BAC-WT - Bank of America Warrants

[bmichaud]

This is precisely the type of trap bank investors get caught up in - book value literally does not matter unless the entity is being liquidated. If BAC is to be valued as a going concern, as I assume you are doing, then it must be valued according to its earnings power. Where a bank trades relative to book as a going concern is 100% dependent upon the level of profitability relative to book. So....

 

If WFC earns the mid-point of its 12-15% ROE target, or 13.5%, and it has a cost of equity of 10%, then under a no-growth scenario it should trade at 1.35X book value (.135/.1). Whereas, say BAC eventually earns 10% on book as Berkowitz envisions with a 10% cost of equity, BAC should then trade at 1X book. Under this scenario, WFC at 1.35X book and BAC at 1X book, all things equal, have the EXACT same margin of safety.

 

Right now BAC is not even close to earning 10% on its actual book value, thus it deserves to trade at discount to book - likewise, WFC just earned over 12% on book this quarter.....

 

Damn, you brought out the big guns with cost of capital.  I guess there's not much else to say.  Those calculations are always accurate.

 

I think you need to step back and think about the real world and not a B-school textbook.  You missed my point completely.  You might be right that at 1.35x BV and 1x BV WFC and BAC have the same MOS.  I'd argue that at that point they both have about zero MOS and are fully valued.  But what you are missing is that WFC IS at 1.35x BV and BAC is at 40% BV, not 1x BV.  So given that I read somewhere along the way that price determines MOS, which stock has the higher MOS?    Your other mistake is using current earnings as the sole ingredient for your earnings power analysis.  It would seem as if you are using GAAP earnings in this case as well.  A bank can't properly be valued on that basis. 

 

In the real world, a profitable bank with good assets would not be sold for less than BV.  I have no doubt that someday BAC will be at BV again.  I have no idea when that might be.  Of course the risk is that when that time comes BV may not be where people want it to be.

 

One last thing, I could disagree with you more that BV only matters in liquidation.  It may not be something concrete that you can plug into your fancy models, but it matters.  There isn't a direct correlation between BV and valuation, but as Graham said, it's the difference between the Wall St and the Main St approach.

 

I agree that BAC has a larger margin of safety. I was responding more specifically to what you said here:

 

No profitable bank should ultimately be selling for less than BV.

 

As Buffett noted back in Berkshire's early days, BRK's intrinsic value was less than its book value of $19 because its earnings power was not high enough to warrant a PB ratio of 1.00X.

[hyten1]

Prasd and Kraven,

 

I hear ya, and I agree. I am just raising the short term concern (could it become long term). Where BAC has a larger deposit base than WFC yet their loan growth are negative while others are positive. Doesn't this mean they are bring in less asset relative to their larger deposit base (liability) which result in lower earnings %.

 

from what I read loan grew at jpm, wfc and c while it went down at bac, just raising an concern of my. I guess I should find out why it went down?!

 

Is it because they are losing biz relative to their competitor? if so why did they lose?

Is the cost cutting/reorg distracting from their core lending biz?

Maybe its because they are running off bad loans faster than they are adding good loans?

 

forgive me for my lack of understanding of the banking industry.

 

hy

[Kraven]

Prasd and Kraven,

 

I hear ya, and I agree. I am just raising the short term concern (could it become long term). Where BAC has a larger deposit base than WFC yet their loan growth are negative while others are positive. Doesn't this mean they are bring in less asset relative to their larger deposit base (liability) which result in lower earnings %.

 

from what I read loan grew at jpm, wfc and c while it went down at bac, just raising an concern of my. I guess I should find out why it went down?!

 

Is it because they are losing biz relative to their competitor? if so why did they lose?

Is the cost cutting/reorg distracting from their core lending biz?

Maybe its because they are running off bad loans faster than they are adding good loans?

 

forgive me for my lack of understanding of the banking industry.

 

hy

 

If this was 2006, I'd be worried if loan growth at some of the other money center banks outpaced BAC, all things considered and everything else being equal.  These are different times though and the banks are in different places.  BAC is trying to climb out of a hole while some of the others have either climbed out or never got that deep to begin with.  It's not an apples to apples comparison.  BAC is focusing on getting leaner, disposing of non-core assets, raising capital, etc. 

 

My personal view is that in this case it really doesn't matter what the other money center banks are doing, at least as it currently stands.  BAC needs to right itself and it's in the process of doing so.  Like generals fighting the last war, investors are always fighting the last downturn, the last problem.  BAC seems to me to be doing a bang up job getting itself in fighting shape.  It would be impossible to understand though on a granular level what exactly they are doing.  Others disagree and I don't envy them plodding through the hundreds of pages of Ks and Qs attempting to make sense of it all.  It's more simple than that.

 

Earning power will eventually be determinative of value (yes, I've read Buffett's statements to that effect, the same as everyone else on this board), but earning power for a bank isn't determined by GAAP earnings.  Also, it depends on your goal in investing.  If you want to buy a bank and hold it for eternity or your death, whichever is later, then sure go for WFC or something.  But those who think WFC is worth 2-3x BV are in my opinion bonkers.  Banks are so fungible.  Money is money.  People don't seem to believe it.  WFC has no secret sauce.  Those who have been out in the real world and worked with banks and businesses understand that.  If someone needs financing, sure, they might prefer someone at one bank over another, but not at the cost of pricing.  They may pay slightly (ever so slightly) more to work with one over another, but nothing material.  Want a mortgage?  If WFC is at 6% and BAC is at 5% who gets the business?  It all comes down to the dollars.  If it's a transaction, it comes down to how much the bankers will charge and execution.  Execution is always first (or should be anyway), but no one will pay too much.  Honestly, there isn't enough business to go around anyway for bankers to charge more than every other bank would charge for most things.

 

So maybe in 5 or 10 years, WFC will be worth 2x BV and BAC 1.5x BV (making this up).  Where are you going to make more money in that scenario?  Some will shout but wait!  WFC is going to be a compounding machine!  Once BAC gets going, so will it.  At the end of the day, if BAC goes down, other banks aren't going to be sitting there drinking pina coladas by the poolside.

[PlanMaestro]

Bank of America, and Wells Fargo for that matter, is earning much more than its cost of capital. You are just not looking at the right place.

[hyten1]

Kraven

 

i agree with your general comment, however your statement of "If WFC is at 6% and BAC is at 5% who gets the business?" in my opinion are quite true. Yes it is true if bank A gives me 6% and bank B give me 5% I will definitely go with bank B.

 

But how likely is that to happen? Either bank B's cost is so much lower than Bank A's or Bank B is out to lose money.

 

I actually what you just said supports why buffett likes WFC so much. This is all base on what I read I have not did into the numbers myself.

 

If bank B's cost of capital is ever so slightly lower than the rest, they have the competitive advantage. Not because they can charge less but because they can charge the same and make more money.

 

Any way, i'm getting off on an tangent. I guess I am concern of the timing and the amount of effort and time it takes to right BAC's ship so that it can get back to normal banking biz. Will this take 2 years or 5 years. And the longer this takes the more chance BAC's competitors can hurt BAC.

 

I guess all this doesn't matter if the time frame is long enough.

 

hy

 

 

[xazp]

So maybe in 5 or 10 years, WFC will be worth 2x BV and BAC 1.5x BV (making this up).  Where are you going to make more money in that scenario?  Some will shout but wait!  WFC is going to be a compounding machine!  Once BAC gets going, so will it.  At the end of the day, if BAC goes down, other banks aren't going to be sitting there drinking pina coladas by the poolside.

 

Actually, in the not-too-distant future BAC is going to be compounding BV/TBV faster than WFC. 

 

BAC has (tens of) billions of dollars in "dead weight" capital.  By this, I mean assets that have a zero or negative economic return.  For example, a delinquent, under-water mortgage holds a lot of capital, and the returns on that capital are negative (foreclosure costs, asset write-downs & time).  DTAs are a large piece of capital that effectively doesn't contribute to earnings, except as they are used.  BAC has an out-sized amount of capital tied up in those two categories, and that's why you see ROE and ROA's well behind their competitors. 

 

These large, zero/negative pieces of capital are slowly being liquidated.  And the cash, starting next year, is going to be used to buy back shares (I think).  And share buybacks are, in my opinion, the best use of capital there is.  It's a direct way to compound tangible book, since you're buying at a 40% discount. 

 

In effect, they will turn something that is currently generating a -15% ROE, into something that immediately produces a very high return, from the perspective of their book.  As long as BAC's share price remains well below TBV, their ability to compound TBV/share exceeds WFC's when they buy back stock. 

 

And that's why I think it's good news they're shrinking their loan book and raising capital.  It's a much better investment to buy their own shares than to lend someone a 4% mortgage.  This is going to start in 2013, and IMO will continue until BAC trades near TBV.  That is also incidentally why I think TBV is a good way to value the company over the long term. 

 

 

[finetrader]

long term I think BAC is a win at this price.

 

I remember seeing an interview with Moynihan this winter or last fall where he said that it is going to take 2012 and 2013 to completely process the bad stuff (legacy mortgages).

 

So I will probably play this with equity and warrants. No more leaps.

 

As for NIN, what if 10year bond interest rate rise to 2% in the next quarter? Does that mean that BAC's profitability would suddenly increase by 5b$/year? To extrapolate current NIN is for short term thinkers.  But I agree that an upward slope yield curve would solve a lot of problems, not just for BofA. And the problem is no one knows when it is gonna come back.

[Parsad]

Prasd and Kraven,

 

I hear ya, and I agree. I am just raising the short term concern (could it become long term). Where BAC has a larger deposit base than WFC yet their loan growth are negative while others are positive. Doesn't this mean they are bring in less asset relative to their larger deposit base (liability) which result in lower earnings %.

 

from what I read loan grew at jpm, wfc and c while it went down at bac, just raising an concern of my. I guess I should find out why it went down?!

 

Is it because they are losing biz relative to their competitor? if so why did they lose?

Is the cost cutting/reorg distracting from their core lending biz?

Maybe its because they are running off bad loans faster than they are adding good loans?

 

forgive me for my lack of understanding of the banking industry.

 

hy

 

No, I think it's an actual decision to shrink the business.  What is the point of growing the loan portfolio considerably when spreads are narrowing?  It could come back to haunt their competition if short-term rates start to rise quickly.  You should write business...be it insurance premium or loan contracts...only when the business provides a commensurate reward for the underlying risk.  I think BAC is choosing to partly write less loan business and give up some ROE, simply to write better business in the future.  Everything at BAC is now about risk control...be it in the balance sheet, the loan portfolio, the investment composition, etc.  Build it for the long-term, not five years out.  Cheers!

[Rabbitisrich]

Good article on banking, and a neat explanation for why bulls focus on liabilities over shrinking margins and weak revenues: http://www.interfluidity.com/v2/3422.html

 

Banks’ advantage in earning an interest rate spread comes ultimately not from anything special about their portfolio of assets, but from what is special about their liabilities. Banks pay no interest at all or very low interest rates on a significant fraction of their liabilities, low-balance checkable demand deposits. The class of bank creditors called “depositors” accepts these low rates because 1) they deem the bank to be highly creditworthy, and so don’t demand a credit spread; and 2) they gain an in-kind liquidity benefit because “bank deposits” serve as near perfect substitutes for money. To me, a bank is any entity that can issue liabilities that are widely accepted as near-perfect substitutes for whatever trades as money despite being highly levered. Bill Gates can issue liabilities that will be accepted as near-perfect substitutes for money, but Gates is not a bank: his liabilities are viewed as creditworthy precisely because he is rich.

[nkp007]

Just wanted to add...I ain't afraid.

 

The data from BAC is overall getting much better. Let them keep building capital. No one wants to litigate against them forever.

 

Better loans, higher capital levels, and a strengthening U.S. housing market.

[Green King]

Bank of America, and Wells Fargo for that matter, is earning much more than its cost of capital. You are just not looking at the right place.

 

Where am i suppose to be looking ? please explain.

[Uccmal]

Bank of America, and Wells Fargo for that matter, is earning much more than its cost of capital. You are just not looking at the right place.

 

Where am i suppose to be looking ? please explain.

 

Yes, Plan.... I second that.

 

Awesome thread BTW, to all.  I am flying all day Sunday so plan to catch up on the earnings release.  This thread shows me alot of different ways to look at things. 

[hardincap]

xasp what are your thoughts on warrants vs stock vs leaps?

 

i initiated a position in warrants in q3/4 '11 but ive been pretty surprised with how quickly bac's top line has fallen over the past year with all the macro headwinds and regulations. im contemplating switching over to stock to be able to sleep a bit better at night.

[alertmeipp]

Not a bad quarter. Obviously the primary goal is still to build capital and move the insolvent or equity raise question out of everyone's mind.

 

Notice no one is talking about those anymore. Just a short few quarters ago, the debate was on whether BAC has enough equity to stand the legacy issues.  Now, the discussion is on earning power - how nice.

 

 

[moore_capital54]

Not a bad quarter. Obviously the primary goal is still to build capital and move the insolvent or equity raise question out of everyone's mind.

 

Notice no one is talking about those anymore. Just a short few quarters ago, the debate was on whether BAC has enough equity to stand the legacy issues.  Now, the discussion is on earning power - how nice.

 

Fantastic point!

[MrB]

Not a bad quarter. Obviously the primary goal is still to build capital and move the insolvent or equity raise question out of everyone's mind.

 

Notice no one is talking about those anymore. Just a short few quarters ago, the debate was on whether BAC has enough equity to stand the legacy issues.  Now, the discussion is on earning power - how nice.

 

Fantastic point!

 

Agree. It is the capital stupid; as Blankflein more or less says at the 33min mark  http://www.bloomberg.com/video/lloyd-blankfein-on-u-s-economy-regulation-libor-y2uG66yeRh6eZWpxcKsJ~Q.html

[berkshiremystery]

BofA visual overview until 1961 in the "SRC Green Book of 50 Years" (at page 7).

http://www.srcstockcharts.com/wp-content/uploads/digital-prods/Dow30-50YearCharts.pdf

 

Specially around the mid 1970's the BAC share price takes a big dive in 1974, from around $5 to $1 (-80%). From there it slowly grows/doubles again from $1 to around $2 (+100%) over some period of 7-8 years,... it goes almost sideways. But then in the early 1980's BofA starts to rise like Peter Lynch type of multi-bagger-rocket til the millennium.

[jeffmori7]

And the share price is going back to where it was at the beginning of the year...as if the balance sheet wasn't improving at all...

 

Maybe I'll buy more if to goes down again.

[xazp]

xasp what are your thoughts on warrants vs stock vs leaps?

 

i initiated a position in warrants in q3/4 '11 but ive been pretty surprised with how quickly bac's top line has fallen over the past year with all the macro headwinds and regulations. im contemplating switching over to stock to be able to sleep a bit better at night.

 

No real opinion - it's beyond my circle of competence.  BAC common is volatile enough for my tastes :P. 

[MrB]

Does anyone have a long term chart for P/BV ratios for the banks covering the 1970's?

 

Food for thought:

1. http://cep.lse.ac.uk/conference_papers/14_07_2010/haldane.pdf

Slides 18-24

See BofA on Chart 30

 

2. https://global.vanguard.com/international/web/pdfs/pzena_2Q08.pdf

Slides 6,7,9,10,12,13 (NB),14

 

3.  http://harr123et.files.wordpress.com/2010/07/fof_allslides.pdf

Pages 1 (see first chart and note the massive deleverage; now compare it with the performance of the banks in the attached spreadsheet), Slide 194

 

4. http://personal.fidelity.com/products/funds/content/pdf/2011_market_update_q4.pdf

Slides 22,23,31,32,33, 50 (look what happened in the early 30's and 70's. Very possible average PE ratio gets to 10 and under for 5 years. Are you ready for that?), 51 (Do you expect inflation at some point? What is the impact of inflation on PE ratios?)

 

5.https://www.fidelity.com/bin-public/060_www_fidelity_com/documents/Q1-2012%20Market%20Update%20FA.pdf

Slides 8, 9 (I have recently seen research that says the opposite - lending attitude is turning up), 15 (time to focus on housing and BofA is one way of playing it), slide 53 (Equities ain't popular, that's for sure)

 

6. http://www.scribd.com/doc/48754209/Bank-Primer

Exhibit 29

 

7. http://www.henderson-conference.com/pdfs/BillMcQuaker.pdf

Slides 9 (still under 1 year), 13

 

8. http://www.dorsey.com/files/upload/MP_CCS09_insolvency_restructuring_updated_powerpoint.pdf

 

Slides 5 (the note on USbank puts BofA's franchise in perspective)

1929Banks.xlsx

[bmichaud]

Page 19 of the Vanguard document us a beaut.....

 

https://global.vanguard.com/international/web/pdfs/pzena_2Q08.pdf

 

Portfolio additions: WaMu, BAC, LEH, Wachovia

 

 

Page 22 of this document, http://cep.lse.ac.uk/conference_papers/14_07_2010/haldane.pdf, is pretty telling about the health of the banks during the Great Depression versus now....capital ratios much higher.

[Packer16]

The LT perspective on BoA via the chart is interesting but the bank in the 1970s (Nationsbank) is a different animal than BoA today.  BoA today is probably more like JP Morgan in the 1970s.

 

Packer

[bmichaud]

Interesting comment in here about FDR forcing Depression era banks to fully disclose what was on their balance sheets....

 

http://www.telegraph.co.uk/finance/comment/liamhalligan/9417866/Is-the-US-losing-patience-with-the-eurozone-debacle.html

[obtuse_investor]

xasp what are your thoughts on warrants vs stock vs leaps?

 

i initiated a position in warrants in q3/4 '11 but ive been pretty surprised with how quickly bac's top line has fallen over the past year with all the macro headwinds and regulations. im contemplating switching over to stock to be able to sleep a bit better at night.

 

With all the short term oriented discussion in the media, it is very easy to forget that BAC warrants aren't ordinary warrants. They have a very long expiration date.

 

For example, the A warrants still have 6.49 years remaining. That is, 6 years, 5 months and 25 days. That is 2,369 days!

 

That is an eternity for Mr Market. That is unfathomable for the myopic Mr. Market!

 

It isn't easy to beat the market. The best way to beat anyone is to know your competitive advantage and take full advantage of it.

 

In this case, your competitive advantage is long term view.

 

BAC commons will likely do just fine. But the warrants will likely provide a huge bonanza by their maturity date.

[Packer16]

At this point, the warrants have such a high time premium there is actually negative leverage versus to the stock up to for example 15.  So if the stock goes to 15, the common is up 112% and warrants would only be up 91%.  I calculated the warrant price at 15 based upon a 3.9% borrowing rate on the $13.3 strike price plus the intrinsic value.  This is the borrowing rate of the slightly in the money GM warrants today.  So one stratgey is to hold the stock until the stock price approaches the strike price then switch to the warrants (assuming the IV is significantly greater than the strike price).

 

Packer