As I have watched the recent sell-off in the huge, money-center banks, I have started to wonder if there is a significant value in owning these stocks at these prices. I am talking about Bank of America (NYSE:BAC) and Citigroup (NYSE:C) in particular.
The risks in these names are well publicized, and I believe fully priced into the shares at this point. The risks include: opaque financial statements, increasing government and regulatory scrutiny, and declining revenue streams. As I look at these companies in the current environment, I look at each company’s individual situation with respect to asset quality and mix, business mix, and potential government and regulatory actions including mortgage put backs and increased capital requirements.
Bank of America
According to its Q1 2011 Earning’s supplement (pdf), BAC earned $.17/share, and had tangible book value of $13.21/share. Net interest margin (NIM) which is arguably the most important metric in banking, was 2.67% which was down sequentially from 2.69% and down from last year’s NIM of 2.93%. Total assets were $2.274 trillion, funded by 44.8% deposits, 19.1% long-term debt, 25.6% other liabilities and 10.2% equity. Allowance for loan losses are 4.27% of total loans, down from 4.45% the quarter before. Revenue by business segment breaks down to 11.8% deposits, 20.6% credit cards, 8% consumer real estate, 9.8% commercial banking, 29.1% banking and markets, 16.6% wealth management, and 4% other.
There is a lot of discussion about how the new Basel III rules will affect capital requirements for banks. Systemically Important Financial Institutions (SIFIs) are rumored to have to carry a 10% Tier 1 capital ratio. This number has been rumored to be as high as 14%. BAC’s Tier 1 capital is currently 11.32% and Tier 1 Common equity ratio is 8.64%. So, if capital requirements are raised to 14% or if Tier 1 capital is redefined to eliminate preferred or hybrid securities, BAC may have to raise a significant amount of capital or sell assets.
BAC is particularly vulnerable to large amounts of mortgage put-backs by Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) due to its acquisition of Countrywide Financial. According to its 10-Q , there were potentially $6.8 billion in claimed losses for which BAC may be responsible. This number is only an estimate of the potential loss. It could be far more or less, but it does roughly show the potential size of the loss. This is particularly alarming because it will either force the company to incur a large loss, or force it to take more non-performing assets on the balance sheet. Either way, this situation hurts its capital levels, and makes additional capital raises more likely.
According to Citigroup’s First Quarter Earning’s supplement (pdf), it earned $1.00/share and had a tangible book value of $46.90/share (note: per share numbers reflect 1:10 reverse split). Total assets are $1.947 trillion, funded by 44% deposits, 19.3% Long-term debt, 8.9% equity, and 27% other shorter term liabilities. Total loans amounted to $637 billion and reserves for loan losses are 5.7% of total loans. Net interest margin was 2.91% in Q1 2011, down from 2.97% in Q4 2010 and 3.34% the year before.
Citigroup operates in three segments: Citicorp, Citi Holdings and Corporate. Citi Holdings is a holding company for most of the legacy assets of Citigroup and will be gradually wound down. Citicorp operates in three divisions: Consumer Banking, Securities and Banking, and Transaction services. When broken out, 48% of revenue comes from consumer banking, 36.4% comes from Securities and Banking and 15.5% comes from Transaction services.
With respect to potential government and regulatory changes, Citigroup has 11.34% Tier 1 common and 13.26% Tier 1 Capital. These ratios show that under most of the proposed changes for Basel III, Citigroup will probably not have to raise capital which can be very beneficial to the share price.
Citigroup is not as exposed to mortgage put-backs as Bank of America. C currently holds $944 million in reserve to cover losses for this purpose; however, last quarter it added $122 million to its estimate which may continue happening for the next few quarters until the situation is resolved.
I believe that both of these stocks have significant medium term value at these prices. Citigroup seems to be hated because of its recent 1 for 10 reverse stock split along with declining loans and net interest margins. Bank of America is being hurt by potential capital raising, along with the unfavorable environment in which it has to operate. If one believes that the economy will continue to recover, albeit slowly, I think one can own these two stocks. Both of these companies have very strong franchises, and almost all investors are terrified to own these companies which tells me they are under-owned and can benefit from a large change in investor sentiment. I recently purchased some Bank of America, and will purchase some more if the price continues to deteriorate. If the economy goes into another recession, I do not think these stocks will perform well.
Disclosure: I am long BAC.