BAC-WT - Bank of America Warrants

[ni-co]

However... if it instead trades up to 12.5x earnings right away and dividends+buybacks are reinvested at that multiple, then the total value only rises to $32 per share.  I'm fine with this scenario because it means the bulk of the contribution to the annualized compounding rate (multiple expansion) is front-loaded and I don't turn fast money down when it just falls into my lap.

 

Indeed, this is the more likely scenario. – I certainly can live with $32, too :D

 

I think even a 12.5 PE for BAC is going to seem quite low a few years from now, once Moynihan succeeds and earnings become stable. Today, nobody is talking about BAC's "franchise" and asset base. I think once legal costs are under control, people are going to focus much more on these aspects of BAC and will consider it a much lower risk investment than they are today. I'm not investing long enough to know at which point in the past BAC was a comparably low risk investment.

 

Further, I think chances are very high that warrants on a value stock with such long durations and good terms are severely underpriced (especially regarding the low recent volatility). Buffett and Greenblatt mentioned on several occasions that the Black/Scholes model is the wrong way to price long dated options. This makes perfect sense for value investors knowing that chances hugely increase over time that the share price reaches its intrinsic value – regardless of volatility. The longer the duration the worse the mispricing.

[ERICOPOLY]

 

I guess I'm the only person here who thinks BAC should be at $20 at year end.... I have no reason to believe how it will get there but just seems like a reasonable market price once all the dusts settle down.

 

 

Give this a still below market multiple of 14 and it's not a big stretch to assume that the share price in January 2019 could be $35.

 

I find it not too difficult to get your $15.20 invested today up to $35 in 4.5 years, but I find it harder to predict if the share price itself will get that high (because it depends on how much is paid out in dividends).  But since you are in the warrants, it's more relevant to ignore share price and instead focus on whether the $15.20 of total invested dollars can rise to $35.

 

Assuming 13% ROTE and today's $14 of tangible equity per share, then it's $1.80 per share.

 

Today the shares are $15.20.

 

Assume shares quickly trade at $18 once large capital returns begin (PE of 10x).  Ignoring the NOLs and such (assume they get eaten by legal expenses), further assume that all after-tax earnings are returned to shareholders (through dividends and buybacks).  Assume the shares trade at 10x earnings throughout this period.

 

Okay, so just compound $18 at 10% for 4.5 years.  You get $27.64.

 

So for you (at that point) to get to $35 of total gain per initial $15.20 invested, you then need (in 2019 but not before then) the shares to trade up to 12.6x earnings.

 

So that's the scenario where it trades at 10x for the whole period, and then gets a sudden boost to 12.6x at the end.

 

However... if it instead trades up to 12.5x earnings right away and dividends+buybacks are reinvested at that multiple, then the total value only rises to $32 per share.  I'm fine with this scenario because it means the bulk of the contribution to the annualized compounding rate (multiple expansion) is front-loaded and I don't turn fast money down when it just falls into my lap.

 

It seems reasonable but I'm sort of giving up with predicting BAC for now because I keep getting it wrong.

 

The pace of lawsuits being filed 3 years ago really seemed to turn off investors.  Lately, there have been several quarters of obliterated earnings due to the pace of settlements.  But now that trend of earnings obliteration should stop cold-turkey with the DOJ settlement being the last of the big ones... new lawsuits may crop up but not at the pace of 3 years ago, and won't be settled for a long time anyhow.

 

So perhaps people just need to collect themselves after too many disappointing massively-above-reserves legal settlements.

 

The smell of easy money has got to bring them out sooner or later.

[ni-co]

The smell of easy money has got to bring them out sooner or later.

 

This is exactly what I think, too. There will be a change in sentiment.

[ERICOPOLY]

Further, I think chances are very high that warrants on a value stock with such long durations and good terms are severely underpriced

 

They're just leverage.  At warrant expiry... you will have made positively leveraged returns if the total investment returns of the common stock exceed the annualized cost of the warrant leverage.

 

$15.20 - $6.68 = $8.52

 

$8.52 grows to $13.30 at approximately a 10.5% pace over 4.5 years.

 

So you can think of the warrants as the synthetic equivalent of a leveraged portfolio of BAC common stock where you pay 10.5% a year interest on your loan.  You have the advantage of no risk of margin calls.

 

However, there are downsides... for example, you mentioned that you expect a quick burst to 12.5x multiple instead of that expansion coming at the end of the period.  Should that happen, you'll find that the cost of the leverage (the warrant premium) for the remaining years will fall.  Thus, your leveraged returns might suck on a relative basis compared to somebody who instead leveraged a straight common stock portfolio using margin (with shorter-dated puts to protect it from margin calls).

 

Think about it... who is going to pay 10.5% annualized cost for a $13.30 strike put when the share price is $22?  You could, at that time, find puts with strikes in the $20 range at that cost or even less than that cost (most likely).

 

So what I'm doing myself is going with margin to leverage my common and pairing it with 2016 strike puts, at $15 strike.  I have non-recourse leverage this way, and it costs roughly the same on an annualized basis as your leverage.  Then, this time next year perhaps, if the stock is at $22 as you expect, it would be dirt-cheap to roll those $15 strike puts out to a longer-dated expiration (because far out of the money puts are dirt-cheap compared to at-the-money puts).

 

This strategy, I believe, will produce a better result if there is going to be some significant stock price PE multiple expansion early in the remaining life of the warrants.  Your strategy will be perhaps no worse if the stock languishes near these levels, and your strategy would be better if that is coupled with things like an astronomical rise in margin interest rates and perhaps higher volatility premiums when I roll my puts (if the stock hasn't risen and volatility is higher at the same time).

 

But... I chose this path because I don't expect the stock to still be at $15 a year from now, two years from now, etc...  Also, you don't expect those outcomes either because, after all, you are leveraged and paying a pretty penny for it.

 

But hey, what do I know. 

[ni-co]

As puts and calls are priced of each other, theoretically, this shouldn't be cheaper. Do your puts cover the whole position or only the part you bought on margin?

 

The implied borrowing costs of a call are normally close to the risk free rate. I think the error you make is assuming that the call premium is only the borrowing cost, but it's the borrowing cost and the cost of the right not to lose money below the strike price (which is the cost of a put for the whole position).

[blainehodder]

As puts and calls are priced of each other, theoretically, this shouldn't be cheaper. Do your puts cover the whole position or only the part you bought on margin?

 

The implied borrowing costs of a call are normally close to the risk free rate. I think the error you make is assuming that the call premium is only the borrowing cost, but it's the borrowing cost and the cost of the right not to lose money below the strike price (which is the cost of a put for the whole position).

 

Pretty sure he is just saying he prefers the 2016s vs the longer duration warrants as he believes the juice will come sooner rather than later. If not, he can always roll the duration.  If his thesis is correct, it would seem unwise to pay up for the longer duration.  Eric understands that a call = stocks + put.  He is going with the stock and the put for tax purposes.

[ni-co]

As puts and calls are priced of each other, theoretically, this shouldn't be cheaper. Do your puts cover the whole position or only the part you bought on margin?

 

The implied borrowing costs of a call are normally close to the risk free rate. I think the error you make is assuming that the call premium is only the borrowing cost, but it's the borrowing cost and the cost of the right not to lose money below the strike price (which is the cost of a put for the whole position).

 

Pretty sure he is just saying he prefers the 2016s vs the longer duration warrants as he believes the juice will come sooner rather than later. If not, he can always roll the duration.  If his thesis is correct, it would seem unwise to pay up for the longer duration.  Eric understands that a call = stocks + put.  He is going with the stock and the put for tax purposes.

 

Ah, thanks. I see. And this also answers what would have been my next question: why not simply buy the 2016 call and rolling it over.

[gary17]

Tax

 

Selling calls and rolling over incurs taxes whereas selling puts at a loss = no taxes. Clever.

[xazp]

Soooo ... what happened to that settlement? 

 

Per the reports late July, Holder says, up your offer or we sue tomorrow. 

 

BAC raises their offer, tons of news reports and then ... neither a settlement nor a lawsuit.  What's going on? 

 

I've grudgingly changed my mind about the lawsuit.  Unfortunately, after reading through the CCAR process, I believe CCAR assumes poor outcomes about litigation - perhaps whatever the prosecution is asking for.  This makes sense as it's trying to be a conservative view on capital.  But that also means from a CCAR perspective, a settlement is probably preferred to litigation no matter how dumb. 

 

 

 

Tax

 

Selling calls and rolling over incurs taxes whereas selling puts at a loss = no taxes. Clever.

[ERICOPOLY]

Soooo ... what happened to that settlement? 

 

Per the reports late July, Holder says, up your offer or we sue tomorrow. 

 

BAC raises their offer, tons of news reports and then ... neither a settlement nor a lawsuit.  What's going on? 

 

I've grudgingly changed my mind about the lawsuit.  Unfortunately, after reading through the CCAR process, I believe CCAR assumes poor outcomes about litigation - perhaps whatever the prosecution is asking for.  This makes sense as it's trying to be a conservative view on capital.  But that also means from a CCAR perspective, a settlement is probably preferred to litigation no matter how dumb. 

 

 

 

Tax

 

Selling calls and rolling over incurs taxes whereas selling puts at a loss = no taxes. Clever.

 

Says last week's article:

 

Bank of America and the Justice Department are continuing to hash out details and the deal could still fall apart, one person familiar with the matter said. An announcement isn't expected this week. On Wednesday, Bank of America General Counsel Gary Lynch met in Washington with Tony West, the Justice Department official responsible for negotiating with banks over mortgage securities, in hopes of ironing out some details.

 

http://online.wsj.com/articles/bank-of-america-near-16-billion-to-17-billion-settlement-1407355290?KEYWORDS=bank+of+america

[Andy Dufresne]

xzap,

 

Most people underestimate the amount of managerial resources and headaches from lawsuits and how this detracts from the performance of the business - I say this as someone who used to litigate, and as someone who owns a business that has gotten sued (though not by the Govt!). A good analogy is that it's like driving your car with the hand-brake still engaged ...

 

A lot of people are b**ching at Moynihan but he's doing the right thing IMHO - finish all the 08-09 lawsuits and then once the hand-brake is off, he can shift into higher hear and maybe get those ROA and ROE numbers to something resembling what we know BAC can do.

 

Still, the lack of concrete news about a settlement makes me nervous as well ...

[ni-co]

Well, what’s another week?

 

Bank of America $17B pact still being haggled over

An immense amount of paperwork and concerns about wording in the settlement are taking up much of prosecutors’ and BofA lawyers’ attention, three people said.

…

The deal is now expected to be announced early next week, according to sources, roughly three weeks after the bank agreed to the broad outlines of the deal.

 

http://nypost.com/2014/08/14/bank-of-america-17b-pact-still-being-haggled-over/

[OracleofCarolina]

Allan Mecham on BAC:

 

http://www.beyondproxy.com/bank-america-bac-2/

 

Thanks for posting. Allan Mecham runs Arlington Value. They just posted an excerpt from his letter.

 

Looks like Meacham added to his BAC per the 13-F

[ERICOPOLY]

Well, what’s another week?

 

Bank of America $17B pact still being haggled over

An immense amount of paperwork and concerns about wording in the settlement are taking up much of prosecutors’ and BofA lawyers’ attention, three people said.

…

The deal is now expected to be announced early next week, according to sources, roughly three weeks after the bank agreed to the broad outlines of the deal.

 

http://nypost.com/2014/08/14/bank-of-america-17b-pact-still-being-haggled-over/

 

Another week is another $500m of pre-tax earnings... since you asked.

 

[xazp]

We have to think in terms of PTPH (Pre-tax, pre-holder) earnings.  Perhaps he told Moynihan, our bill is another $500 million next week!  [i'm not so sure he didn't do a version of that given how fast the number seems to be increasing.]  On the plus side, PTPH earnings are pretty good!

 

 

 

Well, what’s another week?

 

Bank of America $17B pact still being haggled over

An immense amount of paperwork and concerns about wording in the settlement are taking up much of prosecutors’ and BofA lawyers’ attention, three people said.

…

The deal is now expected to be announced early next week, according to sources, roughly three weeks after the bank agreed to the broad outlines of the deal.

 

http://nypost.com/2014/08/14/bank-of-america-17b-pact-still-being-haggled-over/

 

Another week is another $500m of pre-tax earnings... since you asked.

[xazp]

NYT also says settlement announcement expected this week. 

http://www.nytimes.com/2014/08/17/business/in-a-bank-settlement-dont-forget-the-bulldozers.html?partner=yahoofinance

 

 

[ERICOPOLY]

Out of 28 analyst estimates for BAC's 2015 earnings, we have a low estimate of $1.33 and a high estimate of $1.79.

 

Who is forecasting $1.33?  I wonder if that changes with this "last" big settlement landing in 2014.

 

 

[ERICOPOLY]

Also, I suspect the price weakness has a lot to do with the direction of the 10-year yield.  It's headed south quite a bit over the past 5 months.

[Junto]

Are you sure?  It takes a lot less effort to fine $20Bn from one large company versus $750MM from each of 30 small companies.  :P. 

 

It solves the moral hazard.

 

Tiny banks are the ones that draw on the FDIC's reserves when they fail.

 

The big banks pay a lot of money towards establishing those FDIC reserves.

 

You can see where this is leading...  the small banks aren't paying their own fare.  This interference with the free market creates moral hazard.

 

I would like to see your support on this data point. I am not certain this is true when given the largest failures drive much larger losses given the way the FDIC bidding process is organized.

[ERICOPOLY]

Are you sure?  It takes a lot less effort to fine $20Bn from one large company versus $750MM from each of 30 small companies.  :P. 

 

It solves the moral hazard.

 

Tiny banks are the ones that draw on the FDIC's reserves when they fail.

 

The big banks pay a lot of money towards establishing those FDIC reserves.

 

You can see where this is leading...  the small banks aren't paying their own fare.  This interference with the free market creates moral hazard.

 

I would like to see your support on this data point. I am not certain this is true when given the largest failures drive much larger losses given the way the FDIC bidding process is organized.

 

A larger more diversified portfolio is inherently safer.

A less leveraged portfolio is inherently safer.

 

Small banks are relatively less diversified (fewer products spread among less-diverse geography)

Small banks are more heavily leveraged (the government penalizes large firms with higher capital and supplementary leverage ratios)

 

 

Now, if you shatter a Bank of America into thousands of tiny pieces, you'll get some pieces concentrated in New York lending, and some pieces concentrated in California lending.  There will be times when the New York economy is booming and California is in a bad recession.  At this time, the California pieces will be going into FDIC hands, and the New York pieces will be as profitable as ever.

 

Instead, under the current system, the loan losses of Bank of America attributed from a bad recession in California is buffered by the fat profits from the New York arm of Bank of America.  The FDIC sits around bored.

 

So highly fragmented banking means an active FDIC that is handling a lot of small banks failing (in an environment where many are flourishing), versus highly concentrated banking where the losses are just being absorbed by gains elsewhere.

 

[ERICOPOLY]

It appears to be the government's goal to:

 

discourage diversification  (force only the highly diversified firms to deleverage)

allow higher leverage if you are less diversified  (allow higher leverage only at the relatively less diversified firms)

[ERICOPOLY]

I am not certain this is true when given the largest failures drive much larger losses

 

Let's say that one large bank (that was destined to fail at some point) was instead split into 10,000 separate firms.

 

We get to that day when the economy is weak and that large firm would have failed.

 

A few questions:

 

Will the 10,000 separate firms all survive, or will thousands of them be failing?

 

Will it be simpler to deal with thousands of failing firms, versus just one?

 

Will it be cheaper to deal with thousands of failing firms, versus just one?

 

Will it be less pressure on FDIC reserves to deal with thousands of failing firms, versus just one?

 

 

And you think about that large single bank... there is a tipping point where it fails.  Before that failure though, you have a low-profit or break-even situation.  Nothing is going to the FDIC at that point.  But if you have lots of itty-bitty banks, you have thousands going to the FDIC already.

 

 

I forget which book it was about the Great Depression, but they mentioned that one of the problems was that the banking system was very fragmented.  It was an overwhelming amount of paperwork and meetings to administer all over the country with so many individual banks failing.  It would have been easier to deal with if you have fewer phone numbers to dial.

[Junto]

Are you sure?  It takes a lot less effort to fine $20Bn from one large company versus $750MM from each of 30 small companies.  :P. 

 

It solves the moral hazard.

 

Tiny banks are the ones that draw on the FDIC's reserves when they fail.

 

The big banks pay a lot of money towards establishing those FDIC reserves.

 

You can see where this is leading...  the small banks aren't paying their own fare.  This interference with the free market creates moral hazard.

 

I would like to see your support on this data point. I am not certain this is true when given the largest failures drive much larger losses given the way the FDIC bidding process is organized.

 

A larger more diversified portfolio is inherently safer.

A less leveraged portfolio is inherently safer.

 

Small banks are relatively less diversified (fewer loans spread among less-diverse geography)

Small banks are more heavily leveraged (the government penalizes large firms with higher capital and supplementary leverage ratios)

 

 

Now, if you shatter a Bank of America into thousands of tiny pieces, you'll get some pieces concentrated in New York lending, and some pieces concentrated in California lending.  There will be times when the New York economy is booming and California is in a bad recession.  At this time, the California pieces will be going into FDIC hands, and the New York pieces will be as profitable as ever.

 

Instead, under the current system, the loan losses of Bank of America attributed from a bad recession in California is buffered by the fat profits from the New York arm of Bank of America.  The FDIC sits around bored.

 

So highly fragmented banking means an active FDIC that is handling a lot of small banks failing (in an environment where many are flourishing), versus highly concentrated banking where the losses are just being absorbed by gains elsewhere.

 

Thanks, at least we established that you're assuming.

 

Remember IndyMac cost $4 to 8 billion to the FDIC fund. That is a lot of small bank failures where losses are generally less than $20 million. The camel ratings drive insurance payments so given the number of small banks compared to large banks and rating differences, I would take the other side of your viewpoint that small banks don't cover their own in insurance premiums.

 

I personally think trying to plan a dissolution of the largest banks is a backwards errand as they're so interwoven with the economy the assumptions required give way too much variation. Better to control size vs require plans.

[xazp]

I was actually trying to make a bad joke, but apparently the board took me seriously. 

 

Are you sure?  It takes a lot less effort to fine $20Bn from one large company versus $750MM from each of 30 small companies.  :P. 

 

It solves the moral hazard.

 

Tiny banks are the ones that draw on the FDIC's reserves when they fail.

 

The big banks pay a lot of money towards establishing those FDIC reserves.

 

You can see where this is leading...  the small banks aren't paying their own fare.  This interference with the free market creates moral hazard.

 

I would like to see your support on this data point. I am not certain this is true when given the largest failures drive much larger losses given the way the FDIC bidding process is organized.

[ERICOPOLY]

Thanks, at least we established that you're assuming.

 

Yes of course I am making the assumption.  I'm not spending my time compiling comprehensive studies to back my intuition for such a no-brainer.  I am a small investor.

 

I feel much safer investing in Bank of America with it's broad product offerings spread across the country/world... versus say the local community "Bank of Sacramento "(if there is such a thing) which is going to struggle having loans repaid if the levees burst on the Sacramento River Delta (which is actually predicted to be a large risk, much bigger than the flooding of New Orleans).  Or if they undergo some other localized economic shock.

 

I just don't understand the mentality of thinking it's less risky to go small and leveraged.  Bank of America can withstand the legal bills of Countrywide, but Countrywide cannot withstand the legal bills of Countrywide.