BAC-WT - Bank of America Warrants

[Parsad]

One thing that I am interested in is the interest rate risk of BAC (and all banks).  What if you have a large shift in interest rates?  Deposit funding becomes much more expensive and you have a lot of long term loans on your books.  Couldn't that severely hamper earnings power?

 

Yes, in the short-term.  But like insurance, you are constantly running off older business and writing new business at the higher rates.  So, it is a wash in the long-term as long as you stick to the basics and write good business, don't become overleveraged, and avoid stupid, greedy blowups.  Cheers!

 

I agree, but I think that a shock in rates (e.g. the 10 year goes to 5%) could be very problematic and potentially catastrophic to certain banks.  When people are allowing for a more favorable interest rate environment in their analysis of the intermediate term, I am not sure how the bank can get there.

 

Also, in terms of run-off, I think that people need to remember there is an embedded option in a lot of loans.  If rates go up, it is more likely you will retain your low rate loans.

 

If anyone has any experience working at banks, I'd love to hear how the manage interest rate risk and if they know what banks are better or worse at it.

 

Rates in themselves won't have an effect.  It will depend entirely on where along the duration the interest rates hit the most.  As long as spreads stay relatively stable...deposit rates rise 1%, while long-term rates rise 1%...then banks will have little difficulty adjusting.  Problems can happen if you have short-term rates rise dramatically...currency shock, inflation...while long-term rates rise less.  Historically, spreads today have narrowed to historical lows.  They were widest in 2008 after the Fed started pummeling rates, but they have narrowed dramatically since then.  So, it is unlikely that interest rate increases could narrow the spread any more than they have.  Cheers!

[Kraven]

As long as a bank can provide basic savings, lending, business services and investments, with the innate leverage they have, they can return 12-15% ROE for decades, while returning the bulk of that capital back in dividends, share buybacks or expanding their business. 

 

Sanjeev, I sure hope you're right.  Given elevated capital levels and reduced leverage, I tend to think that going forward performance will be more along the lines of say 0.80% ROA and 8-10% ROEs in general with banks trading in the 1-1.5x TBV range.  Obviously stronger numbers will warrant a higher multiple of tangible book.  Even with those numbers, based on current levels it's still around $1.60-2 a share in earning power.

[racemize]

As long as a bank can provide basic savings, lending, business services and investments, with the innate leverage they have, they can return 12-15% ROE for decades, while returning the bulk of that capital back in dividends, share buybacks or expanding their business. 

 

Sanjeev, I sure hope you're right.  Given elevated capital levels and reduced leverage, I tend to think that going forward performance will be more along the lines of say 0.80% ROA and 8-10% ROEs in general with banks trading in the 1-1.5x TBV range.  Obviously stronger numbers will warrant a higher multiple of tangible book.  Even with those numbers, based on current levels it's still around $1.60-2 a share in earning power.

 

Isn't WFC doing better than that with these capital levels and reduced leverage?  I tend to think it will be less than 15% ROE though for the same reasons.

[Parsad]

As long as a bank can provide basic savings, lending, business services and investments, with the innate leverage they have, they can return 12-15% ROE for decades, while returning the bulk of that capital back in dividends, share buybacks or expanding their business. 

 

Sanjeev, I sure hope you're right.  Given elevated capital levels and reduced leverage, I tend to think that going forward performance will be more along the lines of say 0.80% ROA and 8-10% ROEs in general with banks trading in the 1-1.5x TBV range.  Obviously stronger numbers will warrant a higher multiple of tangible book.  Even with those numbers, based on current levels it's still around $1.60-2 a share in earning power.

 

I think 1% ROA is the worst case scenario for the large, well-capitalized banks not taking unnecessary risks.  Legacy issues may interfere in the short-term, but as they get dealt with 1% is not going to be difficult at all with the cost-cutting most banks have done, and the type of business they are writing, as well as the credit quality of the borrowers.  Cheers!

[Parsad]

As long as a bank can provide basic savings, lending, business services and investments, with the innate leverage they have, they can return 12-15% ROE for decades, while returning the bulk of that capital back in dividends, share buybacks or expanding their business. 

 

Sanjeev, I sure hope you're right.  Given elevated capital levels and reduced leverage, I tend to think that going forward performance will be more along the lines of say 0.80% ROA and 8-10% ROEs in general with banks trading in the 1-1.5x TBV range.  Obviously stronger numbers will warrant a higher multiple of tangible book.  Even with those numbers, based on current levels it's still around $1.60-2 a share in earning power.

 

Also, remember we are at historical lows on spreads.  Over time, spreads will trend closer back to the median.  Conservatively, if banks return 1.5% on assets long-term, and you have 9 times leverage, you are looking at 13.5% ROE.  15% would be on the high side, but banks with low funding costs like WFC would be on that 15% side, and the other large-cap U.S. banks would be around 12.5-14% ROE.  Cheers!

[jay21]

 

Rates in themselves won't have an effect.  It will depend entirely on where along the duration the interest rates hit the most.  As long as spreads stay relatively stable...deposit rates rise 1%, while long-term rates rise 1%...then banks will have little difficulty adjusting.  Problems can happen if you have short-term rates rise dramatically...currency shock, inflation...while long-term rates rise less.  Historically, spreads today have narrowed to historical lows.  They were widest in 2008 after the Fed started pummeling rates, but they have narrowed dramatically since then.  So, it is unlikely that interest rate increases could narrow the spread any more than they have.  Cheers!

 

I disagree.  If you fund all your mortgages through deposits, then you are funding long term assets with short term liabilities.  If rates increased equally across the board and spreads stay the same, the cost of all of your deposits will increase whereas only the new loans that you write at the new rates will increase interest income.  That should cause a drag on profitability unless you are properly hedged. 

 

 

[vinod1]

Sanjeev, I sure hope you're right.  Given elevated capital levels and reduced leverage, I tend to think that going forward performance will be more along the lines of say 0.80% ROA and 8-10% ROEs in general with banks trading in the 1-1.5x TBV range.  Obviously stronger numbers will warrant a higher multiple of tangible book.  Even with those numbers, based on current levels it's still around $1.60-2 a share in earning power.

 

As Parsad already mentioned one offset to reduced leverage and reduction in revenue sources is lower costs. Many of the banks like Citigroup and Bank of America never really integrated all the acquisitions they made since it was so easy to make money in the last several years leading to 2008. I work at one of the larger US banks and prior to 2008 we never really had a focus on reducing expenses. In fact the problem used to be one of how to manage profitability so you are not showing too much in profits in a given year to show smooth growth in earnings. Now our #1 focus is cost control and I there is still a lot of fat that could be cut easily. I suspect this might be a general problem with lot of the banks.

 

Vinod

[vinod1]

 

Rates in themselves won't have an effect.  It will depend entirely on where along the duration the interest rates hit the most.  As long as spreads stay relatively stable...deposit rates rise 1%, while long-term rates rise 1%...then banks will have little difficulty adjusting.  Problems can happen if you have short-term rates rise dramatically...currency shock, inflation...while long-term rates rise less.  Historically, spreads today have narrowed to historical lows.  They were widest in 2008 after the Fed started pummeling rates, but they have narrowed dramatically since then.  So, it is unlikely that interest rate increases could narrow the spread any more than they have.  Cheers!

 

I disagree.  If you fund all your mortgages through deposits, then you are funding long term assets with short term liabilities.  If rates increased equally across the board and spreads stay the same, the cost of all of your deposits will increase whereas only the new loans that you write at the new rates will increase interest income.  That should cause a drag on profitability unless you are properly hedged.

 

I think Fed would communicate the intention to raise rates well in advance so that the banks can prepare for it. I think they learned this lesson in 1994 and given the state of banks and what they have gone through recently Fed would telegraph their intentions at least as long as Ben Bernanke is at the helm.

 

Vinod

[Kraven]

As long as a bank can provide basic savings, lending, business services and investments, with the innate leverage they have, they can return 12-15% ROE for decades, while returning the bulk of that capital back in dividends, share buybacks or expanding their business. 

 

Sanjeev, I sure hope you're right.  Given elevated capital levels and reduced leverage, I tend to think that going forward performance will be more along the lines of say 0.80% ROA and 8-10% ROEs in general with banks trading in the 1-1.5x TBV range.  Obviously stronger numbers will warrant a higher multiple of tangible book.  Even with those numbers, based on current levels it's still around $1.60-2 a share in earning power.

 

Also, remember we are at historical lows on spreads.  Over time, spreads will trend closer back to the median.  Conservatively, if banks return 1.5% on assets long-term, and you have 9 times leverage, you are looking at 13.5% ROE.  15% would be on the high side, but banks with low funding costs like WFC would be on that 15% side, and the other large-cap U.S. banks would be around 12.5-14% ROE.  Cheers!

 

I tend to be a little more pessimistic on this issue, but hope you're right of course.

[Kraven]

Sanjeev, I sure hope you're right.  Given elevated capital levels and reduced leverage, I tend to think that going forward performance will be more along the lines of say 0.80% ROA and 8-10% ROEs in general with banks trading in the 1-1.5x TBV range.  Obviously stronger numbers will warrant a higher multiple of tangible book.  Even with those numbers, based on current levels it's still around $1.60-2 a share in earning power.

 

As Parsad already mentioned one offset to reduced leverage and reduction in revenue sources is lower costs. Many of the banks like Citigroup and Bank of America never really integrated all the acquisitions they made since it was so easy to make money in the last several years leading to 2008. I work at one of the larger US banks and prior to 2008 we never really had a focus on reducing expenses. In fact the problem used to be one of how to manage profitability so you are not showing too much in profits in a given year to show smooth growth in earnings. Now our #1 focus is cost control and I there is still a lot of fat that could be cut easily. I suspect this might be a general problem with lot of the banks.

 

Vinod

 

Vinod, that is a very fair point.  However, expenses and fat can only be trimmed so much.  The large institutions never get it right.  They either overshoot (and thus are caught flat footed when the market eventually recovers) or they undershoot and thus the problem raises its head again.  However, I do hope you're right.

[Parsad]

 

Rates in themselves won't have an effect.  It will depend entirely on where along the duration the interest rates hit the most.  As long as spreads stay relatively stable...deposit rates rise 1%, while long-term rates rise 1%...then banks will have little difficulty adjusting.  Problems can happen if you have short-term rates rise dramatically...currency shock, inflation...while long-term rates rise less.  Historically, spreads today have narrowed to historical lows.  They were widest in 2008 after the Fed started pummeling rates, but they have narrowed dramatically since then.  So, it is unlikely that interest rate increases could narrow the spread any more than they have.  Cheers!

 

I disagree.  If you fund all your mortgages through deposits, then you are funding long term assets with short term liabilities.  If rates increased equally across the board and spreads stay the same, the cost of all of your deposits will increase whereas only the new loans that you write at the new rates will increase interest income.  That should cause a drag on profitability unless you are properly hedged.

 

I didn't say that it would have no effect in the short-term.  Bank of America has paid off nearly $200B in long-term debt over 2 years, and funded their business through lower cost short-term Fed funding and deposits.  There is no reason why they couldn't adjust over the other way if rates are better on long-term debt.  So, I don't see it as a significant long-term problem.  Cheers! 

[ShahKhezri]

The more I think about it, the more erroneous the mkt cap discussion is. Say BAC comes out Monday and says it grossly overestimated the time it will take to cut its expense base, and this weekend it cut $17B of expenses via a combination of layoffs, settlements and a sale of delinquent loans. So Monday morning the market would immediately reset BAC's share price according to the new earning power to say $18 per share. BAC trades about 200mm shares on high volume days, or just under 2% of fully diluted shares....so say in the first 10 minutes Monday morning BAC trades its typical volume (I.e. 200mm shares) and the new share price is $18...that's $3.6B of traded value ($18 pps x 200mm shares). So over night BAC's mkt cap goes from 100B to 200B with a mere $3.6B of actual call it "new capital" (I don't know what to call it...).

 

I'm rambling, but I guess what I'm trying to say is that a company's market cap is merely price times shares out, and it's not like $300B of new capital needs to come flooding in in order to drive up BAC's mkt cap. It's merely the market's perception of the underlying earning power that determines the share price. It's our job to determine the sustainability of those earnings.....so RIMM's giant mkt cap in 2007 was based on a wildly false perception of RIMM's core underlying earning power, yet the market still bid up the paper value of the company to absurd heights.

 

Again, sorry to ramble - clumsily trying to say that the mkt cap is merely coincidental to the legitimacy of the underlying earning power, and a no-growth PE should be at a minimum 8x if not 10x, if the market adheres to traditional cost of equity practices.

 

You are correct.  And remember, a well-run bank will always have a better moat and greater longevity than most technology companies.  Apple has to constantly reinvent itself and create a better product. 

 

In banking, the deposit base is relatively captive, as most people hate to switch banks, checking accounts, credit cards, etc.  As long as a bank can provide basic savings, lending, business services and investments, with the innate leverage they have, they can return 12-15% ROE for decades, while returning the bulk of that capital back in dividends, share buybacks or expanding their business.  Banking is simple, executives complicate it with their grandiose ideas.  And BAC as you know has the best deposit base in the world. 

 

As long as they keep it simple, and Moynihan sure is walking the talk, BAC will prove to be a good investment for many years.  I don't know what will happen after Moynihan, but as long as he is there, I think the culture has completely shifted and he won't forget these lean years.  Cheers!

 

I think Moynihan will stay at least for another 5-7 years, he's 52.  Ken Lewis retired 3 years before BAC's mandatory retirement age of 65.  BAC A's with 5-7 years of Moynihan look good if he sticks to 1/3, 1/3, 1/3.

[HJ]

I think Fed would communicate the intention to raise rates well in advance so that the banks can prepare for it. I think they learned this lesson in 1994 and given the state of banks and what they have gone through recently Fed would telegraph their intentions at least as long as Ben Bernanke is at the helm.

 

Vinod

 

But is 1994 the right precedent to look at?  We are definitely not there yet, but at some point, should we be thinking 1979-1982,  when the yield curve inverts?  Can't imagine many banks running 1.5% ROA back then, including Norwest, the predecessor of Wells Fargo.  If mortgage lending, the largest asset item on most bank's balance sheet, over time gets set to 3% coupon, it doesn't take 18% over night Fed Funds rates to wipe out the profitability of any banks.  The speed with which you can adjust balance sheet in that environment, will also be somewhat suspect, due to the famous negative convexity of the 30 year prepayable mortgages.  You could be in the trenches fighting that for several years.  Even though it doesn't seem like we'll be there anytime soon, that's a scenario that is dangling out there.

 

http://www.advisorperspectives.com/dshort/charts/yields/perspective.html?yields/treasuries-FFR-since-1962.gif

 

 

[ERICOPOLY]

and a no-growth PE should be at a minimum 8x if not 10x, if the market adheres to traditional cost of equity practices.

 

The reason why no-growth PE are never 8x over the very long term for a business in which all earnings can be paid out is a mathematical reason.

 

12.5% compounding to infinity as long as the bank remains conservatively managed to survive recessions.

 

10% to infinity is also pretty damn generous for the market if BAC is indeed a low-risk bank conservatively managed.

 

Thus, I believe when confidence is restored it trades for more than 10x in 6 years.  Maybe 12x.  At 12x the money compounds at 8.33% to infinity.

 

But I keep it conservative at 10x normally for discussion to keep people from calling me unrealistic.

 

[bmichaud]

and a no-growth PE should be at a minimum 8x if not 10x, if the market adheres to traditional cost of equity practices.

 

The reason why no-growth PE are never 8x over the very long term for a business in which all earnings can be paid out is a mathematical reason.

 

12.5% compounding to infinity as long as the bank remains conservatively managed to survive recessions..

 

Sorry I didn't follow - are you saying the no growth PE is typically 10x versus 8x?   

 

I tend to think the traditional cost of equity is 10%, especially if BAC can continue to de-risk over the next several years. But I was throwing out 8x in case some want to be more conservative and use a 12.5% cost as you point out...

[ERICOPOLY]

and a no-growth PE should be at a minimum 8x if not 10x, if the market adheres to traditional cost of equity practices.

 

The reason why no-growth PE are never 8x over the very long term for a business in which all earnings can be paid out is a mathematical reason.

 

12.5% compounding to infinity as long as the bank remains conservatively managed to survive recessions..

 

Sorry I didn't follow - are you saying the no growth PE is typically 10x versus 8x?   

 

I tend to think the traditional cost of equity is 10%, especially if BAC can continue to de-risk over the next several years. But I was throwing out 8x in case some want to be more conservative and use a 12.5% cost as you point out...

 

I added more comments to my prior post after coming back from a walk.

 

If BAC is really going to be a highly regarded, conservative, well run bank, then I'll happily compound my Roth IRA for 12.5% to infinity if they pay out all earnings as dividends/buybacks and stock keeps on trading at 8y x.

 

That's why I'm saying 8x is not really conservative, it's totally unrealistic for a long term valuation of a well run conservative highly diversified bank like BAC.

 

I'm not trying to beat you up, just saying don't get way too conservative here in choosing a very improbable outcome.  But certainly for short period of time banks can trade at 8x.  We see that all the time recently.

[bmichaud]

Ok I get it now. Trust me we're on the same page. I think in five years it trades at 12.5x to 15x. But of course you come up with silly price targets with those multiples that nobody believes. Once it hits 10x $1.88 EPS with a 5% dividend yield at FYE 2015, then I'll start talking about 12.5 to 15x FV PEs.... 

 

Edit: Should have said "6.7% payout yield" versus "5% dividend yield."

[Uccmal]

Ultimately, Market cap is irrelevant to what we as investors want assumming you hold common or a proxy such as the warrants.

 

Whether they pay dividends, buy back shares, or keep the cash on the balance sheet, the shareholders get the capital (sort of in the last scenario).

 

As to the taxation argument: It strikes me the warrants are taxable based on their adjusted purchase price as capital gains (certainly in Canada where income trust taxation makes a good guide).  If they expire out of the money they would be a taxable loss based on the purchase price- small consolation as you would lose the dividends.  Given, I figure the latter is highly unlikely, you are probably looking at capital gains.

 

For my money the combination of buybacks and dividends will give the greatest bang.  Both put off the "too big market cap" argument for awhile. 

 

[ERICOPOLY]

I could have expressed this better:

My pessimistic case would be putting a 5x multiple on earning at the terminal value due to a market crash, and assigning only $1.50 (relative to current share count) of average capital return each year.  That only gets me a 1.5x return on the warrants.

 

When I'm saying $1.50 per share average year capital return, I meant it relative to their "basic earnings power".

 

So if we're talking about a company that in the end will be making a 15% (basic earnings power) return on tangible book value, then $1 of capital returned when the stock is trading at tangible book value will be just as good as $1.50 worth of capital returned when the stock is trading for 1.5x tangible book value.

 

So we could have several years of depressed capital return only averaging $1 per share, but as long as the stock is also depressed (trading for tangible book value) then I'm still getting the $1.50 per year that I need in order to make a 50% return on the warrants, as long as the stock is trading for at least 74% of tangible book value at expiration (it's depressed due to a market crash)..

 

The only optimistic part of this scenario is the idea that the company is capable of earning 15% return on tangible common equity.  Against that optimism I've applied a lot of stress, like a stock trading at 5x earnings (.74x tangile book value) and a very rocky road over the next 6 years (only paying out $1 a year is pretty harsh relative to our expectations).

 

 

 

 

 

 

 

 

[RichardGibbons]

If BAC is really going to be a highly regarded, conservative, well run bank, then I'll happily compound my Roth IRA for 12.5% to infinity if they pay out all earnings as dividends/buybacks and stock keeps on trading at 8y x.

 

That's why I'm saying 8x is not really conservative, it's totally unrealistic for a long term valuation of a well run conservative highly diversified bank like BAC.

 

I think that the assumption that BAC will be run conservatively indefinitely is aggressive.  Banks seem to have a crisis every 15-20 years.  That said, I don't think it's unreasonable to believe that in 10 years others will believe that banks are conservative, so maybe that's close enough.  :)

 

(Not that I'm bearish -- I'm long BAC.  I just worry about analysis that assumes earthquakes won't happen in California.)

[ERICOPOLY]

If BAC is really going to be a highly regarded, conservative, well run bank, then I'll happily compound my Roth IRA for 12.5% to infinity if they pay out all earnings as dividends/buybacks and stock keeps on trading at 8y x.

 

That's why I'm saying 8x is not really conservative, it's totally unrealistic for a long term valuation of a well run conservative highly diversified bank like BAC.

 

I think that the assumption that BAC will be run conservatively indefinitely is aggressive.  Banks seem to have a crisis every 15-20 years.  That said, I don't think it's unreasonable to believe that in 10 years others will believe that banks are conservative, so maybe that's close enough.  :)

 

(Not that I'm bearish -- I'm long BAC.  I just worry about analysis that assumes earthquakes won't happen in California.)

 

I totally understand your point. 

 

I tend to try to make points with reductio ad adsurdum logic just because I get bored of being more plain.

 

So my "to infinity" is basically to be taken with a grain of salt.

 

It's just that I have an undergraduate math degree and this limit stuff from calculus is pretty much embedded in my everyday thinking.

 

The idea behind my logic is that the market won't just give away 12.5% compounding forever as long as the management is highly trusted and conservative.  So therefore I see 8x P/E as pretty damn unlikely over the lifetime of the Moynihan tenure (unless he changes his stripes).

[ERICOPOLY]

Another upgrade, but what does it mean for a stock to be "underowned"?  All of the shares are owned.  Where did this term come from?

 

It's like saying that other silly statement "people are pulling money out of bonds and putting them into stocks", Wall Street is a place where logical reasoning goes to die (at least in some of the phrases tossed around it seems that way).

 

 

Meeting the full Basel III requirement "should allow for the company to ask for and receive approval for a dividend increase during the upcoming [2012 Federal Reserve stress test] process, which could improve overall investor sentiment on a name that we believe is under-owned relative to other large cap banks," Mutascio said.

 

http://www.thestreet.com/story/11770961/2/bank-of-america-will-cut-to-hit-earnings-analyst.html

 

 

 

[Cardboard]

Uccmal or others,

 

How would you calculate the capital gain for the CRA on warrants adjustment terms before selling these warrants? Say the warrants are now exercisable for 1.2 shares vs 1 and that the exercise price is now dropped to $13 vs $13.30. Just an hypothetical scenario. The traded price of the warrants would likely go up, but there is no sale. It is kind of like retained earnings within a company.

 

For the income trusts, you would receive a payment which is then broken down by the company in a filing as to what portion is dividend, capital gains, return of capital, etc. and then you would use that to adjust your cost base or your income.

 

It is an "issue" that I had not thought about yet. Now wondering how we would be treating that.

 

Cardboard

[vinod1]

I think Fed would communicate the intention to raise rates well in advance so that the banks can prepare for it. I think they learned this lesson in 1994 and given the state of banks and what they have gone through recently Fed would telegraph their intentions at least as long as Ben Bernanke is at the helm.

 

Vinod

 

But is 1994 the right precedent to look at?  We are definitely not there yet, but at some point, should we be thinking 1979-1982,  when the yield curve inverts?  Can't imagine many banks running 1.5% ROA back then, including Norwest, the predecessor of Wells Fargo.  If mortgage lending, the largest asset item on most bank's balance sheet, over time gets set to 3% coupon, it doesn't take 18% over night Fed Funds rates to wipe out the profitability of any banks.  The speed with which you can adjust balance sheet in that environment, will also be somewhat suspect, due to the famous negative convexity of the 30 year prepayable mortgages.  You could be in the trenches fighting that for several years.  Even though it doesn't seem like we'll be there anytime soon, that's a scenario that is dangling out there.

 

http://www.advisorperspectives.com/dshort/charts/yields/perspective.html?yields/treasuries-FFR-since-1962.gif

 

All I am saying is Fed would be extraordinarily careful in ensuring Banking industry stays healthy through any policy changes.

 

Vinod

[benchmark]

I think Moynihan will stay at least for another 5-7 years, he's 52.  Ken Lewis retired 3 years before BAC's mandatory retirement age of 65.  BAC A's with 5-7 years of Moynihan look good if he sticks to 1/3, 1/3, 1/3.

 

I'm reading 'crash of titan', I'm getting a different picture of Moynihan -- he was always following orders (e.x. shutdown of investment research), not sure that he has any vision -- though I'm not complaining about the job that he is doing at the moment.