As an investor, it's easy to feel good about a position in Bank of America (BAC -0.21%) right now. The nation's second-biggest bank (as measured by assets) essentially passed its so-called stress test regularly administered by the U.S. Federal Reserve, confirming it could survive a serious economic downturn. A few days later, the bank announced a hefty 9% increase in its current quarterly dividend of $0.22 per share. Not bad.
Before you assume BofA's stress-test results and raised dividend mean it's fully eased out of the liquidity crisis that upended SVB Financial's Silicon Valley Bank, however, think again. There may be a better, risk-adjusted bet from the banking industry out there, like Capital One Financial (COF 0.16%).
Take a pass on Bank of America
You read that right -- Capital One. You most likely know it as a credit card company. But it's technically and legally a bank too and must face the same stress tests that other banks do. Indeed, by some measures, Capital One fared better than Bank of America did in its most recent round of regulatory scrutiny.
That's the take from Ian Lapey anyway, who manages Gabelli Funds' Global Financial Services Fund. He explains:
Recently released stress tests were very misleading. They were based on the assumption that interest rates would fall to nearly zero. Obviously, that is not happening. It also ignored the massive losses that some banks have in their HTM [held-to-maturity] securities portfolios.
And that's a particular concern to Lapey when it comes to Bank of America. He notes, "BofA's stress test results benefited from the assumption in the Severely Adverse Scenario that the three-month Treasury rate would fall significantly to near zero and the 10-year Treasury rate would fall to 1.5%. It seems very unlikely that the Federal Reserve would cut rates to near zero again given the sharp increase in inflation."
In the case of BofA's most recent examination, the Fed's probing also doesn't seem to consider the makeup of the bulk of its held-to-maturity securities portfolio. As Lapey goes on to say, these assets are mostly "Agency Mortgage Backed Securities whose underlying collateral consists of long dated fixed rate mortgages that are very sensitive to mid/long term interest rates."
His ultimate math? "BofA's CET1 [common equity tier 1 capital] ratio would be about 5.5% [versus the Fed's calculation of 10.6%] if the $100 billion unrealized loss on their securities portfolio was valued at market instead of cost."
And he's right. Here's how BofA's debt securities break down:
Image source: Bank of America's Q1-2023 10Q filing with the SEC.
Translation: Not everything is quite as hunky-dory with Bank of America's asset base as it may seem to be on the surface.
Take a shot on Capital One instead
So if not BofA, why Capital One? Aren't credit card outfits even more vulnerable at this time, with U.S. credit card debt at record highs near $1 trillion and delinquencies alarmingly on the rise?
They are.
Here's the thing -- everything is relative. Investors are arguably pricing in too little of BofA's actual risk into BofA stock. At the same time, the market's arguably pricing in more risk than is merited into Capital One's stock.
As Gabelli's Lapey notes, "Capital One's seemingly poor stress test results were mostly driven by assumption in the Severely Adverse Scenario that the unemployment rate would increase to 10%... A 10% unemployment rate would negatively impact Capital One more than most other banks because its loan portfolio has a larger percentage of credit card loans, which are very sensitive to levels of unemployment."
Lapey adds though:
"However, if unemployment did start to increase significantly, Capital One would probably tighten its underwriting standards ... Additionally, the stress test results show that risk-weighted assets (RWAs) only decline by 0.4% during the nine-quarter stress period. In reality, RWAs would decline by much more, resulting in higher capital levels than those projected."
In other words, the Fed's number-crunching doesn't account for adjustments being made to Capital One's operation and asset base in the event of an economic worst-case scenario, even though the company has implemented such changes during previous economic downturns.
And the Gabelli Global Financial Services Fund manager isn't the only professional stock-picker to suggest Capital One's mix of business and flexibility is misunderstood. Investment management outfit ClearBridge Investment sees it too, noting in its first-quarter letter to clients:
"We believe recent regulatory changes such as the Current Expected Credit Losses (CECL) methodology of the U.S. Treasury and the ability of credit card companies to manage credit risks have improved the risk profile of leading credit card businesses but have been underappreciated by the market. With its substantial financial reserves, we believe that Capital One is well-positioned to navigate future economic uncertainty."
The commentary concludes by saying, "We believe Capital One's current price has already been overly discounted, and we expect it to offer compelling upside despite further risks of drawdown when a recession emerges."
Image source: Capital One's Q1-2023 10Q filing with SEC.
It's noteworthy that the two separately established points of view are both pointing to the exact same subtle, bullish nuances. That suggests there's something to it.
Capitalize on the market's misunderstandings
Don't sweat it too much if you already own a stake in Bank of America. It'll be fine in the long run. At the same time, Capital One isn't a must-have name that absolutely must be bought now or never. It's got its risks too.
The Federal Reserve's recurring stress tests can paint a confusing picture for investors, though, casting an undeserved shadow of doubt on some banks while making others look healthier than they may actually be. As was noted, one critical detail that the stress-test regimen doesn't consider is how a bank will adapt to extraordinarily difficult circumstances. Another overlooked factor is the makeup of banks' held-to-maturity assets.
Whatever the case, from a risk-versus-reward perspective, the market is seemingly overvaluing Bank of America right now and underestimating Capital One. Invest accordingly.
