What: Shares of Bank of America (BAC -1.29%), the second-largest bank in the U.S. by assets, retreated by $0.23, or 1%, to close at $15.81 on Friday after investment banking firm UBS cut its rating on the company and slashed its price target.
So what: According to Brennan Hawken, the covering analyst at UBS, Bank of America could see a deterioration in some of its capital ratios as a direct result of announced changes to capital models related to the Federal Reserve's annual stress tests.
As Hawken notes, "a qualitative failure is a real risk this year," and the capital model changes could results in Bank of America failing the Federal Reserve's Comprehensive Capital Analysis Review. Were this to happen, it's possible Bank of America would need to raise additional capital and/or suspend plans to return extra capital to shareholders.
Bank of America's annual filing had the following to say: "The U.S. banking regulators have indicated that they will require modifications to these models which would likely result in a material increase in our risk-weighted assets resulting in a decrease in our capital ratios." Hawken estimates these changes will lead to lower capital returns and the potential for Bank of America's ratio of common equity Tier 1 falling by 80 basis points.
In response, Hawken cut his firm's rating on the banking giant to "neutral" from "buy" and slashed its price target 20% to $16 from $20.
Now what: Following this downgrade, investors (especially shareholders like myself) need to ask whether this downgrade and price target cut are justified.
On one hand, even as a shareholder, I have to agree that Bank of America hasn't had the best of luck with the Fed's CCAR. Last year, when everything looked great and shareholder capital boosts were announced, the bank wound up having to take a mulligan after discovering a huge accounting error. This year, capital model changes could sack its plans to further return capital to investors. Taking a wait-and-see approach wouldn't be a bad idea for short-term traders.
However, I'm not a shareholder in Bank of America for six months. I've been a shareholder for more than three years now and have no intentions of selling anytime soon. The bank should be nearing the end of its mortgage-related legal woes from the housing bubble, and it's returned to its roots of growing its deposits and loans while focusing on increasing the credit quality of its loan portfolio.
Is Bank of America perfect? Far from it, and it certainly deserves to trade at lower multiples relative to its peers. Altogether, though, I believe Bank of America's baby steps forward have helped to put a floor under the stock in the mid-teens, and I still suspect it has upside over the long run.
Shareholders may have to wait another year for a dividend increase, but fundamentally, I don't see anything concerning about Bank of America's capital ratios or underlying business model.