BAC and BAC WS A: Much cheaper than WFC?

29/10/2012 BAC: $9.12 per share BAC WS A: $3.63 Market Cap: $98.29B

The Introduction The idea to invest in Bank of America came to me in a strange way. Some of my close relatives were investing in single family homes in Florida and I was asked to join them in their venture. That sounded pretty odd to me taking into account that I am a middle class guy living in Spain. But the economics couldnt look better: there were homes in which the rental yield on the unlevered property could go up to 15%. (Goldman Sachs estimates that the average rental yield in the US is 6.3% - http://www.bloomberg.com/news/2012-03-16/u-s-homes-are-abargain-by-one-measure-the-ticker.html). After studying the situation a bit I realized the opportunity was great for Americans (after all I have heard Warren Buffet, Bill Ackman and Marc Faber among others talking about how cheap some of these properties are at the moment). The problem for me was that the management of the properties and the lack of cheap financing for foreigners didnt make the opportunity that appealing. So I decided to look for listed opportunities where I could profit from the rebound in the US housing market I expected sometime down the road. Big commercial banks certainly looked cheap and I came across the existence of some long dated warrants issued to the US Treasury that could be a very good opportunity as they mature in 2018-2020 and provide a fair amount of leverage. At the same time, I discovered that both Warren Buffet and Bruce Berkowitz were long BAC, which was almost exclusively focused on the US and the price to book ratio looked very attractive at 0.45x (0.69x Tangible Book Value). On top of that, BAC has one of the largest deposit bases of all US banks at more than $1 Trillion, which is the main competitive advantage a bank can have. Berkowitz, in his presentation about the stock thinks that there is no reason why BAC cant earn 1% on its assets and 10% on equity. He has 12.1% ($831 mm) of his portfolio invested in the stock compared to the $5Bn Berkshire put into the company in the form of preferred shares plus warrants to buy 700 million shares at $7.14 a share. Taking into account the generous conditions on the warrants I think the position is worth much more than its original value (Some think that he got a paper profit the minute he made the deal http://www.reuters.com/article/2011/08/25/us-bankofamericaidUSTRE77N4J420110825).

Buffet has recently stated that he would have done $10 Bn if he had been allowed to. If that had been the case, I think Buffets position in BAC would be close to his top position in Coke. I thought that that fact alone deserved taking some time to study the company in spite of my reluctance to invest in banks. After all I was willing to invest in the equity of a pool of several homes in the US, why wouldnt I want to invest in a more senior security (loans) in a much more diversified pool (virtually the whole US housing market)?

The Research: BAC The first thing that struck me as I was reading the 2011 annual report was that it was much more clear and explanatory than I had expected. Being such a big bank, I thought that understanding the balance sheet and the loan portfolio would be a difficult task. Although you probably dont get the same level of information as from an industrial company, I got quite comfortable with the data provided. From the start, you get that the bank is priced for failure and you know the reasons: the litigation they are facing and the legacy loans coming from Countrywide. If the bank can survive and get those issues behind, it could easily go to 1.5 BV in a few years time. As Berkowitz puts it, investors are focusing too much on the right side part of the balance sheet. The provisions they are taken at the moment are clouding the huge cash flows coming in. In his opinion, the situation reminds him of Wells Fargo in the early 90s. You can read an interesting piece about Joel Greenblatts thoughts about it and how he leveraged Berkowitzs idea in the following excerpt from his book You can be a stock market genius: http://es.scribd.com/doc/67041669/Excerpt-WFC-leaps An additional idea I would like to add to the discussion is the state of the home prices in the US at the moment. As seen before, the average rental yield estimated by Goldman Sachs is at 6.3%. In the low interest rate world that we live at the moment, buying a home is generally speaking a good investment for homebuyers and therefore, delinquencies for loans where refreshed LTV < 100% should trend lower over time. In other words, if I were a banker I would increase the lending now as I think its difficult for the collateral to drift lower. In order to get a sense of how much BAC is worth I will make an analysis of its: 1) Earnings power. 2) Balance sheet and book value quality. 3) Management. Along the way I will be comparing BACs metrics to those of Wells Fargo, considered today as the strongest bank and the one most praised by Buffet. 1) Earnings power

I think that the most important metric to measure the earning power of a bank is its pre-tax pre-provision earnings. In the conference call with Berkowitz, Brian Moynihan (CEO) predicted a $ 45 $ 50 Bn figure in a more normal environment: http://www.cnbc.com/id/43343328/Fairholme_s_Berkowitz_Still_Bullish_on_Bank_of_Americ a (The whole transcript here: http://seekingalpha.com/article/286691-bank-of-americacorporation-special-call ). My estimate is around $41 Bn even taking into account this low interest rate environment. As pointed out by the management and several analysts, banks are having trouble to make money as the net interest yield remains low (2.47% in 2011 vs 2.32% in 2Q12). I start from the net income to common shareholders from the 2011 annual report and we subtract one-time gains and add one-time loses (numbers in millions of dollars) to get to an adjusted revenue. Then, we apply a normalized efficiency ratio of 65%:

85 -6,500 -3,400 -3,300 -1,200 -1,000 15,600 5,600 3,200 1,800 1,100 13,410 1,361 -1,676 11,807 117,161 41,006

Net Income to common shareholders Gain on the sale of the CCB shares Gain on the sale of debt securities Gain due to credit spreads on structured liabilities Gain on the exchange of preferred for common and debt DVA gains on derivatives Rep & warranties provision Litigation expense Goodwill impairment Mortgage related assesments and waivers Impairment charges Credit provision Preferred Taxes Interest expense Adjusted Revenue (adding 80,274 as 2011 expense) Total PTPP @ 65% Eff ratio

Another cost cut will come from the repayment of the debt. At the end of 2011 the interest paid on the debt was $11.8 Bn ($ 372 Bn at 4Q11 vs $ 301 Bn at 2Q12). Management is buying back the debt aggressively (the average balance during 2011 was $421 Bn with an average yield of 2.80%), which is great news for shareholders as that yield is well above the net interest yield and has no costs attached. At 4Q11, the eff. ratio stands at a very high 81.6% due to many people employed taking care of the litigations and dealing with foreclosures. Both problems are temporary in my opinion.

Management has indicated that they see the efficiency ratio going to 55% in the long term. Although I see this number fit for the commercial banking part, its almost impossible for Merrill Lynch in my opinion. I have taken 65% for the overall bank to be conservative. One potential catalyst would be the increase in interest rates. At the moment I dont want to guess by how much the net interest yield could rise in that scenario and prefer to leave it as a margin of safety, but we know that the bank is positioned to benefit from a potential interest raise through its ALM operations. In Table 59 of the annual report we see that for 1% parallel increase in the yield curve net interest income would have increased by $ 1.5 Bn (3.66 % of total PTPP). In my opinion, thats not a bad hedge if interest rates were to rise. Lets compare the PTPP to Wells Fargos $ Bn Market Cap PTPP Mcap/PTPP Bank of America 98.29 41 2.40 Wells Fargo 179.69 31.56 5.69

Take into account that Wells Fargos efficiency ratio stands at 61% so there are no projected costs cuts and theres no guessing from management or me. Apart from that, the only reasons in my mind that could justify this difference in valuation would be the litigation that Bank of America is facing at the moment and the credit quality of its portfolio. Ill dive into both issues in the next point Balance Sheet and book value quality. In order to get an idea of how much could flow into net income, I am going to guesstimate the provision that could take place in a more normal environment. For the sake of simplicity I am going to annualize the 2Q12 charge ($ 1.8 Bn per quarter, which is still high as production of new loans remains low and the reserve allowance to net charge off ratio keeps going higher every quarter) and assume a 35% tax rate. Under those assumptions net income would be around $22 Bn, around the 10% ROE mentioned by Berkowitz. That would leave BAC with a P/E of around 4.5 in an environment where revenue is still weak.

Investment Banking vs Commercial Banking In order to do a proper analysis of BAC I think it would be fair to split the investment banking and the commercial banking side and to compare them to Goldman Sachs and Wells Fargo respectively, as the investment banking side of Wells Fargo is very small.

25 20 15 10 5 0 2009 2010 2011 Average 0911 12.06 11.2

Goldman Sachs ROE

Merrill Lynch ROE

Merrill (Global Banking and Markets and Global Wealth and Investment Management) is doing slightly better than Goldman and achieving double digits returns on equity. In my opinion, this type of returns justifies the book value price of the divisions, taking into account that in 1H12 the ROE for GWIM and Global Markets has been strong at 12.46% and 14.29% respectively. (Goldmans ROE for the 1H12 is 8.8% and trades at 0.79x Book Value). If we take out the $ 55 Bn (and the $ 14 Bn of PTPP) allocated to the GWIM and GBM and compare the commercial parts PTPP to Wells Fargos PTPP, we get a better sense of how bad the litigation and credit charges should be to justify this difference in valuation. Bank of America Wells $ Bn (ex ML) Fargo Market Cap 43.29 179.69 PTPP 27 31.56 Mcap/PTPP 1.60 5.69

1H12 trends Trends are improving practically everywhere. In my opinion, management is doing its job nicely. For example, non-interest expense is decreasing at a good rate and management is buying back long-term debt aggressively. Trends about the credit quality in point 2.

2) Balance sheet and book value quality

Capital and Liquidity levels Lets look at some measures to gauge the capital and liquidity levels of BAC. Tier 1 capital ratios for BAC look better than those of WFC. BAC Tier 1 common capital 11.24 Tier 1 capital 13.8 WFC 10.08 11.69

Besides, much of BACs balance sheet is fairly liquid. At 2Q12, they had $ 378 Bn in cash and liquid securities that could last 37 months of debt payments with no additional funding. That tells me that Bank of America is not going under any time soon. In fact, they could buy back all the debt oustanding and a great deal of the shares at current prices.

Goodwill If we have a look at the goodwill for each of the business segments, we get:
Goodwill 17,875 10,014 0 20,668 10,672 9,928 810 adjusted equity* 18.71% 30.06% 29.13% 9.04% 21.26% 34.16% PTPP/allocated

Deposits Card Services CRES Global Commercial Banking Global Banking & Markets GWIM All other

*The adjusted PTPP is calculated with an efficiency ratio of 65%. For those segments with a lower efficiency ratio such as Global Commercial Banking the end result is worse than the real one, while for those with a higher one, the results are clearly better. This isnt intented to be scientific but gives a broad understanding of each of the segments earnings power in a more normalized environment.

Taking out the goodwill from Merrill Lynch (GBM and GWIM), we have a total goodwill of $ 49.3 Bn, compared to $ 25.3 Bn in Wells Fargo. Thats an important difference between the two banks and has to be taken into account. Although, to be fair, the different business segments with goodwill in Bank of America have shown good returns on total allocated equity not to deserve a goodwill impairment in my opinion. Ill take off the difference from my estimate of intrinsic value for the sake of being conservative. Credit quality This is one of the most important sections in the research in my opinion. As seen from the comparison in valuation with WFC, this could be one of the two reasons that justify the huge difference. From the metrics, however, I get a sense that the credit portfolios of both banks are not that different.

2Q12 ($ Bn) Loans outstanding Net charge offs Allowance Non-performing assets NPA/Loans outstanding Coverage to annualized charge offs Allowance/total loans Allowance/Non-accrual status Net charge offs/Total average loans

BAC 892.3 3.6 30.3 23.84 2.67% 2.08x 3.40% 127% 1.15%

WFC 775.2 2.2 18.6 24.9 3.21% 2.07x 2.41% 91% 1.14%

We can see that depending on the metric, BAC is at least as well reserved as WFC, if not more. If we look at the consumer portfolio and days past due we get similar conclusions (the commercial portfolio is in much better shape and not affected by the Countrywide acquisition so I will keep it out of the analysis to make it shorter). Consumer portfolio DPD Current - 29 DPD 30 - 59 DPD 60 - 89 DPD 90+ DPD Government insured Purchased credit impaired TOTAL BAC 494,445 5,388 2,802 17,100 25,400 30,191 575,326 WFC 332,618 5,150 2,345 10,284 42,229 28,521 421,147

85.94% 0.94% 0.49% 2.97% 4.41% 5.25%

78.98% 1.22% 0.56% 2.44% 10.03% 6.77%

The difference in 90+ DPD category is around $ 7 Bn, which is well covered by the reserves BAC has over WFC. If we take the FICO score into account, BAC and WFC report their numbers into different buckets, but we can compare those loans with a credit secore below 680 (thats the minimum number in which they coincide). 2Q12 $ Bn FICO Less than 680 Total %FICO<680 BAC 100,345 574,159 17.48% WFC 95,522 421,147 22.68%

Surprisingly, BAC seems to have a better metric there. The last thing I wanted to check is which percentage of the residential loans exceeded the value of the home. 8

LTV>100 Total %LTV>100

BAC 90,843 380,705 23.86%

WFC 66,924 282,623 23.68%

Almost the same number. Overall, my impression is that WFCs portfolio is better than BACs but not by a huge margin. On top of that, I think that BAC seems adequately reserved and trends seem to be improving acording to the next figure.

Representation and warranties In this regard, I have no special insight on whether the company will have to pay more or less than whats have been reserved so far ($ 15.9 Bn). The total outstanding claims are $ 22.7 Bn at the end of 2Q12, so for the sake of conservativeness I will consider that as the amount to be paid.

Management has stated several times that GSEs are making claims in a different way than the past. For example, on loans that have made at least 25 payments or are more than 2 years old since default. Although I cannot judge how this will turn out, we have to take into account that 9

this is a legacy issue and as time goes by less claims should appear as this type of loans are no longer originated. 3) Management Brian Moynihan seems to be following the perfect path in my opinion. I would like him to reduce expenses faster but I guess it is probably not possible. One of the things he had repeated is that BAC doesnt need to make any acquisition to succeed and thats something I really like as an investor as the risk of making something stupid is greatly dimisnished. He is reducing long term debt aggresively, which is probably the best capital allocation decision (as mentioned earlier) as he hasnt been able to return capital to shareholders through dividends or share buybacks. The share buybacks would be much better as the stock would probably yield close to 22% (P/E of 4.5) in a more normalized environment compared to the 2.8% of the debt. And last but not least, Mr. Moynihan has certainly skin in the game because, as he said, almost all his net worth is tied to the stock and is paid in restricted stock.

Conclusion to invest in BAC The main argument here would be that the stock is cheap based on its earnings power (normalized P/E of 4.5) and book value of $236 Bn. Taking into account the difference in goodwill with Wells Fargo and the extra $7Bn we have added to the rep & warranties provision, we can get an adjusted book value of $200 Bn, almost double its current market capitalization. On top of that, it could be argued that BAC is one of the top contenders for being the most important financial institution in the US. I believe that they will not let BAC go under for mistakes created by Countrywide. Besides, as Berkowitz put it, BAC has more cash in the bank ($123.7 Bn) than its current market cap, which is quite significant. On the negative side we have that BAC is not as easily analysed as other companies and the probability of making a mistake is clearly higher. But, if you are bullish on the stock, there is a way to get a significant amount of non-recourse leverage: Warrants to buy the stock at tangible book value expiring in January 2019 (BAC WS A).

The Warrants: BAC WS A The warrants give you the right to buy the stock at what was tangible book value when issued ($13.3 per share) in Jan 2019. On top of that, they have several adjustments put in place to protect the warrant holders in case of cash dividends or other distributions, pro-rata 10

repurchase of common stock or merger. My feeling is that the warrants are pretty well protected against most corporate actions that could harm the holders. (You can read the prospectus here: http://www.sec.gov/Archives/edgar/data/70858/000119312510044940/d424b7.htm ). I have put all the complex wording into simple formulas to better understand the implications of the adjustments. Cash dividends or other distributions In this case, the exercise price decreases and the number of shares per warrant increase in any quarterly distribution above $0.01 per share. The previous exercise price and number of warrants are multiplied by quotients that follow the following formula:

The exercise price, as you can see, decreases in the same percentage as the amount of assets distributed compared to the market cap. I would consider it fair if it was compared to the book value but as BAC is trading below book, this adjustment is much preferred for warrant holders. The adjustment in the number of warrants is a nice bonus for the warrantholder. Pro rata repurchase of common stock Same procedure as in the previous case, the old exercise price and number of warrants are multiplied by the following quotients to get to the new ones:

No increase in the exercise price or decrease in the number of warrants will take place.

Simulation of possible gains with the common stock and the warrants In order to get a very rough grasp of the possible gains obtainable by the common stock and the warrants, I have assumed the BACs market cap will return to book value and ROE to be 10%. In addition, I have considered a 30% pay-out ratio from 2014 onwards. In this situation, the warrants could yield 587% over the 6 years. For 1.5x book value, it would go as far as 992%, and thats a 10-bagger. 11

2014 2015 2016 2017 2018 Book value 230,000 246,100 263,327 281,760 301,483 Earnings 23,000 24,610 26,333 28,176 30,148 Market cap 345,000 369,150 394,991 422,640 452,225 Dividends 6900.0 7383.0 7899.8 8452.8 9044.5 Dividends per share 0.68 0.73 0.78 0.83 0.89 shares 10143000000 10143000000 10143000000 10143000000 10143000000 strike price 13.03 12.77 12.52 12.27 12.02 Implied market cap 132,204 129,560 126,969 124,429 121,941 Share price 34.01 36.39 38.94 41.67 44.58 Gain w/o share adj 20.98 23.62 26.42 29.40 32.56 Acc Coef share adjustment 1.02 1.04 1.06 1.08 1.11 TOTAL EQUIVALENT GAIN 21.41 24.60 28.08 31.88 36.02 BV multiplier 1.5 1.5 1.5 1.5 1.5 HPR warrants IRR warrants #years HPR common IRR common #years 590% 143% 2 380% 95% 2 678% 89% 3 415% 61% 3 773% 67% 4 451% 46% 4 878% 54% 5 490% 37% 5 992% 47% 6 532% 32% 6

Disclosure: Long BAC WS A

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