Sunday, February 08, 2009

The Fate of Bank of America



Bank of America is being sold down as if its going to zero. Owing to the volatility, that forces many pundits to take a stand on the stock. If you believe it will survive, the share price at $4-$6 is very attractive. If you believe it will be nationalised, then basically it will be going to zero. The bets are huge, the opinions given will make or break many funds' positions.

Bank of America's stock is now selling at 0.28x expected 2009 revenues; 6.9x expected 2009 earnings; 0.19x stated book value; 0.50x tangible book value. Its market capitalization is 3.4% of its total deposits and 1.7% of its assets. These numbers are clear, investors believe that this bank is about to fail and be nationalized by the United States government. If they believed that it would continue as an operating entity it is unlikely that the bank would be selling at such a low value. Generally, with such numbers staring at your face, it will be difficult to think the bank is insolvent.

Those on the sell side:

a) One reason for this conviction, on the part of investors, is Bank of America's acquisition of Merrill Lynch. It is felt that either the company did not do the appropriate due diligence before making this acquisition, or that the company lacked the ability to understand how bad Merrill's problems were. In either case a lose/lose situation.

b) Management is now fighting back. In an article in today's Wall Street Journal it is reported that the United States coerced Bank of America into buying Merrill against management's will. This article could only have come from an interview with Bank of America's management. The point to investors is "we knew what was going on but we had no choice." That serves no purpose other than to absolve management of BoA from the Merrill Lynch acquisition. Not good PR, and a hint of things to come. This, to some extent, alleviates the questions concerning management's competence. It does not take away the belief on the part of investors that the company's woes are so significant that it will fail.

Those on the buy side:

a) The fears does not make sense. In the fourth quarter, Bank of America's deposits rose by almost a net $9 billion. Its loan loss provision was $8.5 billion but 27% of this was a reserve build and the whole amount was a non-cash charge. It took close to $8 billion in losses related to securities. The portion that was non cash in nature may have been as high as 75%.

b) The point is that this bank is cash flow positive. The danger of failing is exaggerated. Plus, the United States is now committed to keep it in business.

My view is that all things being equal, when selling is so concentrated, it is always better to err on the side of caution. Some things are better not to bet on even on the potential of a big payout. BoA is no small thing, it is the biggest thing the US government has left to save on. BoA has already received $45 billion of TARP money. Prior to receiving the bailout funds, its market cap was $159 billion. Now it is less than $30 billion. Obviously something is very wrong. It is certainly not a short selling thing anymore.

This experience would serve all investors very well, when something looks too good to be true (i.e. BoA going on very cheaply), it probably is. The trick is to try and find the pink elephant in the room. How can so many miss the pink elephant? How can BoA, seemingly one of the healthier banks, one that even had the audacity to buy Merrill Lynch and Countrywide just a few months ack when all banks and mortgage companies were collapsing right-left and centre.

The price is always right, and there are always people who will have some additional information than the rest. You just have to do more homework. If BoA did not buy Countrywide and Merrill Lynch (particularly the latter), it would not have to come to this. Obviously the management is at fault.

The problem is BoA's lack of capital. BoA has been on the forefront in share buybacks. Since 1998 it has bought back $62 billion in shares thus reducing its tangible capital ratio. Back in 1998 BoA's capital was 5%, now it stands at just 2.8%. At that level, it is very easy to see the capital being completely wiped out, especially when you look at the toxic assets under Merrill Lynch. The TARP funds does not add to the banks' capital. BoA was forced to write down $4.4 billion in the latest quarter, or 1.8% of its loan portfolio. But that whittled down BoA's capital down to 2.6%. Thats way much weaker than even Citigroup.

For Bank of America the key figure is the fact that the bank only had $1.3 billion of reserves tied to $255 billion in first lien mortgages or about 0.56%. Such a low reserve amount is shocking and will likely be the point by which Bank of America faces the worst pain going forward. The bank’s total managed consumer portfolio was better, yet still only had reserves of 2.83% on a $694 billion portfolio. In addition, its total commercial portfolio of $380 billion only had reserves amounting to 1.96%. If unemployment were to peak at 9%, you can see that there will be substantive writeoffs over the first two quarters of 2009, which will see the reserves and capital adequacy elements being wiped out. On those areas, BoA is in the worst shape among the big banks, even worse than Citigroup, a lot worse off.

Put in another way, Bank of America has assets of $1.836 trillion and derivatives of $39.979 trillion, (mostly swaps). With the demise of the Shadow Banking System (non bank financial institutions), trading derivatives is much more difficult. If marked to market, one wonders just how much of a loss would be realized in this $39.979 trillion portfolio. Nobody, who will talk about it anyway, seems to know. It wouldn't take much to wipe out $1.8 trillion in assets.

Buying Merrill Lynch did boost BoA's capital but Merrill also reported a $15 billion loss in 4Q, which prompted BoA to ask for an additional $20 billion in TARP funds ontop of the earlier $25 billion. Plus it got a $100 billion in guarantee from the government. BoA is now hinging on the 'bad bank' idea, which will buy up the toxic assets at a premium. But the bank needs it quick. Chances are it will not be easy to start the 'bad bank' idea as even the $800 billion stimulus plan is facing hurdles just to get it past the lawmakers.

The 'bad bank' idea needs at least $2 trillion to start with. How do you think that will go down with the Congress and Senate? Geithner may be doing a a twist to the bad bank idea, in that the fund may not be buying the toxic assets but will give a kind of guarantee or insurance on the value of the assets. If the toxic assets are now at 40% of value in the banks' books, the fund could guarantee that if values dropped below 30%, the losses will be borne by the fund. That way, it will put a bottom number to the amount that the banks will have to write down. That will be a big comfort as investors do not know how low these assets could go to. This way, they know the bottom, and the fund does not end up buying the toxic assets. If that eventuate, its good news for the banks.

Still, BoA is most in danger. Watch closely if any of the top management of BoA are leaving the company - if they are then its nationalisation, baby.


p/s photos: Meisa Kuroki


1 comment:

see said...

Is the government guarantee for toxic assets similar to what UK is doing? The guarantee plan doesnt seem to work in UK so will it work in US?