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I've been spending more time with BAC. It gets more interesting with the share price around $7.00. BAC is now selling at 0.33 times book value and at 0.53 times tangible book value. This is dirt cheap presuming:

1. The litigation for reps and warranties is not excessive
2. There aren't further large losses in the loan portfolio
3. There isn't large exposure to unhedged PIIGS debt
4. The company doesn't have to raise equity in order to meet Basel III standards.

I covered some reasons why I thought BAC was cheap in my last post about the bank:

but have since read the new 10Q, read more articles, and have done more spreadsheet work, modeling what the losses in the loan portfolio might look like as well as the capital requirements for Basel III. I've also learned more about the litigation against BAC and found out in the latest 10Q that they've established a litigation reserve of $17.8 billion. Last, I listened to the Berkowitz/Moynihan conference call this week. My valuation is still based on an ROE model, but the key is to build the ROE off of a realistically impaired equity base. So here are my current assumptions, tweaked from last time:

Equity Base
$221.76 billion

Litigation Impairment: $12.2 billion
$12.2 billion accounts for mortgage putbacks and foreclosure settlements. (liability for representations and warranties)
There are $222 billion in total defaulted and nonperforming loans that were sold

BAC settled 60% of the legacy Countrywide mortgages, which represent about 46% of the $222 billion, leaving $120 billion

BAC estimates the potential mortgage putbacks at between $7 to $10 billion or 7%. I'm going with $30 billion or 25% Current claims are $13.6 billion.

BAC has a litigation reserve of $17.78 billion, which will be drawn down before equity is hit.

$30 billion in litigation - $17.78 billion in litigation reserves = $12.2 billion

PIIGS Debt Exposure Impairment: $7.5 billion
BAC has $119 million in net PIIGS sovereign debt exposure after hedging. I'm subtracting all of this, assuming total loss

BAC has $14.845 billion in net PIIGS non-sovereign debt exposure. I'm subtracting 50% of this ($7.4 billion), assuming loss

Loan Book Impairment: $13.4 billion

Loan Portfolio

in millions
Consumer Loans Amount 30 Days Past Due Nonperforming
Home Loans $408,990 $29,772 $19,395
Credit Cards $130,696 $5,478 $3,020
Consumer Loans $90,258 $810 $0
Total Consumer Loans $637,900 $36,060 $22,415

Commercial Loans $303,357 $410 $8,783
Total Loans $941,257 $36,470 $31,198

Total 30 Days Past Due and Nonperforming: $67,668
Assumed Recovery Rate: 25%

Existing Loan Loss Reserve: $37,312

Assumed loss if all 30 days past due and nonperforming loans are charged off assuming recovery rate: $50,751

Assumed loss minus loan loss reserve: $13,439

Impaired Equity Base
Adding all these losses up and subtracting from the equity base of $221.76 billion gives me an impaired equity base of $188.7 billion. Taking that and just dividing by the 10 billion shares that are out there gives me $18.87 a share in book value.

Basel III
A big concern is that BAC will need to raise equity to meet the higher equity holding standards of Basel III that gradually go into effect over the next 7 years. When I look at the amount of capital needed to be raised, even off of an impaired equity base, I'm not seeing that there would be an issue unless the bank was only able to earn a super-low 1-2% ROE over the 2012-2019 time frame.

dollar figures in millions

$114,684 Current Tier 1 Common Equity
$1,393,000 Current Risk-Weighted Assets
8.23% Current Tier 1 Common Equity Ratio

$20,000 Trust Preferred Securities that will no longer count toward Tier 1 under Basel III
$94,684 Modified Tier 1 Common Equity
6.80% Modified Tier 1 Common Equity Ratio

4.50% Tier 1 Common Equity Ratio Needed by 2015 conditions met
5.75% Tier 1 Common Equity Ratio Needed by 2016 conditions met
7.00 Tier 1 Common Equity Ratio Needed by 2017 conditions not yet met
8.25% Tier 1 Common Equity Ratio Needed by 2018 conditions not yet met
9.50% Tier 1 Common Equity Ratio Needed by 2019 conditions not yet met

$0 Capital needed in 2015 to meet Basel III assuming RWA stays the same
$0 Capital needed in 2016 to meet Basel III assuming RWA stays the same
$2,826 Capital needed in 2017 to meet Basel III assuming RWA stays the same
$17,413 Capital needed in 2018 to meet Basel III assuming RWA stays the same
$17,413 Capital needed in 2019 to meet Basel III assuming RWA stays the same

$37,651 Total Capital needed to meet Basel III

$11,088 Annual Earnings Power Assuming 5% ROE
$55,440 Total Capital Raised over 5 years

$9,433 Annual Earnings Power Assuming 5% ROE on Impaired Equity
$47,165 Total Capital Raised over 5 years

It looks to me that BAC could cover the Basel III capital requirements on my estimate off of its impaired equity base comfortably (and that assumes all the losses I estimate are incurred now instead of over the next several years). A 5% ROE is not a high hurdle rate but I think it's realistic assuming the further writedowns, lawsuits, etc. that will occur over the next couple of years. I expect BAC can achieve a 10% ROE when there aren't writedowns.

This is just one way to model it. You could assume a higher ROE but then you'd have to account for more equity writedowns, or you could assume that RWA gets whittled down some as BAC sells assets. There are multiple ways to get there.

I think BAC is cheap. Working through the numbers of the realistic possible losses and requirements for Basel III I don't see an insurmountable problem for the bank. I decided to buy some shares around $7.00 this week. Wish me luck.

Some articles I found helpful:

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I decided to buy some shares around $7.00 this week. Wish me luck.

May whatever deity you worship have mercy on your soul.

I think your approach is sound.

I also think BAC does not have a full grasp of what it is or what it wants to be. I think, internally, they are so busy running around putting out fires left over from surviving and forced digesting that there is not a whole lot of time left over for anything else. Banks books are obscure enough when I am not convinced that they themselves know about every closet that has a stack of skeletons precariously perched on the top shelf I get even more nervous.

Gotta admit 74% discount is a fair margin of safety to work with tho.

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Yeah, I was only marginally interested around $11 a share. But when it dropped below $7.00 on Monday I felt the price was cheap enough to take into account a lot of skeletons in the closet, more so than I thought were likely.

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thanks Mike

Good update
I was surprised by the low exposure to PIIGS --$119 million is nothing. Do you have any sense how this compares to other big banks? If exposure in the US is low, the blow up in Europe may not impact us as much as I feared
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Well, if you want a dividend, discount to book (33%), no exposure to PIIGS, and a bank that looks worse than it is because they cleaned up their loan reserves in the last two months, consider HCBK (Hudson City). All banks have problems, but they drew me in.

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I know Wells Fargo has even less exposure than BAC does. Here's a snippet from WFC's 10Q from August 5:

At June 30, 2011, our gross outside exposure to these five countries, including cross-border claims on an ultimate risk basis, and foreign exchange and derivative products, aggregated approximately $3.2 billion. Of this amount, we held approximately $100 million in sovereign claims, substantially all for Ireland, and no sovereign claims for Greece, Portugal and Spain. We did not have any sovereign credit default swaps that we have written or received associated with Greece, Ireland, Italy, Portugal and Spain.

Citigroup has the most exposure to PIIGS sovereigns of the three banks though it's still not a large amount relative to the company's assets, with only $1.6 billion of exposure to PIIGS sovereign debt vs. almost a trillion dollars in RWA. Here's a snippet from its 10Q also filed August 5:

As of June 30, 2011, Citi's current net funded exposure to the sovereign entities of Greece, Ireland, Italy, Portugal and Spain (GIIPS), as well as financial institutions and corporations domiciled in these countries, totaled approximately $13.5 billion based on Citi's internal risk management measures.

Of the $13.5 billion in existing net funded exposure, approximately $1.6 billion is in assets held in trading portfolios and available-for-sale portfolios, which are marked to market daily, and where Citi's trading exposure levels vary as it maintains inventory consistent with customer needs. The remaining $11.9 billion is net credit exposure, mostly in the form of funded loans composed of approximately $1.6 billion to sovereigns; approximately $6.4 billion to financial institutions, of which approximately 70% represents short-term, off-shore placements with these financial institutions' non-GIIPS subsidiaries or is fully collateralized by high quality, primarily non-GIIPS collateral; and approximately $3.9 billion to corporations, of which approximately 2/3rds is to multi-national corporations domiciled in the GIIPS, and includes Citi's lending to their non-GIIPS subsidiaries.

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Barron's ran another piece on Bank of America this weekend, fairly bullish:

Investors pulled their money out of Bank of America with both hands last week, driving the stock to its lowest level since March 2009, as concerns about a slowing economy rattled the banking industry, and lingering losses from loans it made during the housing bubble raised fears that the bank would need to raise additional capital.

At $7.19 apiece, Bank of America's shares are among the cheapest in the industry. They trade at just 57% of tangible book value and 4.9 times estimates for next year's earnings. If shares trade up to tangible book they'd be worth $12.65. Put a multiple of 10 on 2012 estimates and they're worth $14.70.

The bank has made some progress in cleaning up after the housing meltdown. It has bolstered reserves on its $939 billion loan portfolio to $37 billion. If loan performance doesn't get worse—a big if in many investors' minds—the bank won't have to increase those reserves and a major drag on earnings over the past few years will disappear.

Bank of America (ticker: BAC) has also improved its liquidity and its capital, with $400 billion of cash and liquid assets on hand and $1 trillion in deposits. The bank's earnings power was apparent in its second quarter results. Outside the residential mortgage area, the bank's businesses generated roughly $6 billion of net income, and each enjoyed lower provisions for credit losses.

But the good news has been overshadowed by the bad: the European debt crisis, a chaotic stock market and fears about global growth, which pushed U.S. Treasury yields down. That's to say nothing of the heap of lawsuits stemming from the mortgage mess.

Low interest rates are hurting net interest income at all banks. And a faltering global economy could mean the industry underwrites fewer securities, trades less, makes fewer loans and facse higher-than-expected loan losses.

Matt O'Connor, an analyst at Deutsche Bank wrote in a note last week that his $1.35 earnings estimate for Bank of America in 2012 could fall by 47 cents and his $1.75 estimate for '13 could be too high by 96 cents. Betsy Graseck, Morgan Stanley's bank analyst, lowered her 2011 earnings estimate by six cents, to 76 cents a share and her 2012 estimate by 29 cents, to $1.53 a share. She lopped her bullish target price by $2, to $15.

Concerns also flared over a report last week that claimed the bank may have to lift its reserves dramatically to offset new problems with its residential mortgage portfolio. BofA's consumer real estate division racked up a $14.5 billion loss in the last quarter, hurt by a $12.8 billion increase in the representations and warranties provision. Reps and warranties basically promise investors in mortgages that the bank did its job in correctly underwriting the loan.

"At the end of the second quarter, Bank of America had approximately $18 billion to cover the recently announced $8.5 billion settlement with Bank of New York Mellon and other future representation and warranties repurchase liabilities," a spokesman wrote in an e-mail. Still, the firm has said it may have to boost provisions by up to $5 billion more.

SOME THINK THAT NUMBER could go a lot higher. Last week Compass Point Research & Trading published a report estimating that BofA would have to boost reserves by another $25.7 billion. That's the most extreme estimate so far, and Bank officials disputed it hotly.

Ironically, the shares may have already priced in Compass Point's worst case scenario, which has BAC boosting reserves by $44 billion. Once that reserve increase is adjusted for taxes and divided by the bank's huge share base of more than 10 billion shares, tangible book value would be reduced by roughly $2.50 a share. That would still leave $10 a share in tangible book, estimates John McDonald, a Sanford C. Bernstein Research analyst. He has a $13 price target on the stock.

The other thing weighing on shares is a lack of confidence in Bank of America's ability to meet an increase in regulatory capital requirements by 2019 through retained earnings and the sale of assets. Under Basel 3, the bank's tier 1 ratio needs to be 3.5% in 2013.

The bank's goal is to have a ratio of 6.75% to 7% by 2013 and to exceed capital requirements in all periods without raising equity. But the market is acting as if it needs to raise equity now to meet the requirements and be competitive with rivals like JPMorgan (JPM).

CEO Brian Moynihan failed to convince investors on a conference call last week that the bank had turned things around. But with tons of bad news priced into the stock, a few quiescent quarters may be all it takes to lift the shares out of their funk.

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Thanks, Jack.

The $22 to $27.5 billion in possible litigation costs that Ritholtz estimates is in the neighborhood of what I was estimating before I applied the $17.8 billion in legal reserves:

$30 billion in litigation - $17.78 billion in litigation reserves = $12.2 billion

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At face value and superficially this re-organization makes sense. It looks like they are shuffling their divisions and acquisitions in a manner that will make better sense strategically moving forward.

@TMFSandman BAC was almost back down to your $7 target to buy shares
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Thread resurrection: so here we are about 1 year later, and BAC has made enormous efforts to get its house in order. Now it is the best capitalized of the big 4:

8.97% Basel 3. Cheers to Moynihan and the rest of the team. Still cheap IMO.
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8.97% Basel 3. Cheers to Moynihan and the rest of the team. Still cheap IMO.

They'll only need 8.5%:

Might Bank of America have too much capital? Guesses on the size of dividends and buybacks next year? Looks to me like they could return at least $15 Billion and still be comfortably above their Basel 3 requirements and still build capital.

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Large banks are building capital to meet the new requirements known as "Basel III." For banks, holding more capital - in other words, funding themselves with more equity - makes it harder to wring profit from their balance sheets. But higher capital levels also give banks a bigger cushion to absorb losses, making it harder for them to go broke in bad times.

Barclays Plc and BNP Paribas were assigned the next highest buffer of 2 percent, according to the FSB. Eight banks including Bank of America Corp and Goldman Sachs Group Inc fell in the next highest bucket of 1.5 percent.

while I have not fully worked out in my head how Basel III works from this stuff, I expect the accounting of how BAC is doing could falter at any time.....BAC has all those country wide mortgages along with their own subprime mess of mortgages.....if the housing market slumps.....all bets are off when it comes to BAC......

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I expect the accounting of how BAC is doing could falter at any time

If you mean they could be re-categorized in the future, I agree.

if the housing market slumps.....all bets are off when it comes to BAC......

Yup, BAC is levered heavily to the housing market. Fortunately the market is turning - coming out of the worst slump in recent history. Also, the makeup of their loan book is remarkably different than it was during the bubble. They need to pay for Countrywide's sins of the past, and they have a mountain of capital from which to do that.
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