Bruce Berkowitz on BAC

[Parsad]

How does anyone know whether Moynihan is changing the culture of BAC?

 

This is a 100,000+ person organization.  Perhaps he is changing the incentive structure for most/all of the company.  But that does change the culture.  IMO, that change takes years and years not months.

 

How did anyone know that Buffett would change the culture at GenRe?  What about Prem at C&F and TIG?  These things take time, but it all starts with accountability from the top. 

 

Moynihan is getting lambasted because BAC was in bad shape from past mortgage underwriting and acquisitions.  Between him and the government, as well as the future Basel 3 requirements, there is enormous oversight on the large "too big to fail" institutions.  If anyone thinks things aren't different today at these institutions than say three years ago, they're nuts!

 

The system is slowly fixing itself.  These institutions will be the foundations upon future economic recovery.  The numbers and balance sheets show that they are slowly restoring themselves or have already done so in the case of WFC & JPM.  It doesn't mean there won't be bumps in the road, but it does mean that things are going to get better over time. 

 

Anyone here think WFC is going back to $9?  Or GE is going back to $7?  I remember no one wanted to touch either one when I was buying back in late 2008, early 2009.  I was told I was nuts and it was a black box, until it was revealed that Buffett was buying both.  Today, people are afraid of BAC, even though the tide is turning.  Prem is buying a bank in shittier shape...Bank of Ireland!  You check the numbers, you do your analysis, and then you buy when no one wants to touch the thing!  People are pulling money from Berkowitz...but Berkowitz is right!  Cheers!

[PlanMaestro]

Today, people are afraid of BAC, even though the tide is turning.  Prem is buying a bank in shittier shape...Bank of Ireland!  You check the numbers, you do your analysis, and then you buy when no one wants to touch the thing!  People are pulling money from Berkowitz...but Berkowitz is right!  Cheers!

 

There is more information about banks than almost any other industry. Just check the FDIC site or bankregdata and you will find most of what anyone would want. Also CRE and residential lending are large industries with plenty of information.

 

To consider banks a black box is to take an argument of opacity, that is somewhat true but not completely, and extend it to illogical extremes. Even CMBS, CDOs, and all the alphabet soup, that are supposed to be the most opaque, were heavily stress tested in this downturn and their issues peaked several quarters ago.

 

And if the loans and investments are so bad, why is their cash flow from operations so high?

 

Yes, part of it is because of ZIRP but BOFA and Citi are not the only ones benefiting. Also remember that only charge-offs are real losses while provisions are just estimates that tend to be a lagging indicator and still ... both are going down for most banks.

[DCG]

BAC is a huge holder of U.S. Debt, which is what's scaring people out of the stock in the near term.

[moore_capital54]

Aha, missed this.

 

My biggest issue right now is trying to ascertain the value of the "other assets" block,

 

Other assets

     174,459

 

Other assets, less allowance for loan and lease losses(2)

     378,629

 

 

(2) For the second quarter of 2011, $40.4 billion of non-interest earning equity securities were reclassified from trading account assets to other non-earning assets. Prior period amounts are immaterial and have not been restated.

 

 

Latest Q. I know I am being lazy here, but just started the DD and figure one of you may have already broken this down. I can't find references in the Q.

 

 

[Parsad]

Aha, missed this.

 

My biggest issue right now is trying to ascertain the value of the "other assets" block,

 

Other assets

      174,459

 

Other assets, less allowance for loan and lease losses(2)

      378,629

 

 

(2) For the second quarter of 2011, $40.4 billion of non-interest earning equity securities were reclassified from trading account assets to other non-earning assets. Prior period amounts are immaterial and have not been restated.

 

 

Latest Q. I know I am being lazy here, but just started the DD and figure one of you may have already broken this down. I can't find references in the Q.

 

 

 

You won't find much detail in the 10-Q.  Go to the 10-K:

 

http://www.sec.gov/Archives/edgar/data/70858/000095012311018743/g25571e10vk.htm

 

Check the MD&A under "All Other".  That will give you some idea of the type of assets they hold, but it won't give you the fine, nitty-gritty stuff.  To do that, you are going to have to dig into their filings...big job...and you still might not be able to find all of what you are looking for. 

 

But in the MD&A, you will get some idea of those assets, and you can come to reasonable estimates or more like "guesstimates" of potential for loss.  Then compare that to other assets, capitalization of the bank and cash flows.  In general, read the 10-K.  Cheers! 

[Uccmal]

I dont think banks are any more of a Black Box than anything else.  They are fairly simple entities.  They borrow money at one interest rate, loan it out at a hopefully higher rate, and charge their customers fees to borrow their customers money.  Investment banking is a fee based business.  The whole model when run semi-competently is pretty consistent and safe.  Problems happen when you have a loose cannon like Ken Lewis bent on world domination.  Moynihan is not that man.  Good article on him in Fortune this week. 

 

What you have with BAC is essentially the largest retail banking operation in the US.  They are number one or two across all major retail  categories.  They have an ongoing mortgage business. 

 

And then there is the runoff portion which is shrinking exactly, as runoff at that other black box I hold (FFH) shrank.  I hold the warrants and have been buying at these levels.  I have read the 10 k from last year and kept up with the story.  I expect by 2015 they will reach Moynihan's goal of 20 B/year income without acquistions. 

[Rabbitisrich]

Investment banking is a fee based business.  The whole model when run semi-competently is pretty consistent and safe.  Problems happen when you have a loose cannon like Ken Lewis bent on world domination.  Moynihan is not that man.  Good article on him in Fortune this week. 

 

 

That's a rather generous assessment of the investment banking model (which is still basically a catch all term). Everytime there is a financial shocker, from Credit Suisse FP in the 90s to Morgan Stanley in the 00s, we learn that executives don't really know the details of their own machine, and that it is very difficult to restrain risk taking behavior due to the incentive warping competition for talent. A well-hedged financial product offering today tends to become out and out speculation tomorrow, using the SAME instruments.

 

But BAC longs are likely correct that this is a time where risk management is actually meaningful.

[txlaw]

BAC is a huge holder of U.S. Debt, which is what's scaring people out of the stock in the near term.

 

Well, if we're talking about the move from $14 to sub-$10, it's really the reps and warranties issue that has been on the market's mind.

 

Mr. Market appears to be convinced that BAC will have to raise capital through a dilutive equity issuance, although even many of the analysts who believed that have changed their positions since the last quarter and CC. 

 

 

[Uccmal]

Sorry Rabbit, I meant that banking in total is a consistent business model, not necessarily I-banking.  As you say, certain things need to be kept in check.  Moynihan appears to be capable of keeping a lid on things, so far... He came out of retail banking.

[Parsad]

Mr. Market appears to be convinced that BAC will have to raise capital through a dilutive equity issuance, although even many of the analysts who believed that have changed their positions since the last quarter and CC.

 

They do not have to issue equity.  They could raise $20B in a week by selling their stake in China Construction Bank alone.  As long as they don't suffer any more egregious charges like the 2nd quarter, they should be able to grow their way out of this with a few small asset sales.  If they need more, they could sell that stake in CCB.  Cheers!

[txlaw]

i have been looking at this and I usually stay away from banks (not in my comfort zone)

 

i would like peoples take on WFC vs BAC, taking into account the potential risk vs reward. which one is better investment?

 

I like both.  I've pretty much shifted all my C position into BAC and WFC.  

 

BAC is cheaper, but WFC is by no means at fair value.  If you're risk averse and can't stomach the fact that BAC is a turnaround, go with WFC.  Also, there is a material difference between the two in that BAC has both a premier global investment bank and a premier US commercial bank, whereas Wells is really only a premier commercial bank (although maybe its investment bank will do better going forward).  That's not necessarily a bad thing.

 

Also, take a look at PNC.  Looks to be quite undervalued to me, although I do not own a position.

 

In addition to generating more NIM when interest rates go up, expenses will be going down quite a bit at all the big banks going forward.  Expenses are really elevated right now because of all the crazy sh!# that went down during the financial crisis and because there are redundancies that haven't yet been wrung out of their systems.  We'll also see to what extent there has been over reserving.

[moore_capital54]

Thank You Parsad, I figured as much.

 

Here are my findings and analysis of the situation. To me the biggest issue was understanding what these "Other Assets" are comprised of because when looking at tangible equity of around: $124B. or when reducing the Mortgage Servicing Rights we are at around $111B which is about $13~ per share.

 

Now, this Tangible Equity is essentially a liquidation value which gives no value to the earnings power of the business, which I believe is much higher than the tangible value. So again, I found myself willing to rationalize that any additional mortgage or loan related losses will be more than offset by future earnings. What worries me more is understanding whether additional losses can be realized from other areas of the balance sheet. I don't buy the Treasury argument as we now know the Fed will conjure money and support treasury securities ad infinitum. Same is true for any short term liquidity situation with BAC, which I view as a very low probability scenario.

 

Again going through the balance sheet on the asset side, I really don't have a problem with anything except for this "Other Assets" line and possibly the Customer Receivables.

 

Lets review the "Other Assets":

 

Other assets (includes $70,531 and $55,909 measured at fair value)

  182,124    

 

So we have $182,124 Billion of these "Other Assets" of which BAC is only providing disclosure for $70.5B worth which they account under fair value.

 

The breakdown of the $70.5B is as follows:

 

Other assets Fair Value 1                      Fair Value 2                        Fair Value 3                                                 Total

  32,624       31,051       6,856       –       70,531

 

Are the remaining $112B worth of securities all ABS? What else can be in there. That is the question here.

 

If I can get comfortable with this piece, than this becomes more of a no brainer.

 

 

[txlaw]

Mr. Market appears to be convinced that BAC will have to raise capital through a dilutive equity issuance, although even many of the analysts who believed that have changed their positions since the last quarter and CC.

 

They do not have to issue equity.  They could raise $20B in a week by selling their stake in China Construction Bank alone.  As long as they don't suffer any more egregious charges like the 2nd quarter, they should be able to grow their way out of this with a few small asset sales.  If they need more, they could sell that stake in CCB.  Cheers!

 

I agree.  Moynihan has said that they will be able to generate the required capital through ops.  If they sell the CCB stake, that will also help them out with their capital requirements, as the CCB asset is penalized.  

 

The 2nd quarter charge, which included a huge amount of reps and warranties reserves addition, was actually great.  It reminded me of Wells taking a huge quarterly loss a couple years back to get it over with.

[Rabbitisrich]

 

I like both.  I've pretty much shifted all my C position into BAC and WFC.  

 

BAC is cheaper, but WFC is by no means at fair value.  If you're risk averse and can't stomach the fact that BAC is a turnaround, go with WFC.  Also, there is a material difference between the two in that BAC has both a premier global investment bank and a premier US commercial bank, whereas Wells is really only a premier commercial bank (although maybe its investment bank will do better going forward).  That's not necessarily a bad thing.

 

 

WFC and, to a lesser extent, PNC are my major financial industry plays, along with a basket of community banks. You can benefit from the non-interest expense drawdown, loan performance improvement, and asset management and advisory fees. There are also plays like BK where the businesses warrant a higher multiple. Lots of places to make money in this sector.

[txlaw]

 

I like both.  I've pretty much shifted all my C position into BAC and WFC.  

 

BAC is cheaper, but WFC is by no means at fair value.  If you're risk averse and can't stomach the fact that BAC is a turnaround, go with WFC.  Also, there is a material difference between the two in that BAC has both a premier global investment bank and a premier US commercial bank, whereas Wells is really only a premier commercial bank (although maybe its investment bank will do better going forward).  That's not necessarily a bad thing.

 

 

WFC and, to a lesser extent, PNC are my major financial industry plays, along with a basket of community banks. You can benefit from the non-interest expense drawdown, loan performance improvement, and asset management and advisory fees. There are also plays like BK where the businesses warrant a higher multiple. Lots of places to make money in this sector.

 

I like BK as well. 

 

I own it for my parents but not for myself.  It's one of the least risky "banks" out there. 

 

Should benefit from higher interest rates and long term growth is tied to the growth of financial assets as investments, which is a given over the long term.

[Parsad]

The 2nd quarter charge, which included a huge amount of reps and warranties reserves addition, was actually great.  It reminded me of Wells taking a huge quarterly loss a couple years back to get it over with.

 

I remember the first time we met Sam Mitchell at our dinner, and we asked him about the large restatement and hit Fairfax took that one year.  It was shortly after he joined Hamblin-Watsa, and either Prem asked for his opinion, or perhaps Sam just offered it, but he said something to the effect..."Prem, we just can't have one issue or another coming up every quarter.  One shot...clean it up and move forward."  And that is what happened.

 

I believe when corporations have issues with operating companies that need to be rectified, this is the best way to do it.  You don't want to piece meal it quarter after quarter, year after year.  Moynihan is doing that...take the big hit, clean it all up...move forward.  Eventually, the market will recognize this when things look clearer.  Cheers!

[uncommonprofits]

Something I have not seen mentioned is comparable leverage and return on assets among banks.  I own some WFC and have tried to get my head wrapped around this somewhat.

 

Start with leverage.  The banks seem to be tied into the basel accord and something that WFC is strongly focused on.  Basel can get a little complex but it seems it starts with a base of 7% and works up from there.  Depending on a banks size, complexities, interconnectedness, etc -- they are assessed an add-on factor of generally between 1-2.5%. So in basic terms the minimum equity to asset ratio is 8% (seems to exclude preferred equity).   WFC indicate they are so far off the chart in terms of them being the opposite of interconnected and complex - so in essence their minimum should be pretty close to the bottom one would think.   The banks have a number of years to become compliant, but WFC at Q2 is already at 7.4%.    While they are close to being compliant, with WFC's conservative nature, I find it prudent to figure on an average equity leverage ratio of about 10%.  To me BAC is more complex and more interconnected -- hence, I think they will need a higher conservative capital ratio -- I am using 11%.

 

ROA.  I feel pretty confident that WFC can return to a long term average return on assets of at least 1.5%. Assuming that BAC can achieve net income of $20 Billion by 2015 this would represent around 0.9% return on todays assets but more likely <0.8% on 2015 assets.  Things could go better than expected for BAC but on the other hand so could they for WFC.  For that matter WFC's return on assets was already at 1.27% in Q2 and showing sequential improvement with more ahead by 2012.  But there is more to fix at BAC with further improvements down the road so lets use 0.9% ROA.

 

Over the next decade, I am very confident that WFC can achieve an average return on equity of 15% (1.5 roa /.10 leverage).  With BAC, there is more volatility in estimating an ROE of 8.2% (0.9/.11).  

 

Based on the above and a present book value of $23/share, over the next 10 years WFC would generate about $70 cash based on a 15% cumulative return (assumes dividends distributed are accumulated at same return) - equates to about 2.45x the outlay based on todays price of $28.58.  On the same basis, taking a BV of $20 for BAC, it would generate about $24.00 cash based on an 8.2% cumulative return - about 2.48x the outlay based on today's current price of $9.68.  In both cases these figures only include cumulative cash generation -- any adjustment in P/BV, PE, etc are over and above.  

 

In my view, I would want a higher return on BAC with what seems additional risk.... I don't see that being the case.  If BAC can achieve a higher ROA than I am estimating - it will outperform quite handsomely -- in my view though $20 billion in profit come 2015 does not quite cut it.  Doesn't mean BAC isn't cheap -- just that it would need better execution to out perform WFC.

[Parsad]

Hi Uncommon,

 

I think your reasoning and numbers are sound.  That is based on the assumption...that WFC can achieve 15% ROE, while BAC achieves 8.2% ROE. 

 

No argument there...based on those assumptions!  ;D  Cheers!

 

 

[uncommonprofits]

Hi Uncommon,

 

I think your reasoning and numbers are sound.  That is based on the assumption...that WFC can achieve 15% ROE, while BAC achieves 8.2% ROE. 

 

No argument there...based on those assumptions!   ;D  Cheers!

 

ROA and leverage were my assumptions - ROE derived from that. I don't think the leverage assumptions can be too far out.  ROA however is more of a dart toss.  IF BAC can quickly achieve ROA's rivaling that of WFC then it will significantly outperform WFC and be a HUGE winner.  But to put that in perspective -- just to match WFC's current under-performance (1.27% ROA in last Q) BAC would currently need to be generating close to $30 billion in net income.  Obviously, it will take time -- just throwing the ROA/leverage thing out there as food for thought.... it seems really critical in evaluating this in my opinion. 

[JSArbitrage]

Hi Uncommon,

 

I think your reasoning and numbers are sound.  That is based on the assumption...that WFC can achieve 15% ROE, while BAC achieves 8.2% ROE. 

 

No argument there...based on those assumptions!   ;D  Cheers!

 

ROA and leverage were my assumptions - ROE derived from that. I don't think the leverage assumptions can be too far out.  ROA however is more of a dart toss.  IF BAC can quickly achieve ROA's rivaling that of WFC then it will significantly outperform WFC and be a HUGE winner.  But to put that in perspective -- just to match WFC's current under-performance (1.27% ROA in last Q) BAC would currently need to be generating close to $30 billion in net income.   Obviously, it will take time -- just throwing the ROA/leverage thing out there as food for thought.... it seems really critical in evaluating this in my opinion. 

 

Just to throw some data in here, from 1990-2011(LTM), BoA average 1.03% ROA.  Take out 2007,2008,2009,2010,2011LTM for perhaps a glimpse of normalized ROA, you get 1.31%.  Again, Taking out 2007,2008,2009,2010,2011LTM, you'd have to go back to 1991 to find a year where BOA did less than .9% ROA.

 

[vinod1]

BAC has changed very significantly in the last few years so I would not put too much emphasis on the reported ROA, ROE of the original BAC. We have Fleet Boston, MBNA, US Trust, LaSalle, Countrywide and Merrill Lynch. Merrill Lynch itself is valued at over $50 billion in early 2000s before much of the housing boom. It might be more useful to look at current and potential PTPP earnings given the built in cost savings that are only a matter of time before they would be realized - foreclosure resources and other costs, retirement of more expensive Long term debt, etc. No need to factor in any synergies at all. They dont need growth, they just need to work through existing problems to generate pretty attractive returns on whatever metric you care about ROA, ROE, etc.

 

 

Vinod

[redskin]

BAC has and should earn somewhere in the range of $40-50B in pre tax, pre provision profit.  I think the question is what are the provisions in a normalized environment?  Here are the annual charge offs as a percentage of total loans for BAC...

2010 3.60%

2009 3.58%

2008 1.79

2007 0.84

2006 0.70

2005 0.85

2004 0.66

2003 0.87

2002 1.10

2001 1.16

2000 0.61

1999 0.55

 

What do you use as a normalized charge off ratio?  I think a conservative number would be 1-1.25% of total loans over the long term.  With approximately $950B of total loans, this would give you annual charge offs of 9.5-12B.

 

PTPP Profit of 40-50B and charge offs of 9.5-12B gives you pre tax earnings in a range of 28-40B.

 

This doesn't account for the possibility that they may increase loans in a stronger economy.

[Aberhound]

I hold WFC and no BAC. The way I think about BAC as having closer ties to Europe. When Europe does well BAC will do well. I noticed that when the debt fears about Europe became mainstream, BAC and Morgan Stanley's stocks dropped the most relative to the other big US banks. This is a clear signal to me that the undisclosed exposures in Europe are held by these institutions. In the pre 2007 period when there was little extra yield on Pig debt someone was selling the insurance. So for these two I will wait until the European tide goes out to find out who is exposed.

 

Also, since early this year the Euro is unexpectedly strong vs. the USD. Somebody in the US is lending large to the European banks which is exactly what happened in 1929 to 1931 just before the massive European defaults as described in Pres. Hoover's autobiography. I have been unable to determine who holds this exposure. Hoover was shocked when he discovered how much US banks had lent to the European banks. We are talking big lending enough to move the exchange rate 10% to 15%. History will likely rhyme and I won't hold BAC until we find out who is lending. It could be the Fed because I agree that the current BAC executive are making a lot of smart decisions. Maybe they have has no choice like the seemingly foolish decision to buy Countrywide by the predecessor.

 

After the European bank crisis banks will likely be rewarded by being less opaque. Think how FFH was rewarded as it simplified its balance sheet. I prefer WFC because its derivative exposure is small compared to BAC. The whole theory that you can offset one risk by holding an offsetting risk with another bank is obviously flawed because when one domino topples it is very hard to predict how far the contagion will go. I admit here I rely on faith to a certain extent in buying WFC but I have observed that Scottish thinking has saved many Canadian banks and I think of WFC as benefiting from a greater degree of Scottish thinking than the other big US banks.

[libor.plus1]

Berkowitz is getting man-handled on pretty much any bank sector investment. BAC CDS just jumped, and talks of bankruptcy are in the works.

[bluedevil]

Berkowitz is getting man-handled on pretty much any bank sector investment. BAC CDS just jumped, and talks of bankruptcy are in the works.

 

All the hot money that flowed to Berkowitz may now fly out.  Regardless of the ultimate merits of his investments, he may have to liquidate some holdings and realize losses to pay redemptions.