Bank of America Just Joined Citigroup in Proving That Banks Are Full of Risks

An accounting error threatens Bank of America's capital return plan and investor confidence, two things Citigroup investors are familiar with.

May 1, 2014 at 9:42AM

Source: Flickr / Ken Teegardin.

On April 28, shares of Bank of America (NYSE:BAC) were off over 6%, wiping out billions in market capitalization. The cause of this drop was a realization of an accounting error that caused the bank to overstate its capital levels in the recent Fed stress tests.

With Bank of America's new dividend increase and $4 billion buyback program now in jeopardy, its becoming easier to draw parallels between Bank of America and much criticized Citigroup (NYSE:C).

Disappointment vs. delayed disappointment
Citigroup captured the attention of the financial world after the Fed rejected it dividend and buyback plans, saying Citigroup failed to address previously identified deficiencies. The failure of Citigroup to increase its dividend from a measly penny per quarter or increase its stock buyback knocked shares off around 5% from pre-rejection levels.

The capital return plan rejection could hardly have come at a worse time for Citigroup. Many investors were expecting larger returns from the bank and were probably pricing in their expectations. Additionally, Citigroup wanted something to turn the tide of negative news stemming from the fraud issues at the bank's Banamex unit.

Meanwhile, Bank of America mostly gave investors what they wanted. The bank would continue its buyback and raise its dividend from a penny per quarter to $0.05 per quarter. The stock essentially went nowhere and even slipped a little. The bank met expectations but did not do any more.

The April 28 announcement brings similar disappointment as the negative Citigroup results, just delayed a month from the initial release. Since this could mean a smaller dividend or buyback, Bank of America is being treated as having effectively missed its stress test expectations. Similar to Citigroup's drop, Bank of America shares slid around 6%.

Confidence issue
The potentially lower dividend and buyback is only part of what's concerning investors with this latest announcement. The accounting error at Bank of America is a big $4 billion one, and it managed to go unnoticed for four years.

Shortly before its stress test results, Citigroup had the previously mentioned fraud issue at Banamex that would cost Citigroup $400 million of it 2013 earnings. A second smaller fraud was discovered shortly thereafter and Citigroup has vowed to investigate itself for internal fraud issues.

Although numbers like $4 billion and $400 million seem big for us non-billionaires, these numbers themselves are not that big for giants like Bank of America and Citigroup. Aside from the capital return plan issue, the real concern here is one of confidence. Every time Bank of America or Citigroup disclose a $400 million fraud or $4 billion accounting error, investor confidence in the bank's other numbers is shaken a little more.

With a major bullish argument for Bank of America and Citigroup being a discount to book value, investors want to be able to trust that book value is what the bank says it is. The more of these events that happen at these two banks, the more investors will be skeptical of the banks' numbers making achieving book value level shares prices more difficult.

Going forward
Bank of America reminded investors that investments in big banks still contain significant risks, despite low price to book and price to earnings valuations. 

Based on concerns over the capital return plan and the reduction in capital levels, I view the April 28 drop as a fair amount for Bank of America -- at least until more questions are answered. While I remain bullish on these two banks for the long-term, and they always have been a long-term investments, these recent events are reminders to be patient and realize that, despite their size and valuations, Bank of America and Citigroup do carry significant investing risks.

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Alexander MacLennan has the following options: long January 2015 $20 calls on Bank of America, long Bank of America Class B warrants,long January 2015 $40 calls on Citigroup, long January 2015 $45 calls on Citigroup, and long January 2015 $50 calls on Citigroup. This article is not an endorsement to buy or sell any security and does not constitute professional investment advice. Always do your own due diligence before buying or selling any security. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America and Citigroup. 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.

4 in 5 Americans Are Ignoring Buffett's Warning

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Jun 12, 2015 at 5:01PM

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't 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.

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