I have never liked to sound pessimistic or negative without having a solid reason. On the surface, and without having a depth of knowledge on the current financial position of Bank of America (BAC), I would have opted for a buy rating on its stock, on the strength of the following facts:
1. BAC has now turned the corner on capital adequacy. From being a bank with the worst capital base compared with JPMorgan (JPM), Wells Fargo (WFC) and Citigroup (C), BAC is now the best capitalized bank with a Basel 3 Tier 1 Capital level of 8.97% compared with its big bank peers. The Basel 3 Tier 1 Capital levels of JPM, Wells Fargo and Citigroup are 8.4%, 8.02% and 8.6%, respectively. The bank’s huge capital outlay came from the proceeds from selling its non-core assets and from its Project BAC, focused on cutting costs and expenses.
2. The news of the rebound of the housing sector potentially puts BAC on the path of improved earnings and profitability, since the bank has a big exposure to the housing industry, like Wells Fargo.
However, despite these facts that favor a buy recommendation for BAC, I won’t buy BAC stock now, simply because BAC is still heavily weighed down by the mess of its old mortgage portfolio. Below are the reasons:
1. Profitability is not in sight for Bank of America for the foreseeable future: Bank of America’s old mortgage problem doesn’t seem like it’s going away soon. In 2008, BAC purchased Countrywide Financial which has since become a toxic asset. That subsidiary was bought for $4.1 billion but has never done well financially. The biggest risk Countrywide Financial poses to BAC started some quarters ago when some past investors asked the mega bank to repurchase the bad mortgage bonds it sold previously. The financial effects of these repurchases gradually grew from $10 billion in the third quarter of 2011 to $22.7 billion last quarter, and now, it is $25.5 billion as reported in the third quarter of 2012.
BAC’s souring bonds repurchased claims keep growing in billions of dollars each quarter and it is not certain there is an end in sight. In the recent quarter financials, there was a total of $5 billion reported for repurchased claims – an increase of 12% between June 30 and Sept. 30, 2012. As BAC continues to bear the liability for the souring bonds each quarter, shareholders will have to wait much longer for dividend payouts, and this will also cause the bank to continue to be unprofitable for many quarters to come.
2. Financial losses are still being reported despite housing rebound: There has been the argument that housing rebound will lift BAC’s mortgage business, but that is yet to happen even after mortgage originations rose by 18% year over year. Mortgage servicing costs alone increased BAC’s non-interest expenses by $600 million in the 2012 third quarter results, because tens of thousands of its employees are still being solely involved with either handling litigation or servicing old mortgages and repurchased claims.
BAC made its earnings call in the early morning of Wednesday, Oct. 17, 2012 with a passionate appeal to investors from its chief financial officer, Bruce R. Thompson, to focus on the potentially growing core earnings of the company rather than the obvious negatives in its financial records. While that may sound encouraging, the albatross of Bank of America’s mortgage bonds still remains a potential danger to the financial health of the bank and a lasting solution is not in sight yet. I would prefer to stay away from BAC stock until it becomes certain that the losses are being contained, because I’m concerned that mortgage-related costs and claims will continue to rise and weigh heavily against BAC’s efforts to return to profitability. That said, investors who are not too mindful of the inherent risks can look for opportunities to short-sell BAC stocks.