One of the most interesting investments right now is Bank of America. A number of excellent investors like Mohnish Pabrai have been purchasing shares. Pabrai was on record in 2010 stating that “The typical allocation now at Pabrai Funds is 5%… And once in a blue moon, we’ll go up to 10%.” So his recent 17% portfolio position in Bank of America is a very big bet. It’s not hard to understand what he likes. A quick look at the numbers demonstrate that the company is trading at a fraction of its historical levels. Guy Spier recently stated that he thinks the US banks could be a 3x or 4x investment.
I have little experience with the analysis of banks. I have always been extremely cautious of their massive leverage and have viewed them as black boxes. I would really appreciate comments on where I am wrong or what I am missing. For background on banking and Bank of America, read Bronte Capital’s analysis (you should also sign up for their emails). Bronte is long BAC but discusses the bear arguments from both Naked Capitalism and Zero Hedge.
Downside can be broken down into two concerns: liquidity risk and insolvency risk. I understand that there is limited liquidity risk to US banks. The past crisis demonstrated that US banks have access to short term lending through the Fed. I also appreciate that this is a very different scenario than European banks where each country’s bank can’t print unlimited amounts of money.
Insolvency risk is harder to determine. Given enough time, a profitable bank with solvency issues will be able to increase its capital levels through retained earnings. This has been BAC’s argument for some time, declaring that no new equity would have to be raised (although assets would be sold). However, BAC recently announced a common share exchange and the Buffett sweet heart deal. A recent article detailed the changing language of capital raising in BAC’s filings.
“…Bank of America removed the word “non-dilutive,” from its assertion in its second quarter filing that it would “continue to build capital through retaining earnings, actively reducing legacy asset portfolios and implementing other non-dilutive capital related initiatives.” The bank also eliminated a sentence that read “we currently anticipate that we will be in excess of the minimum required ratios without needing to raise new equity capital.”
Given the flip flop on capital raising, the black box argument has gained some traction. On that subject, I don’t have much faith in the published results. With banks, there are so many ways to manipulate the numbers. The 2009 FASB change in mark to market accounting was controversial and didn’t help matters (although it did help the banks!). The whole process of reserving is open to manipulation. Over the past 9 months the economy is little changed but the provision for credit losses fell a massive 55% from $23.3b to $10.5b. However, if BAC can maintain their profitability they can work out their reserve problems over time.
My concern is a repeat of fear in the markets which forces Bank of America to take capital at the worst time. The planned capital raise through asset sales would fall apart and the company would be forced to issue equity at a low price. This death spiral in the share price could be caused by just about anything: counterparty concerns, basel iii levels, immediate litigation payments or a mandate from regulators. Let’s assume Bank of America is wrong and needs a large capital raise of $40b.
|$40 billion Capital Raise|
|new tangible per share||9.47||7.32|
Even raising $40b at $3 per share (lower than the March 2009), tangible book would still be over $7 per share and investing today at $5 would likely work out well in the long run. It appears that Mr. Market has already priced in a very poor outcome.
There are lots of moving parts here so I don’t see myself taking a double digit position but I clearly see what Mohnish likes.