Break Up Bank Of America? Don't Drink The Kool-Aid

| About: Bank of (BAC)
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Summary

Trump came out Monday and said he is considering breaking up the big banks.

You would think Bank of America shares would crater on the news.

Nevertheless, the stock has popped over 1% on the news.

In the following article, we give our take on the news for concerned shareholders.

President Trump came out and stated he is considering breaking up the big banks Monday. At first, the entire sector sold off, yet rebounded quickly. At this time, Bank of America (NYSE: BAC) shares are trading up over 1%.

Current Chart

Source: finviz.com

This did not surprise me as the "sum of the parts is greater than whole" theory regarding Bank of America has been around for quite some time. Even so, I submit this has about zero percent chance of happening. This was just another slip of the tongue by Trump. Here is why.

Trump appeasing regional bank audience

Trump is known for saying some crazy stuff. His propensity to shoot from the hip during speeches and meetings is well documented. Let's not forget, Mexico is going to pay for the wall, right? It was reported by CNBC Trump made this statement while meeting with 100 community bankers at the White House. These were the leaders of the Independent Community Bankers Association, an advocacy group for small and mid-market institutions. I submit Trump was simply schmoozing his audience as he always seems to do. Furthermore, breaking up the big banks makes no sense whatsoever. We need big banks for several reasons. Let me explain.

Big bank are going nowhere

Need size and scale to compete globally

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 (NYSE: MS), is needed to successfully compete in the global marketplace.

The drumbeat to break up the big banks actually began many years ago. It was first postulated 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 this could have a major deleterious effect on the global economy.

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 in emerging economies.

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 have passed stress tests

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 ratio has been stress tested 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. We need to relieve them from Dodd Frank regulations. What's more, there are just too many unknowns for Trump to make this move at this time.

Too many unknown unknowns

"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. The known cause of the previous two banking catastrophes was due to the fact the banks were too small and not diversified.

The smaller the bank, the higher the risk

History demonstrates small banks carry more risk. The Saving & Loan (S&L) debacle of the 1980's is prime example of this fact. S&Ls primary business was making long-term fixed-rate mortgages. These mortgages lost a considerable amount of value when interest rates began to spike. This for all intents and purposes wiped out the S&L industry's net worth. There was no diversification. I remember it well. I was very busy building apartment complexes at the time. Then one day everything just stopped on a dime. Believe me, there is no way the big banks will be broken up. Even Fed Chair Janet Yellen is on record stating we don't need to break up the big banks. Yellen stated the following three reasons big banks are just fine.

  1. Banks have to hold more money - This is to prevent what happened in 2008 when some financial institutions didn't have enough cash (or cash equivalents) on hand to make their payments to other banks and creditors.
  2. The Fed "stress tests" big banks - Twice a year, the Fed takes a deep look at the finances of each bank and sees what would happen under various crisis scenarios. The Fed then recommends fixes to some banks to make them stronger.
  3. Banks now have to submit "living wills" - Much like a personal will, the bank has to spell out what would happen to its assets and stuff if it "died" like what happened to Lehman Brothers in the crisis.

So, I see the statement by Trump as just another slip of the tongue while attempting to suck up to the audience at hand.

The Bottom Line

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 a little over one. Moreover, Bank of America is still vastly undervalued relative to its historical averages and its peers. Even if Trump does give the go ahead to break up the banks, the sum of the parts will be greater than the whole.

Nonetheless, I posit we need banks with the size and scale of Bank of America today. Furthermore, Bank of America has effectively executed its turnaround program. By increasing revenues and cutting cost, Bank of America is increasing earnings per share year over year. This should pave the way higher for the stock and dividend payouts as well. Those are my thoughts on the matter. I look forward to reading yours.

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Disclosure: I am/we are long BAC.

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.