10 Good Reasons to Short Bank of America

Bailout or no bailout, banks need to be profitable to survive. Bank of America has tremendous resources and connections to stay viable in the long term. But here are 10 good reasons to assume the BAC common stock will continue to fall through 2009 before the crisis abates.

#1 Bank of America also has a huge book of loans to homebuilders. It is time for at least a few to go bankrupt, this will be another severe dent in their portfolio. (Mish Shedlock quotes a minimum 7B+ in writeoffs coming)

#2 Bank of America must buy back $5B of auction rate securities. This is a cash transaction that takes away from their ability to lend in other areas, crimping income.

#3 Bank of America bought MBNA credit cards at the top of the market (2004). Thus Bank of America holds a very large exposure there to consumer spending decreases or increases in unemployment.

#4 In their distress with deteriorating loans, Freddie and Fannie have said that their top priority is to find recourse with fraudulent loans that have gone sour. If fraud is found, then the loan and the loss will be sent back to the originator. Until 2008, Countrywide originated over 25% of the countries loans.

#5 Countrywide has $25B in option arms still on the books that BofA is still liable for.

#6 Countrywide has $38B in debt outstanding. When Bank of America (BofA) took over Countrywide, BofA did not commit to guaranteeing the debt would be paid.

#7 When one of the Big Three automakers goes bankrupt, directly or indirectly this will mean at least a $5B hit to Bank of America

#8 Commercial Real Estate exposure is very significant

“Now what about financing of malls, retailers, office space, etc etc. A modest 10% writeoff across the board (highly likely IMO) would mean another $33 billion in writeoffs are coming from commercial real estate.”

http://seekingalpha.com/article/94896-bank-of-america-credit-weakness-spreading-to-commercial-loans

#9 The sheer arrogence of the Merrill Lynch purchase at $26/share for a company about to go bankrupt.
http://seekingalpha.com/article/94896-bank-of-america-credit-weakness-spreading-to-commercial-loans

#10 Bank of America has huge credit default swap counterparty risk

Bank of America currently holds over $1T in nominal credit default swaps. With deleveraging of hedge funds, parties that took the other side of their trades may not be able to pay out the insurance. In particular, if a party cannot payout on regarding a different CDS event, then the value of that party as an insurer of any other CDS contract becomes void. This could become a huge hole for BAC on many of their commercial loans.

What kind of opportunity is available for those interested in shorting the stock???

Assume a $124B market capitalization for the stock, referring to one year revenue based on 2007 revenue.

Subtract $5B writedown for homebuilder loans
Subtract $30B writedown in commercial real estate
Subtract $10B writedown of credit default swaps due to counterparty risk
Subtract $1B net writedown for auction rate securities
Subtract $5B writedown of Countrywide option ARMs
Subtract $5B writedown on prime mortgages from BAC legacy business
Subtract $1B from boomerang loans from Fannie and Freddie
Subtract $10B writedown to defease Countrywide and Merrill Lynch debt
Subtract $3B in credit card writedowns from legacy MBNA business
Subtract $5B writedown for commercial loans (industrial and especially automakers and their auto industry supply chain partners)

All of these negative events aside, within three years, Merrill Lynch and Countrywide will start to have a positive impact on earnings. But this year, we should expect the market cap of Bank of America ($124B cap) to absorb over $75B in writedowns and losses to net a market cap of $50B, which is approximately a fair value of $13/share.

Thus Lockstep Investing is recommending initiating a short position once Bank of America crosses $26 / share, exit when the stock crosses $12 / share.

Crocodiles smile at Bank of America

“Crocodiles are ambush hunters, waiting for fish or land animals to come close, then rushing out to attack. As cold-blooded predators, they are lethargic, therefore survive long periods without food, and rarely need to actively go hunting.”

In this time of pain and turmoil, investors need to come out of their defensive positions and find easy prey. The J series preferred shares of Bank of America (Ticker:BAC-PJ) are that prey.

For investors, the recent banking turmoil is both a blessing and a curse. On one hand, castrophic losses have threatened the viability of the US banking system. On the other hand, for the surviving companies, there will be tremendous opportunities with reduced competition. This conclusion was presented during the recent JP Morgan Q2 conference call where analyst Mike Mayo, observing the opportunities of big banks to take advantage of weakened competition, approached JP Morgan CEO Jamie Dimon with a point blank question.

“You have been waiting your whole life for this environment,” Mayo asked, so what is holding JP Morgan back from growing through mergers with so many competitors hurt?

Bank of America is in a similar position. Despite the significant downside exposure of the Countrywide purchase, Bank of America deposits-on-hand is enough to weather any major storm. Although common shares may ebb and flow with the distress of the credit crisis, there are lower risk areas that pay premium amounts for capital. Thus, the recent opportunities to buy Bank of America preferred shares at reduced prices have been tremendous.

Any investor in this security will receive a 7.25% coupon with a par value of $25 a share for five years ending 2012. If the investor can buy the shares for less than the par value, then the yield on the shares will be higher. During the recent sell off in financial stocks in July, the shares dropped to $16 which meant a yield of 11.3% on any share purchased.



The J series preferred shares are non cumulative, meaning Bank of America can suspend paying the dividend at any time and will not incur any liabilities. For the investor, this is the downside risk of preferreds. Yet banks often issue their shares as non-cumulative because under accounting rules it allows them to use proceeds of the preferred issue toward their Tier 1 capital reserves. In most cases preferred share dividends are not cut unless common shareholder dividends are reduced to zero and/or bankruptcy occurs. In comparison, even the Bear Sterns non-cumulative preferred shares are still being paid out by JP Morgan without disruption. As of July 28, 2008, Washington Mutual (Yahoo! Ticker: WM-PR) is still paying out their preferreds shares at a 16% yield. Although I view dividend cuts to Bank of America common stock over the next two years very likely due to Countrywide exposure, credit card exposure, and real estate exposure, I do not foresee a total suspension of the dividend in any scenario.

There will only be a few times when high quality will be available at discount price. The turmoil that brought the shares down to $16 will happen again, probably sooner rather than later, and probably in relation to a bank bigger than Indymac. In most cases, the general market will be in fear of complete collapse or unknowledgeable about the opportunities that abound at this time. I recommend waiting until these preferred shares once again reach $16 / share before buying. In most cases, the general market will be in fear or unknowledgeable about the opportunities that abound at this time. Only crocodile investors who wait until the conditions are appropriate will be astute enough to identify this opportunity and enjoy the best returns.

Transparency: Position initiated on Oct 10, 2008 at $16 / share. On that day the security reached an intraday low of $15.50 / share.