The U.S. financial-services sector is undergoing the broadest restructuring of a single industry in the history of Corporate America, and Bank of America Corp. (NYSE: BAC) has positioned itself to emerge as one of three clear frontrunners. Indeed, along with Citigroup Inc. (NYSE: C) and JPMorgan Chase & Co. (NYSE: JPM), Bank of America could well emerge from this financial maelstrom as one of the premier players on the global stage: All three will benefit from increasing market share and increased financial intermediation margins as their weaker rivals have failed and/or been taken over in part or in total by a stronger industry player.
During the many financial crises that I have analyzed around the world, the result has always been the same: The prudently managed, under-levered institutions that did not overstretch their capital bases and that were able to maintain strong funding not only survived – they ran away with the market.
As unsavory as it sounds, the moral hazard argument of too-big-to-fail also helped them, even in the cases where risk taking had been excessive, as was true with American International Group Inc. (NYSE: AIG).
The huge benefit of being conservative – even boringly so during normal economic times – is that when the economy inevitably turns down, or when the periodic financial crisis strikes (as it has right now), these firms are among the few that actually have the capital available to cherry-pick the "crown jewel" assets of their now-foundering rivals.
Indeed, in the very worst of circumstances – such as the one the U.S. financial-services sector currently faces – strong firms actually are begged to swoop in and use their capital to buy up troubled assets, divisions or whole companies.
It helps immensely to have one of the largest deposit bases in the world, which generates dependable income on a daily basis, even during the worst of times. This is precisely the case of Bank of America.
On July 1, BofA snapped up the operations of dying mortgage leader Countrywide Financial Corp. Bank of America ended up paying only about $2.5 billion in Bank of America stock in a deal that had actually been announced back on Jan. 11. BofA had actually already invested $2 billion for a 16% stake in Countrywide.
Then came the weekend switcheroo. In a stunning turn of events back on Sept. 15, when investors were watching and waiting for Lehman Brothers Holdings Inc.'s (OTC: LEHMQ) possible acquisition by either Bank of America or Barclays PLC (ADR NYSE: BCS), BofA instead emerged from the weekend announcing that it had struck a deal with Merrill Lynch & Co. Inc.'s (NYSE: MER) President and CEO John A. Thain. Realizing that the credit crisis had rendered moot the concept of the standalone investment bank, Thain avoided Lehman's ultimate fate – bankruptcy – agreeing to be bought out by Bank of America. BofA's Kenneth D. Lewis astutely took full advantage of the opportunity.
He got to acquire Merrill Lynch in an all-stock transaction for a 70% premium over a very depressed Merrill Lynch stock price at about 1.83 times tangible book value, or about $50 billion, less than a third of its own market capitalization. What's more, when the transaction closes (probably in the first quarter of 2009), Bank of America will jump from $1.7 trillion in assets to about $2.7 trillion in assets, retaining a strong capitalization ratio.
The transaction is only 3% dilutive for BofA shareholders, and will have some $7 billion in cost-reduction efficiencies: The company will achieve about 20% of those reductions next year, and will have them completed so that it can benefit from them by 2012. The deal also includes about $2.5 billion in amortization and restructuring charges.
With this second transformative purchase, Bank of America will jump from merely being one of the largest banks in the world to being a commercial-and-investment banking powerhouse, one of the first true heavyweights under this new industry model that's emerged from the current credit crisis. It will have a dominant presence – shared by very few – in such businesses as commercial banking, asset management and investment banking. In these very uncertain times, size and strength counts for a lot.
Just in retail-brokerage and wealth-and-investment management the figures are staggering. The combined entities will have:
- 20,000 financial advisors, most of which are from Merrill Lynch.
- $2.5 trillion in assets under management.
- 50% ownership in BlackRock Inc. (NYSE: BLK), which in turns manages assets worth $1.4 trillion.
- And the Columbia Management Group LLC fund family, with $425 billion in assets under management
In banking, Bank of America will have a dominant presence on both U.S. coasts, a leadership position in 15 of the 20 fastest-growing states, and relationships with virtually all the leading companies in the United States and most leading companies in the world.
All told, this combination will yield a company that has a very balanced business mix: Global-consumer and small-business banking will still be the dominant segment, despite decreasing to 48% of the total, while global-wealth management and global corporate and investment banking will increase to 32% and 20% of total revenue, respectively.
Very importantly, the failed trading mentality of Merrill Lynch, which under the since-ousted E. Stanley "Stan" O'Neal deviated from its traditionally successful client-brokerage emphasis, a misstep that nearly brought this otherwise successful giant to its knees, will no longer be a major hindrance under the new structure. Indeed, that's why Thain is being kept on to remain as head of BofA's Merrill unit.
Bank of America, strongly regulated as a bank, will necessarily continue with its tried-and-true risk-management discipline.
We've reviewed all the good news. What about the bad?
Investing in these markets has become extremely tricky. The volatility that we experienced last week was almost unequalled for decades. The cause for this volatility is the extreme uncertainties surrounding the hidden risks to the viability of many financial institutions which, in turn, have caused the credit markets to freeze up. This freeze, in turn, has affected both consumer spending and economic growth. This was evidenced in the 26% drop in car sales in September, the 4% drop in August factory orders and the larger-than-expected drop of 159,000 in non-farm payrolls. While the unemployment rate remained at 6.1% the drop was exaggerated by the impact of hurricanes Ike and Gustav in the South, which typically produce initial job losses, but then actually create jobs in subsequent months, due to the necessary reconstruction.
But it is clear that the U.S. Federal Reserve's much-feared feedback loop from Wall Street to main street finally hit as the forced restructuring of the financial industry proceeded with minimalist government intervention, designed to avoid systemic risk only. It becomes blatantly evident that the Fed, with the danger of imminent inflation behind, given the collapse of commodity prices and economic activity, needs to use some of the ammunition it kept in its arsenal by lowering rates further to deal with the liquidity shock. At the same time, the European countries concluded just this past weekend that there needs to be a global response to the crisis that has affected not only the United States, but also markets across the globe, from Europe to Russia to Latin America.
And as the market got out of hand and ground to a halt, as it always goes to extremes, it forced the government to pass the $700 rescue bill. The key to how fast and how high does the system begin to normalize itself depends upon the pace and details of implementation of this package – as well as how the Fed and other central banks around the world decide to act going forward. And this is key to dictate the immediate direction of Bank of America's stock. I could write another paper on these issues, which are rife with uncertainties. I am actually a lot more constructive about the beneficial effects in the market of "surprising" policy responses by governments and central banks around the world than what I hear around in the market.
But something we all seem to agree on is that BofA will undoubtedly be one of the winners in the long term. The company, prior to the Merrill Lynch and Countrywide acquisitions, had already demonstrated signs of increased margins due to a de-leveraging of its balance sheet, moves that had resulted in surprising earnings gains well in excess of market expectations. The economic backdrop will continue to pose challenges, but the strong ultimately become stronger in crises. And individuals and institutions will find safe harbor and dependability for their deposits, investment business and loans, and at higher margins than we used to pay as other survivors get more conservative and as the weak perish.
Investing icon Warren Buffet has acquired stakes in three major companies in three weeks, with his characteristic very-long-term view, so I will strongly recommend you to buy Bank of America with the same very-long-term investment horizon. In the short term, I would take advantage of market volatility to buy in increasing amounts of cash into any market sell-offs on a weekly basis, completing your stock purchases before year end. The ride will no doubt be very bumpy, since market talk will continue to whipsaw – reflecting elation one minute and despair the next – but don't let that deter you from your plan.
It's possible that all of the downside is already factored into BofA's shares. The July 15 lows haven't been re-visited, for instance. Even so, pursue this plan shrewdly. In other words, go for it – but prudently.
Action to Take: Buy Bank of America Corp. (NYSE: BAC). **
[Editor's Note: Horacio Marquez was working as a vice president of the Merrill Lynch Emerging Markets Fixed Income Group in 1994 when he correctly predicted that both Argentina and Mexico were headed for currency crises – cementing his reputation as an expert on both the emerging markets and on the nuances of global finance. Now Marquez brings that expertise to you with his newly created "Shadow Stock Trader" specialized trading service. To find out how to subscribe, please click here. "Buy, Sell or Hold" is a new Money Morning feature that has most recently analyzed such companies as Suncor Energy Inc. (NYSE: SU), Potash Corp. (NYSE: POT), Garmin Ltd. (Nasdaq: GRMN), Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B), . (Nasdaq: CS), . (NYSE: CVX), Valero Energy Corp. (NYSE: VLO), General Electric Co. (NYSE: GE), and steelmaker Nucor Corp. (NYSE: NUE).]
** Special Note of Disclosure: Horacio Marquez holds no interest in Bank of America Corp.
News and Related Story Links:
- Money Morning Special Investigative Report:
The Inside Story of the Collapse of AIG .
- Money Morning News Analysis:
Merrill Lynch's Thain to Remain with Bank of America.