The BofA tail-risk discount

October 19, 2010

Here’s a chart of what tail risk looks like, in the stock market:


The thick blue line is Bank of America stock, hitting a new 52-week low today after reporting losses of $7.3 billion in the third quarter. The thin blue line is financial stocks generally, which are doing much better than BofA. And the thin red line is the S&P 500, which is significantly higher than it was this time last year.

To judge by the headlines, BofA ought to be doing pretty well. Its earnings report today beat expectations, and yesterday it announced that it was going to start foreclosing on properties again, long before anybody expected it would do so. On top of that, it’s the biggest bank in the U.S., with a deposit base of $900 billion—that’s 11.71% of the total U.S. deposit base, making BofA the clear leader on that front and the only bank now to break the 10% cap. With the Federal Reserve throwing free money at the entire U.S. financial system in an attempt to keep the recovery going, and the yield curve sloping upwards in the right direction for easy banking-sector profits, these ought to be good times indeed for BofA.

So why is BofA’s stock in the doldrums, relatively speaking? The answer is tail risk. Part of that risk is regulatory: BofA is too big to fail, and will therefore be subject to extra regulatory scrutiny and higher capital requirements than smaller banks. On top of that, huge swathes of the post-Dodd-Frank regulatory architecture remain to be written in detail, and the risks to big banks on that front are all to the downside, given how deregulated they were up until now.

But the much larger part is mortgage-related: JP Morgan came out yesterday and said that banks could be forced to buy back as much as $120 billion in mortgage bonds from investors. And BofA bears the lion’s share of that risk, incorporating as it does not only Merrill Lynch but also Countrywide.

The mortgage mess hasn’t gone away, and BofA is going to trade at a discount unless and until it’s resolved. That doesn’t mean that the market is pricing in some kind of mortgage-related disaster. It’s just pricing in a very uncertain probability distribution of possible outcomes, some of which are very bad indeed. And since investors hate that kind of uncertainty, the share price is underperforming, and is likely to stay low for as long as the uncertainty persists.


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