Forget Writedowns, Bank of America Gets $16B Writeup!

From the Financial Times:

BofA set to gain $30bn on CCB stake

Tuesday Nov 13 2007

Bank of America (BAC) on Tuesday said it was sitting on a potential gain of more than $30bn on its investment in China Construction Bank, highlighting the paper profits some western banks have made on holdings in their Chinese counterparts.

BofA paid $3bn two years ago for an 8.5 per cent stake in CCB and an option to increase to 19.9 per cent at a very low price. The bank plans to record a gain of about $16bn on its existing stake in the fourth quarter.

“On paper we have a potential gain in excess of $30bn,” said Joe Price, BofA’s chief financial officer, adding that it would be able to cash in some of its holding over the next 2 to 3 years.

Not only does BofA have less subprime mortgage and MBS CDO exposure than other big banks, but they also have done some smart things which will certainly help them weather the storm.

Full Disclosure: Long shares of Bank of America at the time of writing

Countrywide Predicts Trough, Shares Soar 24%

Gauging the outlook for pure mortgage lenders like Countrywide (CFC) is a tough game and one that I am choosing not to play. The company is predicting that the third quarter was the trough and profits will return in Q4 and 2008, but nobody really knows for sure. Delinquency rates are still rising at CFC, standing at 7.1% as of September 30th, up from 5.7% three months before.

Until there are signs of stability and that stability hangs around for a while, I’m not going to bottom fish in mortgage-related companies like pure lenders or mortgage insurers. Honestly, those stocks are down so much, trading far below even recently slashed book values, that I think eventually there will be plenty of upside without even needing to time the bottom of the cycle.

Until then, I continue to like the bigger diversified banks with fat dividend yields. With these stocks yielding more than treasury bonds, I think you can justify buying low and being patient, knowing that calling a bottom is essentially impossible. I would, however, start making a list of the kinds of stocks you might want to target when things start to rebound. You won’t be able to time a purchase perfectly, but there is no way that most of the home builders, mortgage insurers, and big lenders won’t survive and be consistently profitable when the markets get back to some sort of more typical environment.

There will be money to be made, but I’m not comfortable jumping into pure plays just yet. Hopefully by sometime in 2008 things will stabilize and we’ll have a better idea of what “normal” conditions look like. At that point, making bets will be much more prudent.

Full Disclosure: No position in Countrywide at the time of writing

A Trade Idea As Another Bank of America Entry Point Presents Itself

On July 30th I mentioned how I thought Bank of America (BAC) stock at $47 was attractive with a 5.4% dividend yield. The shares moved above $52 since that post, but today are falling back sharply, to $48 each, after the company posted poor third quarter results, just like every other bank has thus far. The dividend now stands at 5.3%, and I think it is very safe.

If you want to generate even more income on this trade, you could buy the stock to collect the dividend and any capital appreciation, while simultaneously selling out of the money call options on the shares to collect more cash. For example, the May 2008 52.5 calls are selling for about $1.75 each right now. Buying the stock and selling those calls would result in a breakeven point of ~$45 per share over the next 7 months or so. Conversely, your upside would be up to $52.50 on BAC stock, plus dividends and option premiums of around $3 per share (up to 15% in total gains).

If you think the stock will trade within the recent range of the high 40’s to low 50’s, this trade would be a great way to make a double digit percentage profit if BAC can make up the few points of recent losses in coming months.

Full Disclosure: Long Bank of America at the time of writing

Banks Announce Major Writedowns? Duh!

That’s not even really my headline. It’s what the market is saying this morning after both Citigroup (C) and UBS (UBS) announced huge losses during the third quarter. Citi plans to take $3.3 billion in write-downs for the quarter, consisting of $1.4 billion from LBO loan commitments, $1.3 billion from losses on sub-prime securities, and $600 million from fixed income trading losses. Also hitting the wires today was news that UBS is projecting a quarterly loss of up to $690 million.

So the market’s getting crushed, right? Well, not exactly. Citi stock is up 1 percent, with UBS up 4 percent. The Dow is higher by more than 100 points, and once again sits above the 14,000 level. Now, I am not telling you this as a proclamation that the worst is over and we are off to the races. I don’t know when the credit losses will peak, and there will be more write-downs in the future, even additional adjustments from Citi and UBS.

The takeaway from this morning’s action is that everyone and their grandmother knew these write-downs were coming. The stocks have been hammered because of that. The rallies today should not be that surprising as a result. It represents a relief rally because, at least for now, the losses aren’t as bad as they could have been. That doesn’t mean things won’t get worse, it just means that, for now, the world is not ending.

Full Disclosure: No positions in the companies mentioned at the time of writing

Reader Mailbag – Is E*Trade a Bargain?

Carol from Phoenix writes:

“Chad, I was wondering if you would comment in your blog about E-Trade (ETFC) from a contrarian, value viewpoint. Their stock has been beaten down lately, but their fundamental business seems strong, and they appear to have rid themselves of what little subprime exposure they had. Thanks!”

Thanks for the question, Carol.

I decided to publish my answer on the blog because I have actually been looking at E*Trade in recent days. This is exactly the kind of contrarian play that I think value investors should be looking at within the financial services sector. It falls into the category of being beaten down due to mortgage market issues, but I do think there is a lot of long-term value here, given that mortgages are not a core focus for E*Trade. Let’s take a look at why the stock has fallen so much. The shares are down a stunning 54% since June to $12 each.

In recent years E*Trade has started offering its core retail brokerage customers a wider array of financial products, including bank accounts, certificates of deposit, mortgages, and home equity loans. Not surprisingly, they are not immune to the mortgage market meltdown. Earlier this month, the company announced it was joining the ranks of those firms moving to shut down their wholesale mortgage business due to market conditions. That, along with a higher than expected provision for loan losses and some institutional brokerage restructuring costs will result in dramatically lower earnings for 2007. E*Trade now expect full year GAAP earnings per share of $1.10, down from their prior target of $1.60 per share.

So, to answer Carol’s question, does ETFC represent a good contrarian value play? To me it appears that it does. With any contrarian investment idea, you will have to be patient, but buying a premier franchise for what could very well turn out to be less than 11 times trough earnings per share looks like a very attractive valuation.

There have been rumors of a merger with Ameritrade (AMTD), but I would not expect a deal in the short term as E*Trade gets their house in order. Ameritrade CEO Joe Moglia would love to do a deal, I’m sure, but at these prices, E*Trade is better suited fixing their issues and waiting for a more normalized profit picture before entertaining offers that maximize shareholder value. A deal does make sense at some point though, as online brokerage mergers have a ton of synergies that can be realized.

You may be curious if I have bought any ETFC shares yet. The answer is no, but not because I don’t find it an attractive option. It is simply impossible to buy each and every attractive stock when managing fairly concentrated portfolios. There are a lot of financial stocks I think are too cheap, and I own some and don’t own others. It’s just a numbers game really. If you are looking for portfolio additions in that space, E*Trade is definitely one worth considering.

Full Disclosure: No positions in ETFC or AMTD at the time of writing

Bank of America Tries the Value Game with Countrywide Investment

In recent years Bank of America (BAC) CEO Ken Lewis has taken a decent amount of heat from shareholders who have seen his acquisition spending spree as a bit reckless, at least in terms of the prices he has been willing to pay. Deals for the likes of FleetBoston and MBNA have made sense strategically, but the huge premiums offered did little to convince BAC investors that they were getting a good deal. That, in part, has contributed to the fact that BAC has been afforded a low multiple in the marketplace, relative to other large banking institutions, in recent years.

I found it interesting, given the deals that Bank of America has done already this decade, when news crossed the wires that BAC was investing $2 billion in Countrywide Financial (CFC) in the form of convertible preferred stock. The terms of the special stock issuance (a 7.25% annual coupon, convertible into almost 20% of the company’s common shares) were attractive, but that would be expected given the turbulence in the mortgage market right now. Countrywide is the largest independent mortgage lender in the nation, but still is facing short term funding concerns as the commercial paper market, a key tool for the company, has been drying up quickly in recent weeks.

With this deal, Lewis seems to be taking a contrarian approach. Obviously, I will not fault him for that given my investment strategy preference, but I just found it interesting that he had the patience to not bid for CFC when mortgage times were good (evidently the two firms have been talking about possible partnerships for years) and was able to pull the trigger when most others would be too afraid to do so.

Only time will tell if the Countrywide investment was a good one, but I like what Lewis did here. He gets CFC shares at $18 each if the company comes out of this mess a strong survivor, gets paid 7.25% per year while he waits for things to play out, and slides ahead in line of common stockholders to claim any assets should the worst case scenario unfold for the country’s leading mortgage player. Evidently he thinks the possible bankruptcy rumors are unfounded, and if he’s right, shareholders will have a tough time arguing with this latest deal.

Full Disclosure: Long shares of Bank of America at the time of writing

Capital One Shuts Down Mortgage Unit, Shifting Attention To More Profitable Areas

Those who have said the mortgage market’s survivors will thrive due to fewer competitors are certainly right, but as the Capital One (COF) announcement last night shows, even those that could survive might not even try to do so. The company has decided to shut down its GreenPoint wholesale mortgage unit and cut 1,900 jobs as a result. The secondary mortgage market is to blame, as Capital One is one of many banks that can no longer sell mortgages at profitable prices to investors in order to fund new originations.

Despite the headlines that will undoubtedly result from this news, let’s go through what it actually means for Capital One in dollar terms. GreenPoint was hardly in shambles before this announcement. After losing $12.6 million in Q1, the division actually earned a profit of $2.6 million in Q2, and management was assuming a breakeven year in 2007. During the second quarter, wholesale mortgages represented an immaterial 0.3% of Capital One’s net income. For the first half of 2007, the unit’s $10 million loss negatively impacted the company’s earnings by only 0.7%.

Why the rush to shut down Greenpoint then? I was actually surprised they didn’t halt new originations for a while to see how the secondary market shaped up in coming months, but given that there were 1,900 jobs within GreenPoint, and the odds of it generating any significant earnings in the short or intermediate term was essentially zero, it does make sense that Capital One management decided it was not a good use of resources to continue to fund the division. Why not just save a ton of money and cut the thing loose now?

Interestingly, even in 2006 when the mortgage market was great, GreenPoint only earned$138.5 million. That’s a lot compared with this year, but even then it contributed only about $0.33 to Capital One’s earnings of more than $7 per share. As you can see, even in good times GreenPoint might not be missed all that much, especially if the company can reallocate that money into higher return projects, which I suspect it can.

And keep in mind that this decision does not mean that Capital One is no longer in the mortgage market. They will still be loaning money to home buyers in the form of new mortgages and home equity loans through their local banking operations. They simply decided to halt the wholesale business in order to have more control over their loan operations.

All in all, this decision sets Capital One up nicely heading into 2008. The mortgage pressures on earnings will be lifted meaningfully, much of the merger related charges and other restructuring charges will be behind them (2007 was an integration and transition year), and the yield curve has steepened somewhat in recent weeks, so the company’s margins should improve.

Given that Capital One is still slated to earn more than $7 per share this year before one-time special charges related to the GreenPoint closing and merger-related charges will decline in 2008 as cost savings are further realized, I would not be surprised to see an earnings per share number meaningfully above $8 next year, (perhaps even approaching $9). In addition, after the company’s current $3 billion buyback is completed (it is more than half done), I would expect a new “bank-like” stock dividend put into place as well. In such a case, Capital One stock should no longer be anywhere near the current $66 quote.

Full Disclosure: Long shares of Capital One at the time of writing

What A Difference A Week Makes

I can hear the class action lawsuits being lined up already. On July 30th, mortgage REIT Luminent Mortgage Capital (LUM) issued a press release confirming that their 32 cent per share quarterly dividend would be paid as scheduled and not canceled, as many on Wall Street were predicting. The stock closed above $7 per share on the news. A week later on August 6th, they canceled the dividend and may be on the verge of bankruptcy, as evidenced by the stock’s more than 85 percent drop to less than a buck.

Either Luminent’s management team has no clue about their business, or there was some wishful thinking inside the company that will likely have to be defended in court. You often hear investors getting upset when companies fail to come out and deny Wall Street rumors that appear are untrue. However, in the case of Luminent it appears that even if a company does issue a statement it might not be accurate.

Now, it’s true that the mortgage-backed security (MBS) market has dried up quickly, but given the market environment, if there was any chance at all that things at Luminent could have worsened that much in a week’s time, the company really blew it by confirming the dividend. Just think how many people held on to the stock (or even bought) because of that press release.

If you own stock in any mortgage REIT, make sure you understand how quickly things can turn for them. Since they are forced pay out their income in dividends each quarter, they can’t stockpile cash for tough times. As a result, when the margin calls come there is no money there to pay, causing the stocks to be worthless nearly overnight. New Century Financial might have been the first mortgage REIT to go under, but it wasn’t the last, and Luminent won’t be either. Many think NovaStar (NFI) might be next.

Full Disclosure: No positions in the companies mentioned at the time of writing

Fear is Driving Market Volatility

We find ourselves in a market that doesn’t trust what companies are saying. Other than mortgage lenders and home builders, company conference calls this quarter have emphasized that things are not as bad as the markets are indicating. However, investors are scared and are selling indiscriminately, regardless of what companies are actually saying their exposure is. People just don’t believe them.

Should they believe them? It depends. If a senior management figure gives their opinion as to when the dust will settle and how bad things will get, you might not want to simply take what they say at face value because, after all, it is simply an opinion. What you can take to the bank though are statistics that companies give you. What kind of exposure they have to mortgages and other types of credit. Remember, numbers don’t lie, people do.

Fear is king right now. Somebody started a rumor that Beazer Homes (BZH) might go under. The stock fell 40% this morning within minutes. Some people might be bottom fishing in the home building sector, based in large part to their seemingly attractive price-to-book ratios. Beazer’s book value is $38 but the stock traded as low as $8 today (it has since rebounded to $11 as investors bet the rumors are untrue).

This shows you that you can’t always trust book values. Land values are often carried on the balance sheet at cost. However, the actual value of the land may be far below what a company paid for it. I don’t know if BZH will go under or not, but I have not purchased any home builders and have no plans to do so. They are simply too hard to value, in my view, since stated book values might not be anywhere close to accurate.

Conversely, when Citigroup (C) tells investors that perceived risky loans make up only 5% of their exposure to the credit markets, you can put things into perspective. You can find out what percentage of the big banks’ loan portfolios come from mortgages, or investment banking, or sub-prime borrowers. We don’t know exactly how many of these loans will go bad, but you can make aggressive assumptions and still realize where the overreactions are in today’s market environment.

Personally, I still stand by my opinion that the mortgage mess will not spill over into every other credit area. This is not to say that people aren’t losing their houses when interest rates reset to levels above a threshold that they can afford on a monthly basis. They will lose their houses, the banks will be on the hook for the loans, housing inventories will rise, and lower home values will result. But will these consumers default on their credit card bills, student loan bills, and file bankruptcy as a result?

I don’t think so, in the vast majority of cases. They will simply lose their house and be forced to move somewhere they can actually afford. Employment remains tight, so the ability of consumer to pay their everyday bills really shouldn’t questioned at this point. I feel confident about this view because when I look at credit card payment statistics, for instance, people aren’t defaulting at above-average rates.

If the sky was really falling, you would see deteriorating credit in every segment, not just housing related loans. As long as people keep their jobs, I am confident they will be able to make regular credit card and student loan payments, even if they are forced to move into a smaller house after their adjustable rate mortgage resets. After all, they should not have been in the other house to begin with.

Full Disclosure: No positions in the companies mentioned at the time of writing

Bank of America Dividend Yield Sits Far Above 30-Year Bond

Bank of America (BAC) is not a stock that has gotten my attention very often in recent years, but last week after the shares dropped to $47 and the company boosted its dividend yet again, I switching into the bullish camp (from neutral) for the stock.

BAC currently yields 5.4%, which is about 50 basis points above the 30-year treasury bond. That also equates to a trailing P/E of 10 times. I am very much aware that investors are spooked about mortgage lending and financial market exposure with the big banks, but compared with larger rivals JPMorgan Chase (JPM) and Citigroup (C), Bank of America has less exposure and should fare better should credit issues persist or get worse from here. Not only do they tend to avoid the very low end of the credit spectrum in the mortgage area, but a smaller portion of their profits come from financial markets than the others.

Given where the stock trades and the enormous dividend yield, I doubt the stock has big downside potential from here, and if the current worries prove to be overblown and BAC’s earnings growth continues, you could get decent capital appreciation in addition to your more than 5% annual payout, which is better than the projected performance bonds are currently offering.

Full Disclosure: Long shares of BAC at the time of writing