On November 10, 2010, I wrote this article for Seeking Alpha suggesting that it was likely prudent for investors to avoid investing in Bank of America (BAC). At the time the stock price for BAC was $12.57. Today the stock price isn’t much more than $6.
I wasn’t suggesting that investors avoid Bank of America because of something specific that I could see on its balance sheet. Quite the contrary, actually. I was suggesting that investors (including myself) should avoid Bank of America because it is impossible to know what is on its balance sheet.
The fact that the stock has been cut in half since my article is simply luck. I had no idea one way or the other how Bank of America is going to play out, and I still don’t. Trying to look into the credit quality of financial assets from outside a company the size of Bank of America is like looking into a black box.
This recent Business Insider article got a lot of attention focused on Bank of America with the following:
Bank of America has about $222 billion of "book value"--the amount that's supposedly left over when you subtract Bank of America's stated liabilities from its stated assets.
The trouble is that the market doesn't believe Bank of America's assets are worth anything close to what Bank of America says they are worth. The market also doesn't believe that Bank of America has reserved anywhere near enough to pay the costs of litigation surrounding its mortgage behavior during the housing boom.
And when you put a more reasonable value on Bank of America's assets, the market thinks, the difference between that reasonable value and today's current value will have to be subtracted from the company's "book value." And that subtraction, the market thinks, will so demolish Bank of America's book value that the company is basically insolvent. (And, therefore, will need to raise more capital or go bust).
Here are some of the things that the Bank of America observers think should or will be subtracted from the bank's $222 billion of book value:
- $15-$20 billion in Increased mortgage-litigation reserves. Zero Hedge thinks BOFA is understating the liability for mortgage litigation costs by this amount.
- Some percentage of $80 billion of "second mortgages." Yves Smith thinks these should probably be written down by 60%, or $48 billion. You can pick your own number.
- Some percentage of $47 billion in commercial real estate loans.* The "extend and pretend" game in commercial real-estate is even more pronounced than in residential real estate. So as Yves Smith observes, there's almost no chance those loans are actually worth $47 billion.
- A healthy percentage of $78 billion of "goodwill." Bank of America built itself by acquisition. "Goodwill" is what's left over when management overpays for something. As Yves Smith observes, Bank of America's former CEO Ken Lewis loved overpaying for things. He overpaid for Countrywide, for example, which has since been written off to zero, and Merrill Lynch, which he could have had for free by waiting a couple more days.
- Untold amounts of exposure to collapsing European banks and sovereign debt.* Yves Smith says Bank of America says its European exposure is $17 billion. (UPDATE: Bank of America issued a statement clarifying that its "sovereign" exposure--to the debt of PIIGS countries--is $1.7 billion. The overall European exposure is $17 billion. But the big concern here is not just sovereign exposure--debt of countries--but bank exposure. Along with the associated derivatives.) Really? Has the firm not written any credit default swaps protecting customers in the event that European banks or countries go belly up? Might the firm have to post some cash "collateral" to satisfy these contracts? That's what Lehman had to do, after all. And that's what made Lehman go from "having plenty of capital" to being broke overnight.
So, taking some back of the envelope numbers, it looks as though we could easily come up with, say, $100-$200 billion in write-offs and exposures to "clean up" Bank of America's balance sheet.
A $100-$200 billion hit to Bank of America's $222 billion of equity capital, needless to say, would do some serious damage. Specifically, it would force the company to raise about the same amount to restore its capital ratios.
How accurate are the assertions in the above about Bank of America’s balance sheet? I have no idea. And as I keep saying, that is it the problem. How can anyone outside the company really understand? I think it is pretty much impossible even for people inside the company to really know for sure what their assets are worth, given the sheer scale involved.
I think investors need to call it like it is. Investing in Bank of America is a contrarian bet, plain and simple. You aren’t value investing, you are making an educated bet that credit problems are bottoming. You aren’t investing because you have dug into 10,000 Bank of America mortgage files to check credit quality.
And trust me, I’ve tried to get comfortable with Bank of America. I badly want to be the guy who wades into the troubled water and scoops up some shares that eventually turn into a four-bagger. Especially after watching the Fairholme Fund and Bruce Berkowitz go in with guns blazing and bet virtually his entire future on the financial sector, I find it hard to believe he doesn’t know what he is doing given his long successful track record.
Berkowitz is so into Bank of America at this point that he hosted a conference call with Bank of America’s CEO, Brian Moynihan, to try and reassure investors that Bank of America was in good shape. If you are a Bank of America shareholder, you will obviously be interested in the details of that call.
This exchange from the call basically captured where Bank of America is today as an investment opportunity:
Bruce Berkowitz: And the last question on estimates is: how can investors verify your numbers?
Brian Moynihan: In terms of accruals and stuff, I think we have a strong management team.
We have a strong process. We have outsiders look at them. I think investors have to look at them, read them, test them and make their own decisions. But we have to test it first to see if they’re reasonable. We get ourselves comfortable for what we know and how we look at it, and we’re able to assess the risk.
The question from Berkowitz was, How can investors verify Bank of America’s reserve estimates? The answer from Moynihan is basically “trust us, we have a strong process and a strong management team." To which I reiterate my "No, thank you."
I think there is a very high chance that Bank of America could be a great investment today. But I’m basically basing that on the premise that things can’t be as bad as the market is making them out to be. That isn’t an investment decision driven by knowing what something is worth; it is simply a contrarian bet. If that is what you are into, then go for it. If you make 100 bets simply taking the contrarian position, I would think that over time you will do ok.
But that isn’t my bag. So I’ll keep avoiding Bank of America.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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