Bank Of America Is Too Big To Fail ... As It Should Be

| About: Bank of (BAC)

Executive Summary

As the title implies, I believe Bank of America (NYSE:BAC) is too big to fail, yet, I posit we need banks with the size and scale of Bank of America today. I believe Bank of America is on a path to success as more people realize the bank will not be broken up and is still vastly undervalued relative to its historical averages and its peers. Furthermore, Bank of America is in the midst of effectively executing a turnaround program. By increasing revenues and cutting cost, Bank of America is increasing earnings per share year over year. If this trend continues, it should pave the way higher for the stock.

I believe the vast size of the big six U.S. banks; Bank of America, JPMorgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS) and Morgan Stanley (MS), is needed to successfully compete in the global marketplace. The drumbeat to break up the big banks started as a way to avoid another financial crisis comparable to the 2008 debacle. The problem with this solution is the 2008 financial crisis was not caused by the banks being too big, it was caused by the failure of a widely held class of assets referred to as residential mortgage backed securities. The U.S. housing market was essentially a massive house of cards which inevitably had to come crashing down. Lehman Brothers, the first big bank to fail, was simply a victim of the crisis, not the cause of it. I posit if we break up the big U.S. banks we may solve the issue of the banks being too big to fail, yet make the banks too small to succeed in the process. This could have a major deleterious effect on the global economy. In the following sections I will lay out my argument as to why the big banks shouldn't and won't be broken up. Furthermore, I will lay out my bull case and projections for Bank of America's stock going forward.

Big Banks Are Necessary

As the major economies of the world have grown larger over the years so have the major banks to accommodate these economies. Big banks competently expedite trade and investment on an international scale. With the globalization of the world's marketplaces, large scale banks with substantial liquidity are necessary to handle the large scale needs of international markets. Furthermore, size limits could increase resource costs of providing banking services which may cause the big banks to discontinue certain programs. This could decrease the number of opportunities for many people.

Big Banks are Good for Emerging Economies

The emerging market economies have benefited greatly from the big banks. Standards of living have been raised across the board based on the banks providing the financing for major infrastructure projects among other things. For instance, Bank of America has trained nearly 1,200 non-profit executive directors worldwide to help to promote vibrant, safe and economically viable communities across the globe since 2004. Bank of America sponsors many people and programs that are making impacts in the world. Without the cost savings provided by Bank of America's economies of scale, I suspect many of these programs would not exist.

Big Banks Passed Mid-Cycle Stress Tests

The six big U.S. banks recently announced the results of the self-imposed Mid-Cycle Stress tests. All the banks passed with flying colors. According to Bank of America, its Tier 1 common capital ratio would remain above the regulatory minimum during a severely adverse scenario. The Tier 1 common capital would fall to 9.2% by mid-2015 under a number of disastrous scenarios such as a sharp GDP contraction, sustained increases in unemployment and severe home price declines. The bank also included interest rates falling and remaining low. The Federal Reserve's initiative to raise capital levels, increase capital quality, reduce leverage and improve liquidity in the U.S. banks has been effective. Even though most of the big banks are still just as big as or even bigger than before the 2008 crisis, the banks are much stronger today. We don't need to break them up. See chart below provided by the Huffington Post regarding historical bank size comparisons.

Too Many Unknown Unknowns to Break Banks Up

"There are known knowns; there are things we know that we know. There are known unknowns; that are to say, there are things that we now know we don't know. But there are also unknown unknowns - there are things we do not know we don't know. " - United States Secretary of Defense, Donald Rumsfeld

I love this statement by Rumsfeld (dad rolling over in grave now). I say this statement applies to breaking up the big banks. There are just too many unknown unknowns to undertake such a grand endeavor. I know the current situation may not be perfect, but better the devil you know than the one you don't. I believe lawmakers will see the light and realize breaking up the banks is an improper solution based on a faulty diagnosis of the true cause of the 2008 crisis.

Bank of America Remains Undervalued

Even though shares of the big banks have been on an amazing run over the past year, there is still more room to run. Bank of America historically trades for close to two times tangible book value. Currently, the company has a price to tangible book value of one. The bank has a forward PEG ratio of 0.7 which is a 64% discount to its five-year average and a 61% discount to the S&P 500. Bank of America's forward P/E ratio of 13 is a 31% discount to its five year average and a 32% discount relative to the S&P 500. Bank of America is trading at a significant discount to most stocks in the S&P 500 and several of its peers at current levels. See peer analysis chart below provided by Thomson Reuters.

Final Thoughts

I posit the overhang of the "Too Big to Fail" stigma is a major contributor to the depressed price of Bank of America and other big bank shares. Market participants are concerned Washington may decide the big banks need to be broken up after all. I don't see it happening. We need global banks of this size and scale. Given time, I see this false argument being ousted. When this happens in congruence with improving fundamentals, bank stocks will return to historical valuations which are much higher than current levels. If Bank of America were simply to return to its five-year average PEG ratio the stock would be trading for approximately $23 per share. If it returns to its historical price to tangible book value ratio, it would be trading for approximately $29 per share. This would essentially constitute a double from current levels. I believe this is attainable within the next 24 to 36 months.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in BAC over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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