Speculating on this Bank's Future
Christopher is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Bank stocks just can't seem to catch a break. The institutions that were at the center of the 2008 financial crisis – at least the ones that didn't go belly up – are still fighting an uphill battle as they attempt to revive the growth and prestige that once characterized the industry. However, every time it seems like things are starting to turn around, a bank manages to do something that forces investors to question anew the value of owning any financial stocks at all.
This fear is only exacerbated when even the strongest banks succumb to the dangers inherent in an unwieldy corporate bureaucracy that employs excessive risk and leverage without proper institutional controls. JPMorgan Chase (NYSE: JPM), which took advantage of its relative strength during the crisis to pick the carcasses of both Bear Stearns and Washington Mutual, clearly demonstrated with its recent trading loss – now at $5.8 billion and still growing – that no bank is immune to the costly consequences of poor decision making.
If even a bank like JPMorgan can stumble so badly, investors have to wonder how a company like Bank of America (NYSE: BAC), a bank that is obviously no stranger to poor decision making, can ever rebound from the drastic losses they suffered in the aftermath of the housing market collapse.
Although the fear of bankruptcy has subsided somewhat, there are still many questions surrounding Bank of America's future viability as an independent entity. Most of these problems are related to what has already been widely panned as one of the worst business acquisitions in recent memory: the 2008 purchase of sub-prime mortgage lender Countrywide Financial.
The original cost of that deal was only $4.1 billion, but Countrywide has become a cancer that has threatened to destroy the company from the inside out. Between the numerous lawsuits concerning unscrupulous lending practices and the potential repurchasing of underwater mortgages, Countrywide has exposed Bank of America to tens of billions of dollars in potential liabilities.
Unfortunately, the uncertainty doesn't end with Countrywide's past business practices; the future of its other business units are also in some doubt. For instance, Bank of America's other big purchase during the tempestuous year of 2008, Merrill Lynch, is not doing the company any favors either: Last year, the investment banking unit lost $1.7 billion, and it is possible that the entire industry will never return to the heady days that existed before the crisis.
It is this considerable uncertainly that helps to explain why Bank of America continues to trade at just over one-third of its book value. On the bright side, even if it is assumed that Bank of America is improperly valuing its assets, the depressed stock price has at least given investors a significant cushion in the event that later markdowns are needed.
This margin of safety should give investors some solace, especially when it is considered alongside the company's initiatives to remake itself into a smaller and more stable bank – a strategy that has received the rather uncreative moniker of Project New BAC. If successful, the plan should allow the company to unlock some of the value that is hidden beneath the mountain of bad loans that is seemingly crushing the bank to death.
Like its name, the strategy is not particularly innovative, but it could still be quite effective. Essentially, Project New BAC is designed to eliminate all extraneous costs within the company, which should allow them to save money in order to buffer its balance sheet and concentrate on its core businesses. Ultimately, CEO Brian Moynihan, who has spearheaded Project New BAC, has made it his goal to reduce costs by $5 billion within the next several years.
Some of these cost savings have come from massive layoffs, which could reach 30,000 when all is said and done. In addition, Bank of America has raised cash by selling numerous extraneous assets, including nearly $20 billion through its divestitures of BlackRock (NYSE: BLK) and the China Construction Bank.
These asset sales have helped to buttress the bank as it attempts to reach equitable settlements with the many homeowners, businesses and government agencies that are demanding restitution for the inherited misdeeds of Countrywide. The company has already set aside $35 billion as a reserve to pay these eventual settlements, but there is no guarantee that this amount will ultimately be sufficient.
Given this fact, it is nice to know that Bank of America is currently a profitable company: In the second quarter, the bank reported net income of $2.1 billion. This was a significant improvement from its first-quarter profit of $653 million, and it should give investors some confidence in the company's ability to protect itself in case its future legal liabilities become much greater than expected.
Although these profits help to explain why the stock rebounded nicely from its lows in December of last year, it has pared back half of those gains in recent months as investors continued their flight to safety in the face of uncertain economic prospects in both Europe and the United States. As the interest rates on Treasuries clearly attest, investors do not have an appetite for risk, and there are few stocks that are more risky at the moment than Bank of America.
Unfortunately, unlike many other bank stocks, Bank of America will not pay you to wait out the worst of the storm as the drama surrounding its mortgage portfolio unfolds; even after the company passed the latest round of stress tests in March, it is still paying a minimum quarterly dividend of just a penny per share. Moynihan appreciates the uncertainties inherent in Bank of America's future and knows that they must continue to boost their capital reserves by retaining their earnings. However, this is little consolation to many investors who have become positively giddy over stocks that pay high dividends in this low interest rate environment.
At this point, Bank of America may seem like little more than a speculative lottery ticket on the solvency of the company, but it could very well be a bet worth taking. Given the current risk aversion of so many investors, Bank of America has found itself trading at a significant discount to almost any traditional valuation metric. With everything that the company has done in the past four years to repair its balance sheet and to settle its legal problems, the stock could be an interesting value play that offers enough potential rewards for any investor who is willing to take some significant risk with a small portion of their portfolio.
cjcoyle has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America and JPMorgan Chase & Co. Motley Fool newsletter services recommend BlackRock. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.