Will Europe Bring Down Bank of America?

The European sovereign debt crisis is now well into its third year of bludgeoning the global economy and stoking fear and volatility in the markets. Just last week, the Dow Jones Industrial Average (INDEX: ^DJI  ) shot up when the European Central Bank promised to do "whatever it takes" to prop up the eurozone. Yet the trend has since reversed itself after investors were disappointed by the bank's half-hearted measures to fulfill its promise.

While the continent's woes have weighed down manufacturing and technology companies in the second quarter, the bigger concern is that a final resolution to the crisis will ignite a "Lehman-type" event if the monetary union dissolves. As many of you will likely recall, this is Wall Street code-speak for a seizing of credit markets and the consequent failure of financial firms.

In response to this, many of the nation's largest banks have started itemizing their credit exposure to Europe's most troubled economies, the so-called PIIGS: Portugal, Ireland, Italy, Greece, and Spain. Two weeks ago, I examined Citigroup's (NYSE: C  ) multi-billion dollar exposure to these countries. I now extend the same critical eye to Bank of America (NYSE: BAC  ) .

B of A's exposure to the PIIGS
In absolute terms, B of A's exposure to the five most troubled European economies is both worrisome and troubling. In its most recent earnings release, the company reported $14.5 billion in such exposure, exceeding its earnings for the last five years combined. As you can see below, this ranks the bank third among its peers on Wall Street, behind both Citigroup and JPMorgan Chase (NYSE: JPM  ) though ahead of Morgan Stanley (NYSE: MS  ) and Goldman Sachs.

Source: Quarterly financial statements.

On a country-by-country basis, much like Citigroup, B of A's single largest liability is Italy, where it has $8.2 billion in gross exposure. Alternatively, and also similar to Citigroup, its least significant exposure is to Portugal, where it has a mere $412 million of credit risk.

In terms of counterparties, approximately 58% of its gross credit exposure derives from corporate clients. Insurance companies, hedge funds, and other financial institutions account for 26% of the total. And the countries themselves account for 16%.

Source: Bank of America's 2Q12 Financial Supplement.

Although these figures can't be dismissed, there are two things to keep in mind. First, B of A has hedged a little over a third, or 34%, of its exposure to the PIIGS with collateral or insurance in the form of credit default swaps -- though, the effectiveness of these swaps assumes that B of A's counterparties remain willing and able to pay if called upon to do so. Once hedges are accounted for, in turn, B of A's net exposure drops to $9.6 billion.

In addition, holding all else equal, even if B of A were forced to write off its entire exposure to these countries, net or gross, it could do so and still stay afloat. At the end of the second quarter, the bank had a $2.2 trillion balance sheet, of which $164 billion consisted of tier 1 common capital, which itself consists of common stock contributions and retained earnings. Consequently, while a loss of this magnitude would further delay a dividend increase, it wouldn't necessarily mean a wholesale destruction of the company a la Lehman Brothers.

Bank of America beyond Europe
Europe or no Europe, I've spent many hours analyzing Bank of America in the last few years, and I always come to the same conclusion: Although it's unquestionably a risky investment, due to its questionable mortgage portfolio and liability for issues inherited from its Countrywide purchase, in light of its current valuation, the potential return from future dividend payments and share price appreciation makes it an exceptionally attractive stock for investors who are willing to wait a few years for the payout.

It's for these reasons, as well as a handful of additional ones, that Bank of America is one of the companies profiled in our free report about stocks Warren Buffett and other top investors are buying. And it's also why Anand Chokkavelu, our senior stock analyst and in-house Bank of America expert, concluded in his recent in-depth report on the bank that "for investors who are comfortable taking a real risk of up to 100% loss of capital, today's prices are attractive and could result in a double or triple within the next five years." You can find the rest of his premium report on Bank of America here.

Fool contributor John Maxfield owns shares of Bank of America. The Motley Fool owns shares of Citigroup, Bank of America, and JPMorgan Chase. Motley Fool newsletter services have recommended buying shares of Goldman Sachs Group. Motley Fool newsletter services formerly recommended JPMorgan Chase. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Read/Post Comments (5) | Recommend This Article (20)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 03, 2012, at 6:32 PM, dcorley wrote:

    I think BA is the most vile bank in the world. It levies every conceivable fee and penalty without shame.

    And then when I think I have heard everything, they invent new shameless charges.

    Yep, I own 'em. If their patrons don't tar and feather them, there is nothing but money to be made.

  • Report this Comment On August 04, 2012, at 8:32 AM, JacksonInVA wrote:

    Not for me. Any bank is too risky. Their business models are over the cliff with risk. BTW, I do as little business with banks as possible. Now a very happy credit union user.

  • Report this Comment On August 04, 2012, at 9:21 AM, Questioner5001 wrote:

    (Well, so much for the haters, who have nothing specific to comment about the article at hand.)

    Anyway, a flaw in your analysis is that you group BAC's exposure to European crporations in with its exposure to financial institutions and the countries themselves. Te thing is, unlike past scenarios in Latin America in the mid 1980's, I don't see the European governments imposing currency restrictions preventing their national companies from paying their global debts. Many of these corporations are world leaders and substantial sources of export earnings for their home countries, so preventing these companies from paying their debts would be self-defeating.

    In other words, Fiat will probably be a much better credit risk than some local Italian bank or even Italy itself.

  • Report this Comment On August 04, 2012, at 2:43 PM, NovaB wrote:

    Why not? The US banks and the failed de-regulations and total lack of oversight in the US banking industry brought down the European economy.

  • Report this Comment On August 04, 2012, at 5:20 PM, neamakri wrote:

    Look, I'm not as smart as you...but aren't "hedges" and "insurance" exactly what brought down AIG and started the whole recession? In other words "hedges" and "insurance" give a feeling of security when in fact it makes everything riskier and less stable.

    The way I see it, if a financial intrument is too risky then buy less of it or none at all. OMG, is it that obvious?

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