BAC Up (NYSE: BAC)

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NEW YORK - The world's most hated highly traded stock — Bank of America ladies and gentleman. A company with year to date performance worse than that of any top 25 U.S. Bank in terms of size, worse than most European banks. Societe Generale and Barclays are down 58% and 31% respectively to 61% of Bank of America. BAC has hardly outpaced Bank of Ireland and National Bank of Greece which are down 76% and 83% respectively.

Bank of America unlike the banks above has little exposure to the troubled countries in Europe. This could decimate the value of European Banks. Bank of America has $16 billion of total exposure to the PIIGS (Portugal, Ireland, Italy, Greece, Spain) and $14 billion of net exposure to these countries. The company's exposure to the most troubled nations: Portugal and Greece is under $1 billion. From a credit standpoint Bank of America reigns supreme. Other banks such as Banco Santander, has 4% of their assets in Portugal. If this country is written off to zero it would wipe out the bank's tangible equity. Bank of America has .6% exposure to all of Europe's troubled countries. BAC can write off 100% of its exposure to zero and only lose 10% of its tangible equity. This is an absurd write-down but illustrating a point to the lack of exposure of BAC to Europe.

What investors should actually be concerned about is Bank of America's poor profitability over the last 3 years. Unlike the European banks, BAC has made little to no profit. Societe Generale has made a healthy profits over the last few years. However mitigating this strong profitability is their exposure to Europe and their excess leverage.

Bank of America today has adjusted leverage of 16.72 to 1 as the company has $2.141 trillion of tangible assets to $128 billion of tangible equity. Technically leverage would be minus 1 from 16.72 since shareholders own 1 of that 16.72 but this number will help illustrate a calculation later and we will continue to define 16.72 as their leverage despite it technically being 15.72.

The number above takes out the $4.5 billion in valuation gains BAC had last quarter because they were more likely to default. It takes out $1.332 billion of preferred shares turned into debt because this has happened since the quarter finished on September 30, 2011 and it adds in a fair value adjustment for their high provisions which is above our estimate of expected loan losses. Further fair value adjustments could be done to their tangible equity. BAC says the fair value of its loans are $25 billion under their current value but the fair value of its debt is $30 billion under so BAC's tangible equity would increase if complete fair value accounting was used. Most of BAC's numbers are presented at fair value. BAC plans to continue to reduce debt going forward and the company expects to buyback $75 to $100 billion of debt to lower its funding costs.

BAC's leverage compares to that of Barclays which has 36 to 1 and generally holds lots of European debt. European Banks tend to use twice as much leverage as American Banks. European Banks currently have returns but are more risky because they have lots of leverage and it is in European debt. This is because previous Basel reforms said sovereign debt was risk free which caused European banks to pile into sovereign debt as it was a way to add to returns. Tell this to the rating agencies who rate most European banks' debt higher than Bank of America. Barclays is rated AA- by Fitch compared to A for Bank of America. Can these guys get anything right? It is really hard to trust any rating agency after one of them downgraded the U.S. I wish they all went away but investors are lazy and would prefer to pay these hacks to rate things. No matter what garbage they spew out it turns to gold when it hits Wall Street and all their mistakes have been largely forgotten.

Bank of America is in the lower quartile of risk among large banks. This is because of its low exposure to the PIIGS, it uses less leverage, and it has provided huge sums of money for future loan losses and mortgage repurchases which has not been done in Europe. So why is it valued lower?

It is valued lower because there is a mispricing in the market. No that is not possible! Never would anyone expect a market that moves securities often times 30% in one day to misprice anything. Netflix always must have been perfectly priced when it moved up 900% higher and 80% lower in a year and a half. These erratic traders may be on to one thing, BAC does have poor profitability. Most of the troubled European banks at least have good profitability. Investors should mitigate this current poor profitability because they get to hold so much tangible equity for pennies on the dollar. On top of this they can expect a company like this is able to turn around their massive ship. Taking costs out of the equation is much easier then inventing an IPhone.

Bank of America has adjusted $128 billion of tangible capital. Including dilution since September 30 but not including the Buffett stake ( currently the Buffett stake is anti-dilutive) the company's market value is $54 billion. Investors get to pay 42 cents for $1 of net tangible assets. For Barclays investors are paying 78 cents. Normally this would be a fair spread given Barclays superior profitability but it makes little sense given the risk to reward of BAC compared to European banks with have much more exposure to the PIIGS and the fact they have more than double the amount of leverage.

Here is why BAC is undervalued and this analysis will no longer compare BAC to junky European Banks. It will look at BAC by its own merits. BAC currently has huge expenses because they have been settling mortgage issues with investors who lost their shirts. They are begging BAC for an reimbursement for their poor investments and BAC has given some of them money back for their mistakes. We wish the world would function as a place that stupid people did not get reimbursed for their mistakes but this is the world today where everyone blames the person bigger than them. BAC currently has too many workers and it will downsize its operations. The bank plans to take $5 billion out of expenses a year for the next 3 years. Which will be a total of $15 billion. The company should be at worst able to make $13.2 billion of non interest income per quarter and for non interest expense should be at most $15.3 billion. So we can build BAC's future income statement and current.

To calculate its current pro-forma returns let us do some calculations.

BAC has 16.72 to 1 leverage and has a spread of asset yield less liability yields of 1.89%. Multiply leverage by the spread to get what the company can return on assets minus liabilities. This number is then multiplied by tangible equity and you get net interest income. Minus out provisions (based on 20 year average of provisions), minus out losses outside interest income, then take out taxes and preferred dividends. From this we can see Bank of America will make a profit of at least $7.5 billion next year. So the bank is quite cheap relative to its normalized earnings. However even better in relation to tangible equity. The return based on this is 5.86% and this can't be much below the banks cost of capital meaning at worst the bank should be valued closer to tangible equity.

In the future BAC will be forced to reduce its leverage. Currently the company under Basel III would have $1.8 trillion of risk weighted assets (RWA). It currently has $128 billion of tangible equity which is a ratio of 7.1%. However the SIFI buffer for (Systematically Important Financial Institutions) required 2.5% more capital for large firms. We expect BAC to be in the 9.5% range and if SIFI comes in, BAC will probably hold a tier 1 ratio of 10%. Given its reported 1.8 trillion of RWA's (risk weighted assets) we would expect BAC to have to hold $180 billion of tangible equity. By having a low payout ratio of around 20% and reducing RWA's, Bank of America can get to this 10% easily by 2019. However we would expect BAC to reduce RWA's by probably $200 billion in this time and reach the required number sooner. After this we would expect Bank of America to start paying nearly 100% of its earnings in dividends as regulation would make it unattractive to continue expanding. So let us see what Bank of America can make 5 years from now with reduced leverage.

The spread in the future would rise. We believe liabilities will be priced down and more expensive funding would be used less and BAC would fund themselves with cheap deposits. The company will also reduce its overnight borrowing, all of this will increase their spread.

The next part is calculating their new leverage. We would expect BAC to continue reducing RWA's and have about $160 billion of tangible equity in 5 years to $1.6 billion in RWA and probably 2 trillion of assets. So leverage would be around 12.5 to 1. The return now would be 26.5% before provisions. Provisions were lowered to $8.1 billion a year which would be around 1% of loans, still high ratio historically and still above their average excluding the credit bubble. Losses outside of net interest income would be $8 billion a year based on reduced expenses. Now you can see BAC in the future should be able to earn around $16.2 billion a year and make a return of tangible equity above 10.1%. Which will exceed its cost of capital.

Given BAC's metrics, its safety and future profitability the stock should be valued far above its current price. Being extremely conservative this stock is worth $11, being a little less conservative it is worth $14 and being a tad optimistic it is perhaps worth $17 today. On top of this all we did not consider the fact that Basel is probably unlikely to ever be implemented. Basel II (yes Basel 2) has still not been implemented by the majority of banks. We think new regulation will come into play but not in its current form. We would not expect BAC to have to reduce its leverage below its current number. In 2008 entering the credit bubble BAC had leverage of 40 to 1 compared to 16 to 1 today (no wonder they made such good returns!). If SIFI didn't exist then BAC's returns would jump even more and this is a definite possibility. We have already seen how dumb punitive regulation can be and forcing banks to substantially reduce leverage is damaging for banks and the economy. Factoring in that Basel III does not pass in its current form, which would just exclude SIFI, we think the stock is worth much more than even our optimistic estimates.
That is under the rosy scenario that regulators come to their senses and do not put extra punitive measures on the banks. It is hard to imagine they would do that today given the government competition to outdo each other and raise their country's bank requirements to the highest level. But Hopefully they remember that they created as much or more of the mess than the banks and perhaps they should blame themselves and not just the banks. When is the last time anyone here has been impressed with the legislative process in Washington or Europe. Both countries take months and months to get anything done and have leaders with deep opposing views, grandstanding around for their own personal egotistical benefit. These people should realize they have no idea how the financial system works unless they spent years and years reading bank balance sheet and are likely unable to say what a good ratio is. Alan Greenspan who was the former Chairman of the Federal Reserve perhaps caused a bubble by making interest rates so low which increased leverage and he did not like regulation and was a staunch believe in the market. The banks failed because government regulations failed to reign in risk. Instead of looking at risk in the future they will just add punitive mathematical measures which will just cause lower profits but does nothing in regulating risk. The financial crisis could have been mitigated by not just reducing leverage but by paying attention. Reducing leverage substantially hurts the economy because it limits loans to people. That being said, and no one should come away and say regulation is dumb. Much of Basel III makes a lot of sense and is important. However it is also important that it does not go from having little regulation to, too much regulation. The SIFI buffer represents the pendulum swinging to the time period of over regulation. SIFI is dangerous and wrong.

Bank of America is attractive on a reward to risk basis and the stock has been unduly knocked. The banks that should be down the most are the ones in Europe.