Those who are uncomfortable about the notion that the U.S. has allowed some financial institutions -- read Bank of America (BAC) -- to become "too big to fail" may indeed have a valid point. Allowing a financial institution to become so large that it cannot fail certainly creates an element of moral hazard.
Sheila Bair, former chair of the Federal Deposit Insurance Commission, recently wrote an editorial for Fortune saying that now is the time to break up the "too big to fail" banks.
Of course, Bank of America is the prime example of "too big to fail." I have recently discussed why Bank of America is an incredibly cheap stock for investors who are willing to sit tight for a couple of years. What I didn't discuss is that in the meantime, if Uncle Sam or Bank of America itself decides that the company is "too big to fail," the company would unlock tremendous value in the short term, and the market would likely recognize that.
Earlier this year, The Wall Street Journal reported that Bank of America management told U.S regulators in a report that if it had to, it would shrink the size of the company in order to shore up capital. While this report was designed to explore Bank of America's options in the case of a capital crunch, a breakup of the bank, whether voluntary or involuntary, would be yet another hidden catalyst. And that's one reason the shares are so attractive today.
In fact, under current CEO Brian Moynihan, BofA has become a smaller financial institution, though it's still on "too big to fail" list. But as a consequence of reductions in risky assets, job cutbacks and a more risk-averse operating model, smaller cities have become less profitable for BofA. Already, BofA plans to reduce its branch count by over 15% in the next few years.
Analysts estimate that more than $60 billion of BofA's $1.1 trillion in deposits resides in cities that have populations of less than 500,000. Those geographic regions are entrenched with many local or regional banking institutions that tend to appeal to people in smaller cities. Such cities are small by BofA standards, but they are quite meaningful to smaller or regional banks. Sales of those deposits, along with the underlying real estate, could be worth a couple of billion dollars to Bank of America.
More so, the market seems to like smaller packages when it comes to banks, and if BofA decides or is required to break up, shares would likely appreciate considerably. One need only to compare the valuation multiples bestowed on big banks such as BofA or Citigroup (C). The average price-to-tangible-book ratio for BofA and Citi is about 0.65, while the average forward P/E ratio is just above 6. Compare those ratios with big yet leaner Wells Fargo (WFC), which trades at a forward P/E of 9 and a P/TBV ratio of 1.6, or a super-regional such as U.S. Bancorp (USB), which trades for 10x forward earnings and a P/TBV ratio of over 2.
Bank of America has banking businesses that are just as valuable and profitable as those of Wells or U.S. Bancorp. A signal to the market that BofA is going the route of "smaller is better" would most likely expand the valuation multiple that currently prices shares at 0.5x tangible book or less than 6x core earnings. Applying a Wells Fargo-like multiple to the shares gets you a share price in the range of $10 to $15.
Also, Wells doesn't have an investment-banking gem in the form of Merrill Lynch, which most everyone seems to forget about these days. In the same report in which Bank of America outlined is reduction efforts, management also mentioned the potential sale of units (shares) that would track the performance of Merrill Lynch.
In the end, BofA is becoming a smaller bank as the company continues to reduce the size of its balance sheet, branches and head count. Over time, that will slowly clear away the clouds of uncertainty that are depressing shares. However, any shrinking that is forced or management-led would also be a very significant value-creating catalyst in the stock price. So at the end of day, whatever path BofA takes or is forced to take, all roads seem likely to lead to a higher share price from here. Therein lies the secret to BofA's value.