bmichaud

I hear what you're saying, but when you think of it from a micro level, I don't see the problem. Deutsche Bank had something like $2B of exposure to Greek CDS, for example - let's say that was ten times larger but spread throughout the system with ten different institutions, that should be manageable on an individual company basis. I've heard El Erian talk about the big problem with Lehman was the "payments" system - I would think this combined with the "inter-relatedness" could be backstopped by the Fed, while allowing bondholders to fail. If the bondholders are allowed to fail and the Fed backstops the payments/inter-relatedness, and the system STILL collapses, then TBTF exists.

I have yet to read/hear a good explanation as to what makes something TBTF. BAC has $120B of tangible equity and $350B of total debt (I'm approximating off the top of my head), which means it has roughly $470B of capital available to absorb any losses before depositors are hit and depositors are insured anyway up to $250K. What am I missing? Counter parties have netting and collateral posting requirements. Isn't the only requirement of the Fed in a "failure" scenario to backstop liquidity and payment systems? I would love an explanation as to why bond holders losing their investment is a risk to the global financial system in a BK scenario. Global equity and bond investors took a BATH from the fall of 2007 to March of 2009 in the form of widening spreads and collapsing equity markets. Why dont we just consider all "risky" investments TBTF?

If and when ECRI's call (http://www.businesscycle.com/news_events/news_details/5065) materializes, it will be interesting to see what bullets we try to conjure up - Dalio's interview back in October at the Economist's Buttonwood conference seemed to indicate the next downturn may not be pretty.... There truly isn't much left that would assist the economy and not cause any future problems. QE3 would create problems going forward. I think we'll have a better idea of how things are as the housing inventory shrinks. If prices don't start to rebound, and unemployment doesn't rebound, then it could be a slow slog. So far, things look quite positive, but China is slowing and we will have to wait and see exactly how they stop the hard landing. Cheers! Someone said today that it will be interesting to look back in ten years at the fact that Apple's market cap is greater than the entire US retail sector. I think the same can be said (not a new revelation whatsoever, I'm just saying) for Bernanke's ZIRP. I'm not nearly smart enough to figure out what he is distorting, but there has to be some type of distortion building up in the system right now that will materialize within the next ten years. I'm not particularly anxious to find out....

Indeed. In my opinion, the BAC story also shoots down the theory that you must focus on the less followed names -- particularly, those stocks that operate in countries that are secular economic growth stories -- to make outstanding returns. My opinion is that this is a myth that RIAs or hedge fund managers perpetuate because that's their niche in the market. When you get a punch card opportunity like BAC, one of the most followed stocks on the planet, you damn well better take it if you are confident in your analysis and can summon up the intestinal fortitude. Unless you're an RIA, of course. Given that the crowd is so often WRONG, why NOT go to the most followed names? Aeropostale has 22 estimates on it right now - it's more than doubled since last September. You have the best of all worlds with heavily followed names - 1) the influence of the crowd in both directions, and 2) untold amounts of research on the names, making the analysis process that much more efficient, and 3) greater liquidity, so size isn't as great of an issue.

If and when ECRI's call (http://www.businesscycle.com/news_events/news_details/5065) materializes, it will be interesting to see what bullets we try to conjure up - Dalio's interview back in October at the Economist's Buttonwood conference seemed to indicate the next downturn may not be pretty....

What does RIA stand for? guessing .... Registered Investment Advisor Ah, ok. That makes sense, I guess. Why take the career risk of owning BAC until everyone likes it? Exactly. No saying describes this phenomenon better, IMO, than "It's better to fail conventionally than succeed unconventionally". Riding Apple down from $1,000 to $500 along with everyone else is much easier to explain away to clients than holding a stock showing up on A-1 of the WSJ everyday with litigation headlines.

What does RIA stand for? guessing .... Registered Investment Advisor Roger

It's amazing to witness first hand the improving sentiment around BAC, and the fins in general, the higher the price. The general RIA population that I am in contact with truly feels more comfortable owning these things AFTER this gigantic move, and particularly after the stress test. Behavorial finance at its best.

I love the continuation of a thread that has been inactive for six months as if anyone cares hahahahh

Thank you!

You only give an exerpt on your website..... Thanks in advance.

Great article, thanks!

I don't understand why you are using BAC's price/book, but KO's price/earnings. I would rather have BAC at 0.40 book with 10% ROE than Coke trading at 5X book and earning 40% on equity. So would I. I'm just saying that the investments are equal with BAC trading at 10 times earnings (or 1 times book under a 10% roe scenario) with a 10% roe and KO at 21 times earnings with a 40% roe.

I think BAC's return on equity will be better than 10% after 2-3 years. Why? Because much of their earnings will be driven by a recovering housing market. There is every reason to believe that once BAC gets their litigation issues out of the way, and their operating costs down to very efficient levels, they would entertain a price not much less than Wells Fargo relative to book. - Moynihan's model for BAC over the next five years is to copy the culture and customer-centric focus of Wells. - They have the deposit base and the mortgage business. - They also have a much more complete investment business than Wells. - The credit quality of their portfolio is improving every quarter. - Their operating efficiency should be on par with Wells over time. When you have a CEO who truly puts his compensation aside to do the right thing for the business, you start to develop a culture that will permeate the ranks over time. Compare Moynihan's compensation to Vikram Pandit's. Look at what Moynihan had to work with and turnaround and look what Pundit had to work with...then compare their compensation. That changes the way employees behave when the CEO does the stuff that no one else is willing to do. I'm very keen on BAC, because I'm very keen on Moynihan...he's the intangible asset in the valuation that you guys aren't including in your calculations! Cheers! Well said!! I like what you said about the investment business in particular. If JPM's belief that the next 10 to 20 years will see significant capital markets growth, then BAC's capital markets business will prove to be a highly valuable business going forward. JPM_IB_Slide.pdf

I'm not comparing BAC and KO right now. I'm saying BAC at BV with a 10% ROE is the same as KO at 21 times earnings with a 40% ROE. Parsad said he plans on holding BAC for much longer than two years. He also said he believes it will reach BV in two years, which implies he believes BAC is worth holding at BV, which further implies BAC will earn higher than its cost of equity. Thus I was curious what his thoughts were.

This was precisely the reason for my question to Parsad. If we assume BAC earns no higher than its cost of equity, then once it reaches book value it is no longer a compelling long-term investment, regardless of the payout. If in fact normal EPS is $2.60 as Eric posited, BAC's cost of equity is 10% and it earns 10% on reinvested earnings, then BAC is no longer a compelling investment once it hits $26. If in fact ROE is 12% as you said, then BAC remains interesting even at an EPV of $26 since 50% of earnings reinvested at 12% equals a growth rate of 6% and a 4% dividend yield (required yield to reconcile 6% GR w/ 10% cost of equity) means a stock price of $32.50 (.5 x 2.6 / 4%). Bottom line - I was curious what Parsad thought was "normal" ROE for BAC since that will largely determine the attractiveness of holding BAC for a long period of time.

Moynihan just told us last week that $35b-$40b pre-tax income is still doable in a normal environment (normal Fed interest rates, GDP growth of 3%, and planned cost cuts in place). So $2.60 per share is possible if 11b shares and tax rate of 28%. So a reason to hold the stock longer term is perhaps to wait to sell it into a stronger economy when full earnings power is realized. He fields a question about it at the 21:30 mark (replay on BofA website). I can't make it work with these calculations. $2.6 per share at 11b shares is $28.6b of net income. EBT is then $39.7b assuming a 28% tax rate, which implies nothing for loan loss reserves since ptpp is 35 to 40. Perhaps the $2.6 eps assumes a tax shelter? Even if so, 2.6 is not sustainable earnings usable for valuation purposes. It's 35-40 of "income" before tax but AFTER provisioning for losses. Ah yes, didn't notice that. Dang that seems high for EBT. Would be sweet though.

Moynihan just told us last week that $35b-$40b pre-tax income is still doable in a normal environment (normal Fed interest rates, GDP growth of 3%, and planned cost cuts in place). So $2.60 per share is possible if 11b shares and tax rate of 28%. So a reason to hold the stock longer term is perhaps to wait to sell it into a stronger economy when full earnings power is realized. He fields a question about it at the 21:30 mark (replay on BofA website). I can't make it work with these calculations. $2.6 per share at 11b shares is $28.6b of net income. EBT is then $39.7b assuming a 28% tax rate, which implies nothing for loan loss reserves since ptpp is 35 to 40. Perhaps the $2.6 eps assumes a tax shelter? Even if so, 2.6 is not sustainable earnings usable for valuation purposes.

Petec, I followed up this discussion with my energy friend, and this was his response in regards to what will drive US gas prices toward global prices: XOM's exports aspirations were noted in the article Parsad just posted as well: http://www.bloomberg.com/news/2012-03-12/chesapeake-ceo-courts-asians-for-100-billion-resource-energy.html

I like that calc better. If so, FYE 2014 BVPS is at least $1.25 higher than it would be otherwise.

If I'm understanding you correctly, what you're saying is exactly what I'm saying - at some price, all investments are of equal attractiveness. The key is price. So KO at 21 times earnings with 40% ROI for reinvested earnings, a 4% payout yield and 6% growth (6% growth achieved by retaining only 15% of $1 of earnings due to 40% ROI) is the exact same (assuming the economic prospects of KO and BAC don't deteriorate permanently going forward) as BAC at 10 times earnings with a 10% ROI for retained earnings, a 5% payout, and 5% growth (5% achieved by reinvesting 50% of $1 of earnings due to 10% ROI). This is why I'm curious as to what Parsad sees in BAC long-term given the prospect of elevated capital ratios and correspondingly lower ROEs.

I was being conservative with $1.50 EPS by 2015. I can't quite get to $2 like BB, but I think $1.75 is quite doable after New BAC is fully implemented. Parsad, I picture BAC being a low-return, high payout asset in a few years, thus not a great buy and hold investment once it reaches book value (let's say $20). What do you see that makes you want to hold over a super long time horizon? If it eventually earns its cost of equity, say 10% on a $20 BV, then it won't matter if it pays out 100% of earnings for a 10% yield or pays out 50% for a 5% yield and 5% growth. I guess it comes down to this - do you foresee more WFC-like returns on equity of 12 to 15%?

Agreed. I'm just saying that BAC was inaccurate in the recent past, thus Mr. market has that recent memory in mind when assigning an asking price to BAC. Not that anyone cares, but this is how I look at it. Total potential repurchase losses are about $60 billion assuming all loans under 25 pmts are bought back and experience a 30% loss rate. Realistically let's say $30 billion instead. So over the next three years that works out to $10B per year in further losses. BAC generates roughly $30B PTPP before factoring in New BAC but assuming $300 million per quarter for LAS expenses. Let's say "core" provision is around $8 billion - in other words, what it takes to reserve against the "current" loan portfolio. So that leaves let's call it $20 billion to cover additional repurchase and loan losses. Over three years thats $60 billion of PTPP to cover $30 billion of repurchase losses and leaves $30 billion to write off anything 30 days or more past due over and above what is currently reserved for. So by 2015, BAC could have all repurchases taken care off, all non-current loans written off and/or fully reserved for, New BAC fully implemented, a clean book value somewhere between $20 and $12 per share, and clean "though-the-cycle" EPS of around $1.50 per share. I say by FYE 2014 it trades for 12.5 times that EPS number, or $19 per share. Not a bad three year return. Yes I have a position in BAC and yes it goes against my rhetoric of the last six months. However, I've learned from my mistakes, rolled up my sleeves and really dug into BAC's financials, and taken heed of Berkowitz's recent words of wisdom: "the world rarely comes to an end."

The doubts arise from whether or not BAC has charged off enough and if the figure you cite, 2.1x charge offs, is actually indicative of BAC over reserving. Further, based on BAC's historical loss rate on repurchases and the amount of loans still at less than 25 payments, there is a chance BAC could suffer further repurchases losses of greater than $15 billion. Right now BAC says "possible" losses are $5 billion - given that last year bac said possible losses were less than $10 billion and had to reserve for an additional $15 billion, IMO the market is right to question management on its assumptions. However, while I believe the market is quite correct in discounting BAC for the above risks, I believe all of the above concerns are strongly mitigated by $30 billion of ptpp before accounting for "New BAC" cost cuts, and time (i.e. the more loans that reach greater than 25 pmts the lower the risk of repurchases). If we have another recession, NPA will have to be written down even further, loans less than 180dpd will go bad at a faster rate and thus have to be written down to NRV, and the current loan portfolio will experience standard loss rates. So at risk of pointing out the obvious, BAC could languish for longer than expected, but the current price may provide reasonable compensation for such risks...

Petec - very interesting thoughts. Perhaps niavely I just assumed the more expensive older methods would continue to represent the marginal cost, but I guess lower prices may drive that type of production offline, which would lead to the more efficient methods setting the marginal cost. However, I have a good friend that runs a successful long/short energy shop who believes the price of gas will rise to the global price of $9 sometime in 2013/2014 time frame. Perhaps there are more expensive extraction methods worldwide that he believes will set the price. I'll have to ask... Regarding the price of oil....Exxon Mobil just came out with a $185 billion five year capex budget and is projecting very little production growth. Given XOM's stringent ROI standards, the only way to reconcile this (big capex, small production growth), IMO, is that XOM believes the price of oil is NOT going down. This is confirmed, again IMO, by Tillerson saying the cost of extraction is rising and that XOM's production growth rate is declining due in part to quota sharing agreements that stipulate a lower share of volume when prices rise. Further, for my own sake since I tend to have a more pessimistic view of the global economy, I think it is enormously bullish that greatest operator perhaps in corporate history is committing to a $185 billion capex budget based on a commodity who's price would, in theory, be strongly affected by a Chinese slowdown and/or a developed world slowdown.