Bank of America
Is BAC "heavily exposed to big losses"?

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By johnnymaynard
October 11, 2007

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There seems to be a lot of misconception, and misunderstanding about what I am saying, so I want to clarify some of it, so that there will be no misunderstanding.

Several people have commented that they are willing to hold BofA for 10 years or more. That is what I would call "long-term" rather than medium term. I am talking about medium term. I define that as the next 1-3 years.

My point is that the banks' current big profit centers, upon which the last six years of record profits have been made (ie: issuance of junk bonds, based upon leveraged buyouts and worthless mortgagees) are ending. We will see immediate writeoffs, as we have seen in the announcements from Citibank and Merrill, but that is just the beginning.

We will also see a significant drop in continuing earnings, over the next 1-3 years. The drop in continuing earnings is not based solely upon temporary writeoffs for unsaleable securities. It is based upon the fact that the securitization business is dying. Defaults in traditionally issued type of mortgages, held for investment purposes, will also take a minor toll, and defaults by builders they are currently bankrolling will also hurt. Beyond this, many big banks have off-balance sheet conduits that are suffering serious losses, and these losses are not yet showing up on the balance sheets.

If you just look at BofA's securities division's already issued balance sheets, you will see a big rise in "securities held for sale" of over $20 billion, up to July 07, which is the most recent balance sheets publicly available. I interpret that to mean that, even before the so-called "credit crunch", they were finding increased difficulty in selling junk bonds. Now, BofA is holding a large portion of the $300 billion in "securities held for sale" issued since the July statement of financial condition, and the situation must be much worse. They have been able to sell certain higher rated portion of these bonds, after they discount them to 96%, but the remainder of the bonds may be less creditworthy. The remainder probably have a true market value much less than 96% of the issuance price.

Even if you assume that BofA is holding merely $150 billion, including pre and post-July "securities held for sale", and mark it down by 4%, you are looking at a short term writeoff of some $6 billion. Whether all of it will be taken in the 3rd quarter is anyone's guess. To counter this, BofA does have a paper gain in some of the banks it acquired, but those capital gains are not true profits from continuing operations, regardless of whether the accountants choose to use them to offset the losses. And, the capital gains are a one term thing, that should already have been discounted into the current selling price of the stock, since they are well known.

Looking forward, as stated, the previous high profits from the leveraged bond business are gone. Billions of $$ in profits, previously flowing into bank coffers, adding to bank profits, in the last 6 years, will no longer be adding to bank profits, in the future. I am not saying that the dividend doesn't look good, nor am I selling that the current P/E ratio doesn't look favorable. The dividends are nice given the 15% rate on such dividends, but companies can lower dividend payouts if they need to conserve cash. And, when profits dip, the P/E ratio changes.

Big banking institutions can make catastrophic mistakes. The old Bank of America almost went belly up, in the 1980's, after making bad loans to South Americans. Then, it almost went belly up again, in 1998, after getting itself embroiled in the Asian financial crisis and the Russian debt collapse. In fact, if Nations Bank had not rode to the rescue, buying and taking on BofA's name, the company, as it then existed, might have been liquidated by the FDIC.

I am not saying BofA is in danger of going bankrupt this time. However, they will suffer very serious losses from their current crop of speculative mistakes. In ten years, the situation may be different. The financial wiz kids may yet dream up some other financial vehicle with which to mint money for themselves. However, personally, I am not willing to watch my portfolio suffer losses, while hoping, and waiting for something new and novel to come along, in 10 years time, and I don't think many people are.

These problems are not exclusive to BofA, which is why I posted my opinion on many boards, as I went surfing around "the fool" website. It applies to most bank stocks, with only a few exceptions. BofA, however, is of particular interest because, as far as I can see, it is a player that is very heavily exposed to big losses, this time around.

As I said, buying uncovered puts is a very risky move. But, buying BofA's stock, or any of the other bank stocks, at the current prices, in light of the surrounding circumstances, seems quite irrational.