Crocodile Investors Smile at Bank of America

Crocodiles are ambush hunters, waiting for fish or land animals to come close, then rushing out to attack. As cold-blooded predators, they are lethargic, therefore survive long periods without food, and rarely need to actively go hunting.

In this time of pain and turmoil, investors need to come out of their defensive positions and find easy prey.  The preferred shares of Bank of America [BAC-PJ] are that prey. 

For investors, the recent banking turmoil is both a blessing and a curse.  On one hand, castrophic losses have threatened the viability of the US banking system.  On the other hand, for the surviving companies, there will be tremendous opportunities with reduced competition.

This conclusion was presented during the recent JP Morgan Q2 conference call where analyst Mike Mayo, observing the opportunities of big banks to take advantage of weakened competition, approached JP Morgan CEO Jamie Dimon with a point blank question. 

“You have been waiting your whole life for this environment,” Mayo asked, "so what is holding JP Morgan back from growing through mergers with so many competitors hurt?"

Bank of America (BAC) is in a similar position.  Despite the significant downside exposure of the Countrywide (CFC) purchase, Bank of America deposits-on-hand are enough to weather any major storm.  Although common shares may ebb and flow with the distress of the credit crisis, there are lower risk areas that pay premium amounts for capital.  Thus, the recent opportunities to buy Bank of America preferred shares at reduced prices have been tremendous. 

Any investor in this security will receive a 7.25% coupon with a par value of $25 a share for five years ending 2012.  If the investor can buy the shares for less than the par value, then the yield on the shares will be higher.  During the recent sell off in financial stocks in July, the shares dropped to $16 which meant a yield of 11.3% on any share purchased.

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The J series preferred shares are non-cumulative, meaning Bank of America can suspend paying the dividend at any time and will not incur any liabilities.  For the investor, this is the downside risk of preferreds. 

Yet banks often issue their shares as non-cumulative because under accounting rules it allows them to use proceeds of the preferred issue toward their Tier 1 capital reserves.  In most cases preferred share dividends are not cut unless common shareholder dividends are reduced to zero and/or bankruptcy occurs.

In comparison, even the Bear Sterns (BSC) non-cumulative preferred shares are still being paid out by JP Morgan without disruption.  As of July 28, 2008, Washington Mutual (WM) is still paying out their preferred shares (WM-PR) at a 16% yield.  Although I view dividend cuts to Bank of America common stock over the next two years very likely due to Countrywide exposure, credit card exposure, and real estate exposure, I do not foresee a total suspension of the dividend in any scenario.

There will only be a few times when high quality will be available at discount prices. The turmoil that brought the shares down to $16 will happen again, probably sooner rather than later, and probably in relation to any bank bigger than Indymac.  In most cases, the general market will be in fear of complete collapse or unknowledgeable about the opportunities that abound at this time. 

I recommend waiting until these preferred shares once again reach $16/share before buying.  Only crocodile investors who wait until the conditions are appropriate will be astute enough to identify this opportunity and enjoy the best returns.

Disclosure: Short BAC common shares; no position in the preferreds.

Comments

[Randy Fay:]

Great long idea. Thanks for the analysis. The J series preferred will likely be in my stable over the next few days.

2008 Jul 29 08:15 AM

[Gary A:]

My concern about financials is that NAB wrote down super senior commercial paper by 50% and took a total loss on residential AAA CDO's. So, with BAC having 781 billion in level 2 assets that don't trade and a lot of level 3, are you saying that we are out of the woods and should start buying BAC? I guess I am just not smart enough to take that chance.

2008 Jul 29 11:07 AM

[notsosmart:]

no courage to do this.too much accounting trickery.

2008 Jul 29 11:25 AM

[richandmer:]

I am a novice on preferreds. When I go to Yahoo finance and enter bac.pr.j, they show no record. I tried bac-pj. It may be the preferred you mention in your article, but there isn't any information. Is there a website that provides specific details on the preferred stock? It sure would be nice to have some assistance with these securities.

2008 Jul 29 01:57 PM

[Lockstep In...:]

Each of the sites uses different tickers for preferreds. At Yahoo! the ticker is BAC-PJ. At QuantumOnline.com, it is BAC.PR.J. I recommend QuantumOnline.com for getting all the details regarding preferred issue.

2008 Jul 30 01:02 PM

[Christopher...:]

What's your opinion on the ZION Bank preferred A? It's trading at less than $12 per share and was issued (and has a preference in liquidation) of $25.

2008 Sep 12 02:55 PM

[Lockstep In...:]

Transparency: On Dec 24th I closed the BAC-PJ position at 17.40/share.

The reason for closing the BAC-PJ position is the poor leadership decisions of Ken Lewis, CEO of B of A. The recent acquisitions of Countrywide, a defunct mortgage originator, and Merrill Lynch, an asset manager with an unknown quantity of toxic assets on their balance sheet, are questionable at best. Due to the unquantifiable risk and need for capital to sustain this new financial conglomerate, I see preferred shares as at risk for being seriously being diluted. Thus I am closing my position with a small gain and moving on.

Feb 17 01:37 AM