Wednesday, February 25, 2009

BAC's War Of Independence - Nationalization Is Wholly Unnecessary

I estimate that the pro forma combined market capitalization of the companies that now constitute Bank of America (BAC) -- Bank of America, Merrill Lynch, Countrywide Financial, et al. -- was once in excess of $372 billion. At last Friday’s closing price, the market capitalization of the combined entity was barely north of $24 billion - an incredible $348 billion has been wiped away with breathtaking speed.

As if that weren't enough, various commentators are saying that Bank of America is worthless and needs to be nationalized. But are they right?

Bank of America currently has tangible common shareholder equity (or TCE) of about $67.5 billion. However, a reasonable estimate of the “hold-to-maturity” (or HTM) value of the losses the bank may sustain over the next few years would be about -$330.3 billion. Thus, if the bank were forced to immediately “mark” these HTM losses, it would have a tangible book value of -$263.1 billion.

The fact that it has negative tangible equity on a mark-to-HTM basis has done a great deal to spark nationalization fears.

Book value and intrinsic value are very different things. As long as Bank of America is allowed to carry its assets at acquisition cost and charge off its losses over time, the bank can organically generate enough value to pay for its losses, and still have a substantial amount of value for common shareholders. In other words, despite currently being $263 billion in the hole, Bank of America still has a positive NPV due to its ability to generate positive cash flows over time.

According to my calculations, Bank of America currently has an NPV per share in excess of $30. That's 700% higher than its closing price last Friday. As a check on my NPV valuation, I calculated the NPV of the 15 years of charge-offs and added it to our current estimate of the bank’s NPV.

The fact that the sum of these 2 values gives us a figure quite similar to the market capitalization of the combined entity prior to the crisis, gives us a pretty good indication that we're on the right track. In other words, if you subtract the NPV of the charge-offs from the market cap of the combined Bank of America entity prior to the crisis, you get a value quite similar to the one we're now estimating is the correct valuation for the company's common equity.

There are some risks to this analysis. First, it's assumed that, unlike Citibank (C), Bank of America doesn't have significant off-balance-sheet exposure that isn't reflected in its financial statements. Second, while the losses in the bank’s portfolio are estimated quite aggressively in our example, it's possible that the losses could ultimately prove to be even greater. In either case, the calculations presented here would have to be modified. It's worth noting, however, that losses would have to be more than double those estimated in our example for the NPV of Bank of America's common equity to fall below its present market capitalization.

The other risk involves government regulation. For Bank of America to be able pay for the losses it has sustained -- and to be able to create value for common shareholders -- the government will need to change current accounting rules to allow the bank to carry its assets at acquisition cost and charge off its troubled assets over time. Although there are no guarantees that the government will do this, they would be crazy not to.

There are 2 important conclusions to be derived from this analysis:

1. Taxpayer bailouts for Bank of America shareholders aren't warranted; nationalization isn't at all necessary.

2. At current levels, investment in Bank of America stock can be considered. Needless to say, an investment in the company is a very risky proposition. In particular, its success will greatly depend on government decisions regarding accounting regulations.

However, based on a pure calculation of economic value, the NPV of the Bank of America franchise for common shareholders is probably in excess of $30. Don't you think this is why CEO Ken Lewis and virtually the entire Board of Directors have been aggressively buying its shares during the months of January and February? The worse that can happen: It'll go to 0. On the other hand, if the government would simply do the right thing, gains could be in excess of 700%. The reward/risk is favorable. But please - don't invest a penny more than you can afford to lose.

Most importantly, write to President Obama, the Secretary of the Treasury, and your Representative and Senators to stop the current bank bail-out bonanza and this destructive talk of nationalization. Tell them to take the necessary steps to amend the mark-to-market rules in FAS 157 and to put in place accounting regulations that will allow banks to carry their assets at acquisition cost, and charge off their losses over time.

I'm not arguing against bailouts or nationalizations on ideological grounds. Rather, I'm saying that such measures -- which would dramatically increase our national debt and redistribute wealth unfairly -- are simply not necessary. Those who insist on arguing in favor of tax-payer funded bailouts and/or nationalization (assuming that the banks are broke and that such a solution is inevitable) are simply misinformed and are doing the nation a great disservice.

Long BAC Leaps

1 comment:

BigDaddy said...

Great article, I feel the same way on BAC. I own BAC, starting at $14.00 all the way down to $3.00. I have read several articles now about investors buying BAC LEAPS. I have traded options before and are familiar with them, but not LEAPS.
The Jan 2010 CALL LEAPS for BAC at the strike price of $2.50 have several options WBAAZ $3.40/$3.65, KGZAQ $0.08/$0.11 and KPVAC $2.65/$2.97 Bid/Ask. Whats with the different options, and how does one differentiate between them. With those variances in the Bid/Ask Im afraid to jump in on the "cheap" ones without knowing precisely what Im buying. Thanks!