BAC-WT - Bank of America Warrants

[ERICOPOLY]

Anyone have any thoughts on BAC pretax preprovision earnings in light of continued consumer deleveraging over the long term? I'm counting on solid profitability cushioning any liability issues. But a Japan like anemic growth situation is certainly possible.

 

Most of the consumer debt is mortgage, at historically low fixed rates.  Household debt service is at historically low levels.  Low interest amortizations pay down faster in the early years. 

 

Why is this a cause for concern? 

 

 

If the US consumer were to head back to pre2000 levels of debt to income, new loan growth and revenue would be pretty weak for an extended period of time.

 

 

The household debt service ratio is already at nearly the lowest level of the past 30 years.

 

See slide # 9:

 

http://investor.shareholder.com/common/download/download.cfm?companyid=ONE&fileid=515337&filekey=85746b44-384f-4eab-8c22-498b7d509acf&filename=BAAB%20Conference%20Presentation%20Final_11.4.11.pdf

 

 

[racemize]

Nice slide--however, Prem showed a slide in his presentation where private sector debt was extremely large, historically on a percentage basis as supporting the deleverage/deflation thesis.  I can't remember the specific metric though, so perhaps another attendee could remind me.

[ERICOPOLY]

Nice slide--however, Prem showed a slide in his presentation where private sector debt was extremely large, historically on a percentage basis as supporting the deleverage/deflation thesis.  I can't remember the specific metric though, so perhaps another attendee could remind me.

 

The analysis is too simplistic.

 

Would you personally rather have a 30 yr $50,000 loan with 4% interest rate or a $40,000 loan with 8% interest rate?

 

Me too -- I'd pick the 50% cheaper financing cost even though it comes with a 25% higher principal burden.

 

Wouldn't Prem?  I mean, if somebody came to him and said how about you owe me 25% more principal on your loans but in return I'll halve your interest rates?  He should be eager to accept those terms.

 

This is elementary math, and common sense is you'd be better off owing more on the far cheaper financing terms.

 

So why should the consumer be any different?

 

These guys never normalize these slides to account for the cost of servicing the debt. (and the rates are primarily fixed given that's it's mostly mortgage)

 

Let's review:

1)  The debt service costs are nearly the lowest in 30 years 

2)  The mortgages are paid off in 30 years without extra payments (so who cares how big they are)

3)  Cash flow matters -- slides ignore cash flow

 

Additionally, going forward housing is already back at historically normal price levels.  So new mortgage debt is of normal size.  As days go by the new smaller mortgages dilute the average loan size in the pool of larger ones, so the total consumer debt-to-GDP contraction happens through natural decay, not additional payments.  Secondarily, the payments (once again) on low interest amortization schedules are very highly weighted towards principle repayment -- so the principle balance on each low interest loan decays at an accelerated rate.

[Rabbitisrich]

Nice slide--however, Prem showed a slide in his presentation where private sector debt was extremely large, historically on a percentage basis as supporting the deleverage/deflation thesis.  I can't remember the specific metric though, so perhaps another attendee could remind me.

 

These guys never normalize these slides to account for the cost of servicing the debt. (and the rates are primarily fixed given that's it's mostly mortgage)

 

Let's review:

1)  The debt service costs are nearly the lowest in 30 years 

2)  The mortgages are paid off in 30 years without extra payments (so who cares how big they are)

3)  Cash flow matters -- slides ignore cash flow

 

Yeah good point. The FHFA posts a monthly survey of purchase SFR mortgages. Adjustable rate share fell from 35% in 2004 to 5% in 2010.

[PlanMaestro]

Nice slide--however, Prem showed a slide in his presentation where private sector debt was extremely large, historically on a percentage basis as supporting the deleverage/deflation thesis.  I can't remember the specific metric though, so perhaps another attendee could remind me.

 

* Did it include financial firms leverage? If yes, that's a chart that much exaggerates the problems

* Did include other the left side of the balance sheet? If no, probably it is not given the businesses credit for a very decent balance sheet (and a lot of foreign assets)

* As Eric says, did it include an analysis of the debt service history? People are managing and refinancing.

 

What matters is we are getting growth traction from the low interest rates for a substantial part of the economy, even if not all of it participates. And compared with Japan we are. When banks relax credit conditions, as they are starting to do, credit growth responds.

 

http://www.businessinsider.com/what-stagnation-looks-like-in-one-chart-2012-3

 

We do not have magneto problem. We are not pushing on a string ... well, just a little bit.

 

 

 

 

[ERICOPOLY]

Nice slide--however, Prem showed a slide in his presentation where private sector debt was extremely large, historically on a percentage basis as supporting the deleverage/deflation thesis.  I can't remember the specific metric though, so perhaps another attendee could remind me.

 

These guys never normalize these slides to account for the cost of servicing the debt. (and the rates are primarily fixed given that's it's mostly mortgage)

 

Let's review:

1)  The debt service costs are nearly the lowest in 30 years 

2)  The mortgages are paid off in 30 years without extra payments (so who cares how big they are)

3)  Cash flow matters -- slides ignore cash flow

 

Yeah good point. The FHFA posts a monthly survey of purchase SFR mortgages. Adjustable rate share fell from 35% in 2004 to 5% in 2010.

 

If Prem does another one of those question-and-answer sessions online, here is my question for him.

 

Would you refinance Fairfax's debt on these terms?:

1)  50% lower interest rate 

2)  30 year fixed rate

3)  25% higher principal amount  (so you are gifting 25% to the lender in exchange for 50% lower rate)

 

It's not an academic example.

 

Fairfax's cash flow would increased.  Why should that be a reason to feel stressed out? 

 

[Packer16]

The key assumption behind the Debt/GDP is crushing conclusion is high interest rates.  High interest rates occur in response to inflation or in the case of foreign debt when the foriegners decide to stop lending.  Given the history of deleveragings in cases where a good portion of the debt is domestically owed (the 1930s/1940s and 1990s/2000s Japan), interest rates are typically low for long periods of time.  In additon, the Fed has studied the Depression and Japan and seen that the only tool it has to fight deflation is easy money.  For the folks who think interest rates will rise, what is your rationale beyond this is what has happened over the last 50 years?   

 

As to inflation, I think we are in a new world were the labor supply will outstrip demand for generations.  If you look at history, labor has gained the upper hand when labor is scarce due to war, famine or epidemic.  Since we have prevented all three and the formally communist world has joined the capitalist world, the labor portion of goods and services will be in abundant supply.  Also if you look at most of the goods and services purchased in developed counrties it has a high labor cost component to it.  This will keep inflation down even if there is input inflation.  This will also reward capital versus labor in most industries.  That is why I am skeptical of the reversion to the mean for profit margins and for interest rates.       

 

Packer

[Guest bengrahamofthenorth]

Interesting take Packer, thanks for all the responses. This was Moynihan's response on the conference call in regard to pretax preprovision:

 

Andrew Marquardt - Evercore Partners Inc., Research Division

 

And do you still have confidence in, maybe it's an outdated range now of 45 to 50 on an annual basis? Is that still valid or have things changed enough that, that needs to be rethought?

 

Brian T. Moynihan

 

I think on the prior calls, we brought -- that range has been a lower range just because we sold off a lot of the credit card and stuff when that number was originally published, but I think as we said last quarter, we're continuing -- confident that we can push the number, given the time and the interest rate environment and over $10 billion a quarter, but it's going to take that normalized interest rate environment and economy growing at 3%. As opposed to the economy growing at 1.5% or 2%, which is what we've been consistently seeing.

[shalab]

Eric is right, U.S household debt levels are at 17 year lows per NYTimes.

 

http://www.nytimes.com/2012/04/20/business/not-exactly-a-miracle-but-us-debt-levels-are-falling.html

 

[CONeal]

If anyone has a question they want asked at the annual meeting for BAC let me know.  I'll do my best to squeeze in a question or two.

 

This is the first time I've ever attended a meeting so looking forward to the experience and to see what actually happens at one.

[redskin]

The key assumption behind the Debt/GDP is crushing conclusion is high interest rates.  High interest rates occur in response to inflation or in the case of foreign debt when the foriegners decide to stop lending.  Given the history of deleveragings in cases where a good portion of the debt is domestically owed (the 1930s/1940s and 1990s/2000s Japan), interest rates are typically low for long periods of time.  In additon, the Fed has studied the Depression and Japan and seen that the only tool it has to fight deflation is easy money.  For the folks who think interest rates will rise, what is your rationale beyond this is what has happened over the last 50 years?   

 

As to inflation, I think we are in a new world were the labor supply will outstrip demand for generations.  If you look at history, labor has gained the upper hand when labor is scarce due to war, famine or epidemic.  Since we have prevented all three and the formally communist world has joined the capitalist world, the labor portion of goods and services will be in abundant supply.  Also if you look at most of the goods and services purchased in developed counrties it has a high labor cost component to it.  This will keep inflation down even if there is input inflation.  This will also reward capital versus labor in most industries.  That is why I am skeptical of the reversion to the mean for profit margins and for interest rates.       

 

Packer

 

My rational for higher interest rates is that fixed income investors will eventually demand a positive real return.  The CPI is currently running at a 2.7% annual rate.  This is with the current oversupply of labor.  An investor in 10yr treasuries at 2% is receiving approximately 1.4% after tax for a real return of -1.3%.  This has lasted for a while and can last for a period of time.  However, I don't believe it is sustainable over the long run.  As Herb Stein said, 'If something can not go on forever, it will stop.'

[PlanMaestro]

Eric is right, U.S household debt levels are at 17 year lows per NYTimes.

 

http://www.nytimes.com/2012/04/20/business/not-exactly-a-miracle-but-us-debt-levels-are-falling.html

 

I think the article makes the point that the debt service is at 17y lows, not the total level, thanks to low interest rates and refinancing.

[ERICOPOLY]

Eric is right, U.S household debt levels are at 17 year lows per NYTimes.

 

http://www.nytimes.com/2012/04/20/business/not-exactly-a-miracle-but-us-debt-levels-are-falling.html

 

I think the article makes the point that the debt service is at 17y lows, not the total level, thanks to low interest rates and refinancing.

 

Better than 17 year lows if you expand a bit beyond merely debt service...

 

But now the situation has turned around. The latest figures, for the final quarter of 2011, show that required debt service payments now make up just 10.9 percent of disposable income, the lowest proportion since 1994. A broader measure — which adds in such obligations as property tax and insurance premiums for homeowners, and rent for those who do not own their homes — has fallen to the lowest level since 1984.

 

[alertmeipp]

Same old same old, savers are saving the borrowers thru ultra-low rate.

[PlanMaestro]

Same old same old, savers are saving the borrowers thru ultra-low rate.

 

Supply and demand. Sometimes you win (1982) sometimes you lose (2012). And even in this case it is not that clear

 

http://krugman.blogs.nytimes.com/2012/04/28/where-the-productivity-went/

[Packer16]

I agree eventually interest rates have to go up but in the 1930s/40s they stayed low for 15 to 20 years and slowly increased to levels lower than inflation until the 1960s/70s.  Financial repression by the central bank is a formadable force and today it is reducing the real level of debt of debtors. 

 

Packer

[mankap]

I think the rates are going to stay low till the time Fed is forced to hike them by inflation rise.Fed can keep .The only constraint that Fed has is inflation.I think Fed strongly believes that inflation cannot increase till the time unemployment is high.So they are not increasing rates till the time unemployment comes down.

[benchmark]

I think the rates are going to stay low till the time Fed is forced to hike them by inflation rise.Fed can keep .The only constraint that Fed has is inflation.I think Fed strongly believes that inflation cannot increase till the time unemployment is high.So they are not increasing rates till the time unemployment comes down.

 

Isn't inflation is already starting? food/gas prices have been creeping up for the last few years, and it will force fed to move

[mankap]

Fed looks at core  PCE and not CPI.Core PCE excludes food and energy prices.Core PCE is 1.9% as per the latest report.PCE is still within Fed's range.Based on PCE Fed is not going to move anytime soon.

[ERICOPOLY]

The BAC class A warrants sold for $3.60 when the stock was at $8 last summer.

 

Nine months later the warrants are 10% higher and the stock is the same price.

 

However the volatility in the options is lower -- the 2014 $10 calls are cheaper than the 2013 $10 calls were at the time (but with a few extra months of time value on them).

 

So... warrants should continue to slide a bit further (relative to the common) is my guess.

 

[racemize]

The BAC class A warrants sold for $3.60 when the stock was at $8 last summer.

 

Nine months later the warrants are 10% higher and the stock is the same price.

 

However the volatility in the options is lower -- the 2014 $10 calls are cheaper than the 2013 $10 calls were at the time (but with a few extra months of time value on them).

 

So... warrants should continue to slide a bit further (relative to the common) is my guess.

 

out of curiosity, are you moving in and out of the A/B warrants and common over time (e.g., to act on analysis like the above) or are you generally holding a mix?

[ERICOPOLY]

The BAC class A warrants sold for $3.60 when the stock was at $8 last summer.

 

Nine months later the warrants are 10% higher and the stock is the same price.

 

However the volatility in the options is lower -- the 2014 $10 calls are cheaper than the 2013 $10 calls were at the time (but with a few extra months of time value on them).

 

So... warrants should continue to slide a bit further (relative to the common) is my guess.

 

out of curiosity, are you moving in and out of the A/B warrants and common over time (e.g., to act on analysis like the above) or are you generally holding a mix?

 

I initially bought them last summer, then changed my mind on them and went an unlevered calls route.  Then as the stock began to recover I bought some common, calls, and some warrants to juice the returns.  Then I sold some common and all warrants and bought AIG.  Then (last two days) I sold the AIG and I sit unlevered once again (in the BAC calls).  But I'm fidgety and I'm watching how the warrants behave.

 

Mostly I'm watching the volatility premium in the calls.  Should it rise enough I can gain a lot of intrinsic value by selling the ones I own and buying an equal amount of underlying shares.  I have some $7 strike that we might soon get down to (or lower) in the common -- depending of course on degree of market panic.

 

As for the options premium already in those calls -- I am chipping away at it by writing MBI puts which have much higher volatility.  Actually, the MBI volatility is off the charts.

 

One other part of the plan is I can move (now that there are no longer any gains in them) my $10 strike 2014 BAC calls out of my taxable account and into my RothIRA account.  That way on the upswing the gains won't get taxed.

[tombgrt]

I've also noticed the warrants being pricey at the moment. If we drop lower (sub $7 would be very nice) I'll change some common for warrants if they correct accordingly. I assume they would do that very fast if we get a fast drop down from here.

[BRK7]

I just got a call from "AST Fund Solutions", apparently a proxy voting/solicitation firm hired by BAC.  My experience is that such firms are hired when either a) there is sensitive proposal in the proxy on which the board wants to reiterate its FOR/AGAINST recommendation, or b) there is some doubt that a quorum will be established, and the company does not want to risk having to incur the expense of another round of voting.

 

But, perhaps this is standard operating procedure for BofA?  Thoughts?

[Grenville]

If anyone has a question they want asked at the annual meeting for BAC let me know.  I'll do my best to squeeze in a question or two.

 

This is the first time I've ever attended a meeting so looking forward to the experience and to see what actually happens at one.

 

Hi Coneal,

 

Sent you a PM with questions. Thanks for asking! I hope you enjoy the meeting.

 

Thanks,

grenville