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:
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.
Based 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:
Note 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.
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).
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.
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:
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.
Based 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:
Note 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.
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).
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.
