Stock of the Day
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Bank of America (BAC)
BofA Will Recover But Without Ken Lewis
Bank of America's Ken Lewis has taken the job of selling the bank's prospects to the stock market on himself. He appeared in a lengthy CNBC interview a couple of days ago and painted an optimistic (some would say unreasonably optimistic) picture of the behemoth of a bank that he is running now, thanks to all the acquisitions. He says the bank's Tier 1 capital ratio is in great shape, it is benefiting immensely from the current refinancing boom and within a year or two we will see the full earnings power of Bank of America. So that begs the question - why is BAC a $7 stock?
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Bank of America has had a horrible last 3-4 months. The trouble started in earnest when Ken Lewis purchased Merrill to fulfill one of his long-held dreams. John Thain did a good job of hiding some of the Merrill losses until December and when BofA found out, it was too late to back out of the deal. They had to go to the government for additional TARP funds and backstops and since then, they have become sort of a laughing stock and the word 'nationalization' has entered the discussion numerous times. But Ken Lewis thinks the tough times are mostly in the rearview mirror now and given the fact that he thinks the economy will pick up towards the latter part of this year, he believes BofA will be in prime position to capitalize because the company has some sort of a banking relationship with one out of two Americans (that's an oft-repeated statistic but an impressive one nonetheless).
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Cutting through some of the hyperbole from BofA's chief salesman, here are some of the factors in the stock's favor. The brunt of the financial crisis has probably passed. Credit markets have started thawing, and so borrowing costs are lower, the yield curve is sloping upward again which means banks are making money from their core operations. The refinance boom is also helping given the Countrywide acquisition and BofA's significant involvement in the mortgage sector. Additionally, FASB this week relaxed some of its strict mark-to-market accounting standards which means banks like Bank of America will given more latitude in marking down their mortgage assets and you won't see the kind of losses you saw last year as banks will be able to price certain assets based on what their models indicate rather than the current depressed market price. Also, if the economy starts to revive at the end of the year, there will be a surge of pent-up demand in various sectors (e.g. auto sales) which will benefit the banks that will be called upon to finance these purchases. Finally, there is also a school of thought that believes banks have had to mark their assets down too deeply and once it becomes clear that the real losses are not as high as the loan reserves that banks currently hold on their balance sheets, there will automatically be a flood of new equity on balance sheets. The main assumption is that the delinquency rate of mortgages will start to stabilize and the eventual haircuts on mortgage assets will end up 15-20 cents on the dollar rather than 70-80 cents on the dollar.
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The bearish case for Bank of America goes like this. Even if the economy improves as planned, BofA will still have a number of issues to deal with that will prevent it from fully enjoying the upturn such as the TARP funds. Bank of America took $45 billion from that program, so there is a high cost of servicing that debt plus there is the huge risk that the government could change its mind about anything anytime. For example, if the bank has one bad quarter, Treasury could decide to nationalize it or impose further restrictions on compensation etc. Secondly, BofA's Tier 1 capital ratio is solid but the more insightful measure is the tangible equity ratio which just takes into account just common equity. Bank of America is low on that which means it might have to raise more capital in a dilutive fashion. The FASB easing mark to market rules is positive but this change is not retroactive, so the bank cannot go back and revise its marks, so most of the damage has already been done. Then there are questions about this whole financial supermarket approach that Ken Lewis is trying with the Merrill and Countrywide acquisitions. It's becoming clearer and clearer that this approach does not work (see Citigroup (C: Charts, News, Offers)) so there are real doubts over Bank of America in this regard. Already, there has been a significant outflow of talent from the Merrill side because the smart people at Merrill don't want to work under the restrictions of a conservative commercial bank.
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Given all this, is the stock worth more than $7? It probably is. But the real value of the stock will not be unlocked until Ken Lewis is gone. He has been a great banker and has given the company a huge national footprint through a number of solid acquisitions. But over the long term, there is almost no way he survives the Merrill debacle. Shareholders were already concerned about the Countrywide acquisition but he was essentially getting as pass on that until he offered a heavy premium for a bank that would probably have been in Chapter 11 in a week with only a day or two of due diligence. And then it came to light that he did not have a firm handle on Merrill's books and its losses. So the chances of Ken Lewis being the CEO for the next 3-5 years are pretty slim and once he is forced out, the stock market will have more confidence in Bank of America.
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