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Financial Crisis Impact on Bank of America (BAC) Valuation

December 04, 2011 | About:
Did the recent financial crisis negatively affect the worst-case scenario valuation for Bank of America? Our prior report on the downside risk to shares of Bank of America concluded that the intrinsic value estimate under a worst-case scenario was $4.85 ("Where's the Bottom? 30% Downside Risk to Shares of Bank of America from Current Levels," Sept. 12, 2011). At that time, BAC was trading at $7.05. Since then, a significant number of macro-economic and company-specific events took place that drove BAC shares as low as $5.03, perilously close to our estimate. In this report, we review the impact — if any — of these events on the worst-case scenario for shares of Bank of America.

Challenges facing Bank of America trace their roots back to the onset of the mortgage-led financial crisis that started the middle of 2007. A weak economic outlook, persistently low interest rates, introduction of stringent regulation (including Basel III, a new global regulatory standard on bank capital adequacy and liquidity), weakness in the housing market, lingering litigation issues related to the Countrywide acquisition, and the European contagion, further exacerbated the headwinds facing shares of BAC.

In response, management has undertaken a massive strategic repositioning of the company with a focus primarily on the domestic retail market. Restructuring steps include disposal of the non-U.S. credit card business, exiting the mortgage wholesale channels, selling half its interest in China Construction Bank, accepting a $5 billion investment from Berkshire Hathaway (BRK.A)(BRK.B), decreasing investment in its private equity segment, and continuing disposal of non-core assets.

Distilling Events into Financial Impact on BAC

The Board of Governors of the Federal Reserve System, together with Bank of America’s third quarter 2011 earnings results released on October 18, serve as the most thorough and credible sources of information for the analysis in this report. These sources of information prove invaluable to identifying the direct financial impact of the headline news events and management’s recent actions on the intrinsic value of Bank of America shares.

The worst case scenario estimate calculated in our prior report used base case assumptions of adjusted tangible book value per share of $10.75 and a price-to-tangible equity multiple of 0.45x, which produced the $4.85 intrinsic value estimate ($10.75 x 0.45x = $4.85) referenced earlier. We believe the probability of BAC trading at the worst-case scenario level — on a sustained basis — is no greater than a 10 to 15%.

The process for estimating Bank of America’s intrinsic value comprises the following steps:

1. Calculating reported tangible book value of equity per share;

2. Insuring management took appropriate reserves for loan losses;

3. Adjusting the tangible book value, if appropriate; and finally,

4. Multiplying the adjusted tangible book value per share by the warranted multiple.

Reported Tangible Book Equity

Consolidated Financial Statements for Bank Holding Companies - FR Y-9C filed by Bank of America with the Board of Governors of the Federal Reserve System is the primary source for data used in the calculation of BAC’s tangible book value. According to the Federal Reserve website, the FR Y-9C is "used to assess and monitor the financial condition of bank holding company organizations, which may include parent, bank, and nonbank entities. The FR Y-9C is a primary analytical tool used to monitor financial institutions between on-site inspections. The form contains more schedules than any of the FR Y-9 series of reports and is the most widely requested and reviewed report at the holding company level."

Bank of America’s Sept. 30, 2011, FR Y-9C provides the necessary data to calculate reported tangible equity per share:

65057624.jpg

Chief Financial Officer Bruce Thompson stated during the third quarter 2011 conference call, “Tangible book value per common share increased $0.57 to $13.22 at the end of the third quarter” (actually more conservative than the above calculation). One of the footnotes found in Bank of America’s 10-Q mentions "tangible equity ratios and tangible book value per share of common stock are non-GAAP measures. Other companies may define or calculate these measures differently." As a result, the variance between the two estimates at this point isn’t relevant. For purposes of this report, the trend in tangible equity — and maintaining consistency in how it’s calculated — is far more important than having agreement on the actual per share value.

As of June 30, 2011, the reported tangible book equity for BAC using FR Y-9C data was $12.76. It appears, on the surface, Bank of America’s operating results improved considerably with this quarter’s tangible equity per share increasing by $1.31 over the prior quarter. However, closer inspection reveals a substantial portion of the improvement in tangible equity came from a reduction in the other intangible assets account, down $5.02 billion or 23% from last quarter. This is not indicative of enhanced operational efficiencies but rather a change in accounting (likely a result of the disposal of other non-core, bank assets). Total bank holding company equity, including intangible assets, increased a modest $8.1 billion or 3.6% sequentially.

Perhaps more important than the magnitude (or lack thereof) of the increase is the fact these results reflect the first sign of growth in Bank of America tangible equity in three quarters, a notable achievement.

Loan Portfolio Review & Adjusted Tangible Equity

The first step to better understanding the condition of Bank of America's balance sheet is by carefully reviewing its loan portfolio, the value of the loans that are underperforming, and the extent to which management is properly taking reserves for loan losses.

Recall that increasing the balance sheet account Allowance for Loan and Lease Losses reduces the company's reported net income and, consequently, the book value of its shareholder’s equity. With hair-trigger investors quick to sell in event of a quarterly earnings shortfall, management’s incentive not to take appropriate reserves for loan losses can be significant and must be monitored closely.

One approach to independently determining the adequacy of provisions for the Allowance for Loan Losses account is by reviewing the reported number and comparing it to the sum of Other Real Estate Owned (OREO), Loans 90+ days Past Due, and Nonaccruals (less 75% of the latter two, which are wholly or partially guaranteed). The “Nonperformance Coverage ratio” (calculated below) is the Allowance for Loan Losses divided by this amount and serves as a very useful indicator of the extent to which management is adequately taking reserves for potential loan losses.

1684792488.jpgBased on this analysis, it appears the Allowance for Loan Losses account should increase $19,887,214 and the Shareholder's Equity account reduced by the same amount. This results in an Adjusted Tangible Equity per share value of $12.10.

Uninspiring Trend in BAC Nonperformance Coverage Ratio

Chief Executive Officer Brian Moynihan commented in his opening remarks for the third quarter 2011 Bank of America quarterly conference call: “Our credit quality and delinquencies continue to improve while reserve coverage remains at high levels.”

It’s true loans 90 days or more past due (minus 75% of those delinquent loans that are wholly or partially guaranteed) declined $1.38 billion from September 2010 to September 2011. However, this is partially offset by an almost 7% or $250 million increase in OREO, or non-income producing real estate from foreclosures over the same period. Regardless, it appears premature to conclude credit quality are delinquencies are improving; particularly within the context of almost $55 billion in underperforming loans on Bank of America’s balance sheet.

The chart below shows the trend in the Nonperformance Coverage ratio over the past five quarters, using the calculations from the table above:1294008756.jpgNote Bank of America’s Allowance for Loan Losses account – the amount determined by management – steadily decreased from $43,581,376 in September 2010 to $35,081,508 in September 2011 (representing an $8.5 billion decrease), while the total of nonperforming loans decreased only 67% of this amount or $5.68 billion, over the same period. The result is a material decline in the nonperformance coverage ratio from 71.9% to the current level of 63.8%. This may reflect increased management optimism that loans made by the company will be repaid as planned and provisions for loan losses are less necessary than a year ago. Another potential reason is the company has employed stringent criteria for making new loans or there is a subdued demand for credit by consumers. An alternative, albeit less flattering explanation, is management is either unaware of the need for – or simply unwilling to take – the necessary reserves for these loans because of the negative impact it would have on BAC’s reported quarterly earnings per share.

Price-to-Tangible Equity Multiple

In November 2011 shares of Bank of America traded at, but not below, the worst-case scenario, base case multiple of 0.45x tangible book value equity. We based this multiple on BAC’s trading history while also incorporating the price-to-tangible equity multiple at which Citigroup (C) historically traded. This multiple remains unchanged with the improvement, on an absolute basis, in Bank of America’s tangible equity per share and the reversal of the downward trend.

291561488.jpg

Worst Case Scenario: Intrinsic Value Estimate for Bank of America

The matrix below offers a sensitivity analysis for the intrinsic value of BAC shares using various adjusted tangible equity per share and price-to-tangible equity ratios. Shares of Bank of America closed at $5.44 on November 30, 2011, which is consistent with the one would expect using the matrix below at the base case 0.45x ratio (the recently reported adjusted tangible equity per share of $12.10 x 0.45x = $5.45).

1663182163.jpg

Until the downward trend in the nonperformance coverage ratio reverses and the increase in tangible book value equity proves to be more than a onetime occurrence, the worst-case scenario intrinsic value estimate remains unchanged at $4.85.

Disclosures:

One or more clients of CastlePoint Investment Group, LLC, own shares of Bank of America.

About the author:

John G. Alexander, CFA, is managing partner and portfolio manager for CastlePoint Investment Group where he achieved and sustained a record surpassing the S&P 500 eight of past nine years and 98% of all 36-month rolling, overlapping periods. During his 12-year career as an equity portfolio manager, his annualized returns through September 30, 2011, exceed the S&P 500 and Russell 1000 Value indices by 532 bps and 467 bps, respectively. John earned an M.B.A. degree from the Wharton School of the University of Pennsylvania and a B.S. degree from Indiana University. He co-authored "The Future of Value Investing" published by the Journal of Investing in 2000. Please visit the CastlePoint website (www.castlepoint-inv.com) for additional information.

About the author:

John G. Alexander
John G. Alexander, CFA, is managing partner and portfolio manager for CastlePoint Investment Group where he achieved and sustained a record surpassing the S&P 500 eight of past nine years and 98% of all 36-month rolling, overlapping periods. John earned an M.B.A. degree from the Wharton School of the University of Pennsylvania and a B.S. degree from Indiana University. He co-authored "The Future of Value Investing" published by the Journal of Investing in 2000. Please visit the CastlePoint website (www.castlepoint-inv.com) for additional information.

Visit John G. Alexander's Website


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Comments

gav_sharma
Gav_sharma - 2 years ago
How come you didn't mention that one of the reason why tangible equity increased was because of buffets investment ?
John G. Alexander
John G. Alexander - 2 years ago


Berkshire Hathaway's investment is another example of an improvement in Bank of America tangible equity that's unrelated to improvements in the company's operations. In the article I cited an $8.1 billion improvement in bank company tangible equity that, I believe, included that $5 billion received in August 2011 (I need to double-check the financial filiings to be certain).

One thing I find bothersome about the Bershire investment (and the frequency with which people refer to it) is that transaction is not that same as an investment in BAC common stock- in fact, there's a *big* difference between the two.

Furthermore, I think it's misguided - at best - to use Buffett's investment as justification for buying BAC since we're talking about two different financial instruments. Recall Buffett is "getting paid to wait" at the rate of 6% per year with dividends that are paid prior to any dividends going to the common shareholders.

On top of that, Buffett has warrants to purchase 700,000,000 shares of BAC common stock at an exercise price of $7.142857 per share. And finally, Bank of America must pay Berkshire Hathaway $250 million when the day comes the company doesn't want to continue paying $300 million annually and redeem those shares of Cumulative Perpetual Preferred Stock.

In essense, the transaction is much more like an expensive issuance of debt (paying 6% with the warrant sweetener) than Buffett buying BAC stock. For more information on these types of transactions, check out: Trust-Preferred Securities on Wikipedia.

For the record, I'm still convinced at these levels the risk-reward trade-off for shares of BAC remains attractive. I believe year end tax-loss selling and portfolio manager window dressing, however, may drive the stock down lower over the coming weeks providing more attractive entry points.
yaronguru
Yaronguru - 2 years ago
Dear John,

Two issues:

1. You haven't said a word about BOA's mortgage-related litigation risk. Any attempt to quantify it? I think it's on many people's mind.

2. The multiple of x0.45 of TBV at trough -- where does it come from and what's its intellectual underpinning? Just because BOFA (and perhaps Citi) has never traded below it, it won't in the future? What if BOFA needs to be bailed out and the value of equity goes to zero, or nearly zero, because of massive dilution of existing shareholders? Alternatively, if BOFA is sound and gets past the turbulence, why should it trade at x0.45 book, and not say x1 book, assuming it is able to earn its cost of capital?

Thank you!

Yaron
noblepaladin
Noblepaladin - 2 years ago
Buffett's investment in BAC is different than buying the common stock, but it is not that different. It is still an aggressive bet that BAC will go up substantially. Note that the 6% preferred alone is a terrible terrible investment. The market value has BAC preferred yielding 9% (or when Buffett purchased it, over 10%) and the preferred trusts, which are senior to the preferred, yielding 8.5%. I don't think BAC will ever redeem those preferred shares. An infinite duration "loan" (and it is not really a loan, it is preferred equity) at 6% is pretty good, even with these record low interest rates. In a few years, if rates go up a tiny bit (Buffett believes in inflation, so he probably thinks that rates will go up), 6% infinite duration will probably match the risk free yield. If Buffett thought that 6% is reasonable, he'd scoop up as much WFC, JPM, GS, USB, etc, preferred as he wanted, all yielding higher. Across the board, there is enough liquidity for a multi billion dollar investment.

The question is, would Buffett prefer 6% preferred (which is worth about 2/3 of par if you match it to existing market prices of preferred) and $7.14 warrants or the current price of BAC below $6? Note that if you like, you can create a hybrid investment with similar characteristics to Buffett's investment through the TARP warrants and with preferred or preferred trust securities. You'd get a higher strike on the warrants, but a much higher yield.

John G. Alexander
John G. Alexander - 2 years ago
Warren Buffett could have made "an aggressive bet" that shares of Bank of America will appreciate and invested directly in the common shares, as he's done on countless other occasions. In fact, this transaction could have been executed taking a move straight out of the Berkshire Hathaway (BRK.A) playbook. First, issue BAC puts and collect the premium from writing those options; if exercised, buy the BAC shares outright and pocket the proceeds from the puts, thereby reducing the effective price paid for the stock.

But he didn't do that...

Instead, he crafted a much more attractive deal - the extent to which is open for debate - and herein lies the the crux of the issue.

In plain terms, there's much more to the headline news "Berkshire Hathaway to Invest Billion in Bank of America" than is immediately apparent. This transaction is not the same as buying common shares. And, in my opinion, the terms of this deal are materially different in several important, highly relevant respects.

In summary, his investment is less risky (preferred shares, senior to common stock), compensates him until BAC appreciates (paid 6% dividend prior to common dividends), gives him the potential for a 5% added return to his investment (5% redemption fee), and offers him an arguably multi-billion instant rebate.

The last point is the most controversial and I'll touch on it briefly using some simplifying assumptions. Let's first take a quick look at an SEC filing made by BAC on March 4, 2010, whereby 150,375,000 ~10-year warrants were offered for $8.35 at a $13.30 strike price ($3.07/share in the money, as BAC was trading at $16.37 the time). This offering, according the the filing, was expected to generate approximately $1.26 billion in proceeds.

Recall an option is fundamentally comprised of both intrinsic (the difference between the market price and the strike price) and time value (the value of the option, but not the obligation, to exercise the warrant over the period until the option/warrant expires). The value of the warrant increases the longer the time period before expiration. Warrants on highly volatile stocks are worth considerably more than warrants on securities with low levels of volatility. Without knowing anything about the Black-Scholes model for valuing options but understanding these two basic concepts, it's pretty clear these options or warrants are of considerable value.

After subtracting the warrants' intrinsic value, $461,654,135 ($3.07 x 150,375,940) from the sale proceeds we're left with about $800 million - a reasonable estimate for the time value portion of the warrants. This works out to $5.28 per warrant.

Admittedly there's the illusion of precision because I failed to round many numbers in this quick analysis and the warrants used in the SEC filing I cited differs from those issued to Berkshire Hathaway (though I don't believe materially so). Regardless, the fact remains those warrants are of considerable value.

The Berkshire Hathaway transaction included 700,000,000 warrants.

Admittedly, the warrants in the Berkshire transaction are out-of-the-money, so it's not reasonable to assume the warrants are worth $5.28 each. However, even if we discount the calculated value of the warrants by 50%, Berkshire Hathaway received $1.85 billion ($5.28 x 50% x $700 million) in BAC warrants as part of this transaction.

If we take the $1.85 billion and spread it evenly over the ten-year life of the warrants, we reach an effective yield on the Berkshire Hathaway investment to 9.7% ($300,000,000 + $185,000,000) / $5,000,000,000), a level consistent with what one would expect - but not at the level presently offered to common shareholders of Bank of America.

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