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I have summarized ten reasons why I think Bank of America (NYSE:BAC) is a buy at these levels.

1. Recent strength in earnings.

Bank of America reported their earnings on April 19, 2012, and reported what was a stellar quarter. The company reported earnings of 31 cents excluding DVA adjustments resulting from tightening of credit spreads. The company showed strength across business lines and geographies with continued effort to strengthen the balance sheet and shred non core assets.

2. Project new BAC reduces costs and expenses.

Bank of America is planning to cut about 2000 jobs in its investment banking, commercial banking and non-US wealth management units. The reductions would be significant as they target high earning employees and the cuts are on top the 30,000 announced earlier. The bank is doing everything it can do bring the disproportionate increase of personnel expense as a percentage of companies revenue under control. Personnel expenses rose 17% between 2009 and 2011 while revenue dropped 22%. Bringing the personal expenses under control to prior levels would mean savings of about $6 bn at the current revenue levels and would add substantially to the bottom-line in the next 3 years.

3. Strength in Housing and general economic recovery.

There are several analyst reports suggesting that housing prices have bottomed and a recovery in home prices is bound to occur over the next 3 years. Bank of America would be the largest beneficiary of an overall recovery in the economy and housing market in particular. I would like to highlight the following to bolster my argument that a general rebound in the economy and housing is underway at this point.

  • Unemployment down to 8.2% from a peak rate of 9.5% over the last 6 quarters.
  • Housing rebound is happening with new constructions at 3 year highs and supported by commentary from companies like Alcoa (NYSE:AA) , PulteGroup (NYSE:PHM), Toll Brothers (NYSE:TOL), Honeywell (NYSE:HON), Home Depot (NYSE:HD).
  • Lending markets have began to thaw, with lending for small business up about 17% this year when compared with last.
  • Foreclosure rates are at 5 year lows and have been going down steadily, reducing losses and write-downs by banks.
  • Good corporate earnings for the quarter from sectors across the board, with especially banks reporting good numbers.

4. Low exposure to European debt and European operations.

Bank of America's retail operations are centered around North America and have no exposure to Europe. Bank of America also has very low exposure to European sovereign debt and have kept the exposure to reasonable numbers even with counterparty risk taken in to consideration. Bank of America however stands to benefit from new underwriting which has been going on in Europe as it has a big presence in Investment banking facilitated by its purchase of Merrill Lynch.

5. Improved capital adequacy ratios.

Bank of America improved their Tier 1 common ratio under Basel III from 7.25% to 7.5% on a fully phased-in basis at the end of 2012. Based on the improvement this quarter, they are increasing that guidance to above 7.5% at the end of 2012. The Tier 1 common ratio under Basel I stood at 10.78%. Bank of America is marching well towards targets set under Basel III for 2013 of 3.5% of Common Equity as a percentage of their Total RWA, 4.5% of Tier 1 Capital as a percentage of their Total RWA and 8% of Total capital including capital conservation buffer as a percentage of their Total RWA. The TCE as a % of Total RWA stood at 6.58%.

6. Passed stress test with flying colors. Explain the criterion for the stress test.

Bank of America passed the stress test by the Federal Reserve with flying colors. The stress test was unlike the sham test they did in Europe back in 2010 and was a pretty stringent one. The stress test assumed 13% unemployment, doubling of oil prices, interest rates going up substantially, home prices going down by 20%, half the instruments in pension portfolio terminate their contract in 5 years and GDP going down by 3%. What it means is that these scenarios combined is a perfect storm and even then Bank of America would survive.

7. Five out of six Bank of America divisions make money and CRES is showing improvements.

The bank is basically divided in to Global wealth management, Consumer and small business banking, Global commercial banking, Credit cards, Investment banking and trading and Consumer real estate. Apart from Consumer real estate all the other divisions of Bank of America are making money hand over fist. The losses and loan loss reserves for CRES keeps coming down q-o-q, and it is a matter of time before CRES becomes profitable. In 2011 the five money making division made $16 bn in profits while that was all consumed by losses and allocations in CRES.

8. Lower valuation than book value and TCE.

The book value for the stock at the end of the quarter was at $21.57, while the tangible common equity is at $12.87. The stock currently trades at 38% of its book value and 65% of TCE. Bank of America trades at a much greater discount based on its TCE and book value when compared with peers like JPMorgan (NYSE:JPM), Wells Fargo (NYSE:WFC), and Citigroup (NYSE:C).

9. Cloud behind legal issues clearing up.

Bank of America is nowhere near putting all its legal woes behind them, but the good thing is that the damage is now quantifiable. The major legal issue the Bank of America has with respect to its mortgage pools can be dividend in to 3 categories.

Put backs from Countrywide originations by GSEs like Fannie Mae. In layman's terms, Countrywide originated about $424 bn in mortgages and Bank of America is liable for their lax underwritingm as they assumed all liabilities from Countrywide merger as they took over Countrywide before bankruptcy. The holders of Countrywide securities are suing bank of America for damages, as underwriting standards set for the mortgages were not met by Countrywide.

Bank of America had a huge win, and a stunning loss for those suing Bank of America for the sins of Countrywide. Should the court follow this ruling (it is precedent now) the Bank of America legal liability for Countrywide just plummeted to pennies. This ruling makes a Chapter 11 for Countrywide doable with minimal damage to Bank of America itself (should they go that way) and further gives Bank of America untold leverage in settlement talks in any suit that involves potential Countrywide liabilities.

This is a very big win, and we'll start to see the ramification filter down. Expect Bank of America to be far less amenable to settlements in the future, or expect the end value of those settlements to begin to fall precipitously. The settlement should be for about $8.5 bn, should the judge move quickly.

The second set of lawsuit is from MBIA and other mortgage insurers. MBIA accused Countrywide of misrepresenting the quality of underwriting for about 368,000 loans that backed 15 financings from 2005 to 2007, while the housing market was booming. It said it would not have insured the securities on the agreed-upon terms had it known how the loans were made. This is not going Bank of America's way as the judge has asked that the CEO appear directly in the court and also that to show fraud, MBIA need only show that Countrywide had misled it about the $20 billion of securities that it insured, not that the misrepresentations caused its losses. This is not too bad if it goes completely against Bank of America, as it would mean settlement of about $1.4 bn.

The third set of suit is the one led by mortgage investors lead by AIG. AIG sued bank of America for misrepresenting the quality of mortgage-back securities they had bought. The 193- age lawsuit holds Bank of America liable for about $10 bn on an investment of about $28 bn. The law suit goes on to shows security by security how the then Merrill had misrepresented the quality of the homes that were bundled. The case is still pending, and in my view Bank of America will fight this to death before settling for a number somewhere in the middle.

10. Earnings potential and dividend

Prior to merger Bank of America had peak earnings of about $21 bn in the year 2006. Merrill Lynch in 2006 had earnings of about $7.6 bn. The chief executive has consistently said that the firm could return to normalized earnings of about $25 bn a year in the next 5 years. A buyback is not unlikely given the low stock price and excess capital. Bank of America is likely to do a buyback if It gets approval from the regulators and normalized earnings of about $25 bn with dividend payout of about $20bn with a 20% buy back should value the company at about $400 bn against the current market cap of $87 bn. Assuming the company does only half of what I am expecting ( $12.5 bn in Net Income, $10 bn in dividend payout, 10% of outstanding shares bought back, 5% yield on the stock) would value the stock at $20.06.

Conclusion:

Bank of America is a stock seriously out of favor at the moment. The company has had a history of strong institutional ownership and has rewarded shareholders with huge payouts at every opportunity they have had. The current management has been executing well the last 3 quarters, and continued performance should bode well for the stock.

Source: 10 Reasons Why I Think Bank Of America Is A Buy