The Trouble With Bank of America

 | Jan 08, 2014 | 5:00 PM EST
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Bank of America (BAC) shares have performed fantastically over the past year, rising to about $16 from its December 2012 low of about $5 -- more than triple. By comparison, Wells Fargo (WFC), JPMorgan Chase (JPM) and Citigroup (C) shares increased by about 31%, 33% and 38%, respectively, in the same period.

But one of these things is not like the others. I was originally going to write about this after the fourth quarter 2012 report, but since BAC has been getting a lot of attention recently, I thought I would do so now (and I'll revisit it in a month or so).

Although BAC experienced an existential crisis in 2012 because of its very low recovery rate on non-performing loans, the value of the three remaining money centers were also substantially negatively impacted. Investors appear to have decided that the existential issues affecting BAC have passed and that organic growth largely provided by a strengthening housing sector will cause its mortgage originations and income to rise.

That may happen, but it shouldn't be taken for granted. BAC's dominant position in the residential mortgage markets has been ceded to Wells Fargo. I wrote in November that the new challenger to Wells Fargo's near monopoly of the mortgage market is coming from JPMorgan, not from Bank of America. As BAC attempts to re-establish its reputation with consumers and real estate professionals to originate mortgages efficiently, it faces competition it did not have before the 2008 financial crisis and in a market that is more regulated than it was previously.

The inability of any lender, especially a money center, to differentiate itself from the others with unique underwriting guidelines is almost absent today given the new rules referred to as "Qualified Mortgages" that went into effect the beginning of this year. These rules mandate a rigid set of universal underwriting rules for all conventional conforming loans, as well as most jumbo loans. This means that most mortgages are now commoditized products.

The only way for a mortgage originator to differentiate itself from competitors is through servicing: how quickly can it get loans from start to finish without errors. Bank of America is in a poor position with respect to this as it has already lost many proficient loan officers, processors and underwriters to Wells Fargo, JPMorgan and smaller companies as it's had to concentrate on legacy issues and a large portfolio of non-performing loans.

The second cloud overhanging BAC is its unfinished regulatory issues from the housing boom that the other three have largely disposed of. JPM has received a lot of negative press over the past year for numerous penalties and settlements with government agencies concerning these legacy issues. But JPM has had earnings that have afforded it the opportunity to pay the penalties and arrive at the settlements because it has continued to expand its lending operations. BAC has spent most of the past five years just managing the residual financial issues associated with its operations during the housing boom and subprime era, as well as those associated with its acquisition of Countrywide.

The same issues that caused JPM to pay large penalties, predominantly due to its acquisitions of Bear Stearns and Washington Mutual, are almost certainly waiting for BAC due to its Countrywide acquisition. Regulators are likely waiting until BAC is strong enough financially to pay similar fines -- but they won't wait forever. Investors are currently pricing Bank of America stock on expectations of imminent growth and without a concern for the prospect of fines like those paid by JPMorgan over the past year.

The respective price-to-earnings ratios for JPMorgan, Wells Fargo and Citigroup are about 13, 12, and 18, respectively. For BAC, the ratio at the current stock price is above 25. Its dividend yield is only 0.2% vs. 2.6% at both JPM and WFC. Citigroup's dividend yield is only 0.1%, but this is because it is retaining earnings instead of distributing and not a reflection of not having earnings, as is the case for BAC.

The bottom line is that speculators have driven BAC up over the past year beyond what is rational, given both its legacy issues and forward-looking revenue hurdles.

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volatility is quite low here, and we could see some downsides here in the short term. ...



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