reported that housing prices made new lows in November. Declining housing prices also increase the likelihood of defaults and write downs of Bank of America’s assets.

However, the most worrisome element of Bank of America’s financial standing is its off balance sheet risk, through warranties on securitized mortgages originated and sold off between 2004 and 2008 can cost Bank of America up to $52 billion in losses. As seen in Table 1 below, nearly of Bank of America’s asset value (net of previous write downs equaling 74% of mortgages previous value) is at least 180 days delinquent. Total principal at risk, which includes these delinquent loans plus those who have missed at least one payment over the past 36 months, consists of 58.6% of its warranty commitments. Through my scenario analysis in Table 2, a 5% default rate can cause up to a $10.8 billion loss. With a total book to equity value of $228 million, these warranty claims (even after a potential negotiated settlement) seriously threaten Bank of America's solvency while limiting profitability.

Table 1: Off Balance Sheet Non-Agency Backed Mortgage Risk BAC

Residential Risk from Off Balance Sheet Securitization 2004-2008
#'s in billions
Original Principal Balance: 963
% Countrywide: 74.35%
Current Balance 12/31/2010: 372
Outstanding Bal 180 Days Overdue: 104
% Outstanding Bal 180 Days Overdue: 27.96%
Principal at Risk 216
% Principal at Risk 58.06%
Click to enlarge

Table 2: Scenario Analysis of Principal at Risk Default

Scenario Analysis of Off Balance Sheet Warranty Risk on Non Agency Backed Debts:
Losses (billions)
5% Default of Principal At Risk 10.8
10% Default 21.6
20% Default 43.2
50% of 180 Day Delinquent 52
Click to enlarge

Overall, due to weakening fundamentals in the US financial sector, the housing market, and their own balance sheet, I remain very bearish on Bank of America and have initiated my own short position. The pop in the stock Tuesday morning provides an excellent entry opportunity to short Bank of America. I entered at $5.84, and I recommend entering the position at these levels with a trailing stop slightly that initially triggers slightly above $6 per share (unless if B of A gaps down this morning that slightly revises a stop downward). Then ride it down to the $5.06 to $5.02 range and cover.

I anticipate a bounce for Bank of America when it first hits $5 due to major institutional investors either having limit buys or selling puts of Bank of America at $5. Psychological barriers also have an impact on the $5 price point as well. However, any run after that will be short as the fundamentals of Bank of America point toward bankruptcy or a bailout. I recommend re-entering the short at the $4.98-4.95 range as the sell off from panicked longs and mutual funds that are required to not own any stock trading below $5 a share will trigger a large price decline. Once that point comes, I will update readers when it's time to cover.

Disclosure: I am short BAC.