7.18.2011

BAC versus the ABX

At the IRA Sohn Conference this year, Jeff Gundlach, of Doubleline Funds put up a chart of Bank of America versus the ABX 2007-1 AAA tranche. Here is that graph:



Pretty tight correlation. A month or so ago I pointed out that non-agency mortgages were attractive and an uneconomic seller (the Fed) was really weighing on the market. With the Fed putting on hold any further Maiden Lane II auctions, the market has really taken a leg up. And because of that, the above relationship is falling apart:


This graph is normalized since January 1st, 2011 - I thought it better shows the dramatic out-performance of the ABX vs BAC equity.

For full disclosure, I have been buying BAC leaps in the last few weeks (Jan 2013 @ 15 strike). Call me crazy, but all the data I have gathered and read indicated the banks are ready to lend to their customers on the residential mortgage side. All "lending surveys" out there show an easing of conditions for everything but resi mortgages, but the tide is turning here and I believe this metric will go positive soon. Furthermore, the valuation argument is quite compelling. Eventually, loss provisions will normalize, and at run-rate operating earnings the equity looks like a steal (I have it at $2/share normalized EPS)

Finally, there is so much negativity in this name. Here are the list of reasons I've heard or read to not invest in Bank of America:
  • They are going to have to raise more capital to meet all Tier 1/Basel 3 requirements
  • They will have to settle with all the bond guarantors at billions of dollars each / Other put-back issues
  • Their housing exposure dwarfs the other money center banks and home prices still have a long way to go before reaching bottom
  • Litigation coming from every which way (AGs -> robo signers for instance)
  • The debt ceiling won't be raised and the world comes to an end (Side note: That August 2nd date is silly...if push comes to shove, the Fed will accept expiring bills as repo collateral to give the morons in Washington a few weeks)
  • China Construction Bank trade likes a dog
  • They aren't well positioned for a rise in rates
  • Etc. Etc.
Why the leaps you ask? I very rarely invest in leaps just because the potential downside is 100% (option expires). In this case, I feel like I've given myself enough time for the market to reprice BAC's equity to a more normalized level and I've converted my upside downside from say 1:1 being long the stock (b/c BAC's equity, in theory could still go to zero) to 3-4:1 for most likely a binary situation. For the conservative investor you could buy 2 year protection on BAC at 100 basis points running and simply go long the equity. I've been spending a significant time on financials the last few months and will try to update my thoughts here as trades unfold.

8 comments:

Anonymous,  7/18/2011  

Why not Citi instead of BofA? Both trade at close to the same TBV multiple -- maybe BofA a little cheaper, but Citi doesn't have many of the same risks, no?

Anonymous,  7/18/2011  

$c has larger international and Eurozone risk which I would indicate is less defined than the mortgage risk.

Anonymous,  7/18/2011  

I would respectfully disagree. -- Eurozone risk as disclosed on the call on Friday was $22B, of which, only a small portion was related to sovereigns. Mortgages are a far larger problem than Citi's sovereign risk. Further, Citi's overseas businesses are a source of strength, not weakness.

Anonymous,  7/19/2011  

BAC is levered 40 to one the up tic in ABX doesn't matter as BAC has been toast for a year kept on life support by the FED

Anonymous,  7/19/2011  

The one negative to buying leaps is the impact of a big dividend increase - you participate in a re-pricing of BAC but any time premium goes away

Anonymous,  7/19/2011  

Why not buy the 2019 TARP warrants instead? The strike price of $13.3 is adjusted down for dividends.

Anonymous,  7/19/2011  

Post the news of the BAC settlement with many large investors, the ABX and BAC relationship diverged. That is because it is expected that Subprime securities (which make up the ABX) will benefit more then other MBS securities from lawsuits (which are similar in effect to the BAC lawsuit) which previously moved closer to in sync. The settlement dollars go from BAC and into deal cashflow waterfalls. Notice CIM vs ABX as well.

Josh 7/26/2011  

Looking forward to more of your thoughts on BAC.

Email

hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.