Bank of America Corp (BAC) Capital Raising Rumor Indicates Sentiment


This is truly dismal stuff people, but there is a great lesson in it….

So let start with the rumor:

Bank of America Corporation (NYSE:BAC) has denied it has any plans to issue shares, contrasting a market rumor that sent shares sliding after a rally for most of the day.

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“Contrary to market rumors, Bank of America has no intention of issuing additional equity in a secondary offering,” a spokesman said in an emailed statement to media members.

Now, it seems as though the market in general dismissed the rumor as although share were off that day, other financials were off and $BAC has regained most of the 3% loss since.

Then I saw this piece in the WSJ and video:

Bank of America BAC +0.46% shareholders know how much dilution can hurt. From the start of the financial crisis to today, they have watched the bank’s shares outstanding more than double, even as the share price has fallen by about 80%. No wonder the stock, which briefly topped $10 a share on Monday for the first time in about seven months, sold off sharply on talk that more dilution may be forthcoming. Or that BofA was quick to shoot down the chatter. The reaction on both sides is telling: The market believes it would be only natural for BofA to consider taking advantage of the recent share-price strength, while BofA chief Brian Moynihan remains loath to consider such a move.

But his stance could prove foolhardy, even if it led the shares to rebound on Tuesday. It was just a few months ago that the bank’s viability was called into question. Given that, Mr. Moynihan shouldn’t assume the share-price surge has completely erased investors’ capital concerns. Any decision on capital, meanwhile, is a big bet on the strength of the now-improving U.S. economic recovery.

BofA’s latest denial of any capital-raising plans reflects Mr. Moynihan’s insistence that BofA has more than enough to operate its businesses. Indeed, the bank passed the latest round of “stress tests.” For BofA, though, the issue is whether it has enough capital to keep credit investors sweet, not simply the amount it needs to run its businesses. Indeed, after saying no new capital was needed early last year, Mr. Moynihan ended up selling $5 billion in preferred stock to Warren Buffett in mid-2011 to bolster sentiment and ultimately had to sell common equity later in the year.

Mr. Moynihan also has to consider that he will at some point have to buy back Mr. Buffett’s preferred stock since it doesn’t count toward key measures of capital. Raising new equity if and when the stock stays above $10 a share could allow for that yet keep the balance sheet strong.

And while BofA’s shares have nearly doubled since late December, the stock still trades at just 50% of book value and about three-quarters of tangible book.

Granted, legal issues over soured mortgages sold by Countrywide Financial, which BofA bought in 2008, are starting to look more manageable. And BofA’s financial position has grown stronger. Alongside improvement in its Tier 1 common ratio, the bank has also seen its ratio of tangible equity to tangible assets improve to about 6.2% at the end of 2011 from about 5.2% a year earlier.

But investors continue to fret about BofA’s earnings power in a low interest-rate environment. The bank still faces about $14 billion in outstanding mortgage-repurchase requests. And there are fears that recent improvements in housing and the economy c1- ould yet prove to be another false dawn.

Better then for Mr. Moynihan to use periods of strength to his advantage. As painful as dilution is, the bank would still be highly geared to a U.S. economic recovery. Reassuring investors with a stronger balance sheet could actually put more wind under the stock’s wings.

The logic here is so flawed it is hard to know where to begin. It seems to be thus:

1- Bank of America’s stock has risen 100% so it should take advantage of the move and issue more shares

Why? Just because it has risen? This is a basic argument that mistake the notion that price = value. According to this argument, last fall when shares fell 50% in a few months, $BAC should have been repurchasing shares. No one would have made that argument at the time. Let’s look at value. Issuing shares at 50% of BV is double dilutive to shareholders. Why? You are issuing $1 worth of stock for $.50 at current prices.

The reasoning seems to be “They should do it now because the stock is higher than it was before”. This also utterly and completely ignores the other argument……. “They don’t need it”

This is akin to me telling you to go to the bank and take out a personal loan you do not need. You’d laugh at me.

2- Mortgage put back risk

We’ve covered this incessantly here so I will be brief. Every “potential ligation risk” number you see? They are bunk. The reality is these things settle for pennies on the dollar. Why? No one wants to go to trial on these cases (too complex, no one has clean hands, juries are unpredictable) so they eventually settle. Guaranteed money now is much better than a very uncertain outcome years down the road. But, for arguments sake, let’s just pretend they get stuck with the $14B number (its fun to pretend), The article also fails to mention that $BAC currently has over $36B sitting in reserves to pay claims. It also fails to mention that $30B – $40B of cash flows through the company each year. Bottom line? There is MORE than enough money to pay these claims.

3- “…just a few months ago the banks viability was called into question”. So they should raise capital

Well, lets reverse the logic of this argument. Isn’t the reason for the 100% surge in the stock price due to the fact that the “bank is in danger” sentiment was wholly wrong? If we follow that to its logical conclusion then we would say if we eliminate that irrational price movement and take the stock price back to its pre-panic sell off area of ~$12 or so, we would then say “why would they issue more shares 20% below the stock’s price from last year? Without that extreme dip and rally, the price of the stock has wafted down over the past year while the health of the bank has gone up exponentially.

Under that scenario, no one in their right mind would recommend they issue shares at these levels.

We have to remember that the stress test revealed that $BAC fared better than JP Morgan Chase & Co (NYSE:JPM). Yet, we hear no one talking about JPM  raising capital even though it trades at about par with its book value meaning they would be selling $1 of value for $1 vs the scenario above for BAC.

The whole exercise above perfectly illustrates the effect of sentiment. It causes perception to obscure fact. When it is negative or highly skeptical, every event is filtered that way and good news is “ok” and anything else is simply “bad”. However, it does lead to wonderful mis-pricing and allows people to take advantage of that. The simple reality that BAC can have superior stress test ratios to JPM and be dealing with these rumors and have the stock price react to them is telling. That the media eagerly jumps into the fray to pile on is also telling.

What is all means is that you need to look critically about everything you hear and read on the subject…

By Todd Sullivan of Value Plays……

Updated on

Todd Sullivan is a Massachusetts-based value investor and a General Partner in Rand Strategic Partners. He looks for investments he believes are selling for a discount to their intrinsic value given their current situation and future prospects. He holds them until that value is realized or the fundamentals change in a way that no longer support his thesis. His blog features his various ideas and commentary and he updates readers on their progress in a timely fashion. His commentary has been seen in the online versions of the Wall St. Journal, New York Times, CNN Money, Business Week, Crain’s NY, Kiplingers and other publications. He has also appeared on Fox Business News & Fox News and is a contributor. His commentary on Starbucks during 2008 was recently quoted by its Founder Howard Schultz in his recent book “Onward”. In 2011 he was asked to present an investment idea at Bill Ackman’s “Harbor Investment Conference”.
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