Stock Traders Blog

I mentioned in my previous post that Baidu’s September option pain was $300. I checked it again and the option pain was higher a little bit at $310 at the moment. What would be your guess if you predict Baidu’s price movement without looking at the option pain a couple weeks ago when Baidu was about $340? I would probably think it would go up instead of retreating. Obviously option pain can really tell something. It can tell how institutional traders see a particular stock. If option volume on an issue is large enough option pain on that issue may be able to tell how institutional traders see the market overall.

I checked INTC and BAC September and October option pain. They are trending downward. They seem to tell the bearish sentiment of the market should be extended into October. However Baidu’s Oct option pain is at $330 which is higher than September’s. I am not sure if you agree or not but I have already convinced that option pain is a very good leading indicator on the underlined issue or even the overall market.

Anyway I didn’t trade for a while. I was busy looking for a new job. I add 200 shares of CSKI at $13.09 and I sold 2 contract of Baidu Sep 290 Put at $3. I was thinking if Oct Baidu option pain is $330 I wouldn’t mind to have it at $290 in the mid of September. There is $20 difference or about 9% difference between $290 and Sep option pain. I thought it could be safe. But again who knows. We will see how it goes.

There are a lot of concerns about the banks’ off balance sheet asset lately. New accounting rule will take effect starting next year and require banks to move certain off balance sheet asset back to their balance sheet. This change was triggered by the shady practice of using off balance sheet financing in the Enron case. Many analyst expect when that happens banks with large off balance sheet asset will be forced to raise capital again.

I tried to find an example of bank’s off balance sheeting financing but didn’t really find one. However I found the following was very close to an example and it is the best explanation about off balance sheet financing. “Uncovering Hidden Debt“

Wells Fargo and Bank of America were said to have huge off balance sheet asset.

• 2009-07-24 Wells Fargo’s Balancing Act
• 2009-07-21 Analyst sees $12 bln reserve charge for B. of A.

That was why I didn’t trade any financial stock lately. I don’t want to short. I don’t want to trade in and out as frequent as I did. I don’t believe in the banks’ balance sheet. All of these make me trading nothing lately. I am still waiting for the DOW to come down below 9000. I believe it will happen.

I read through Well Fargo’s first and second quarter earning releasing and jog down the hightlights of the report in a comparable list. Hightlights number 24 and 27 to 30 are the focus. I will blog more about them in later post.

Reference: https://www.wellsfargo.com/invest_relations/earnings.

Wells Fargo 2009 Second Quarter Earning Highlights

• 1, Net income: $3.17 Billion
• 2, Net income applicable to common stock: $2.58
• 3, Diluted earnings per common share: $0.57
• 4, $0.7 billion ($0.10/per common share) credit reserve build
• 5, $0.24 billion ($0.03/per common share) merger-related expenses. $0.57 billion ($0.10/per common share) FDIC assessment
• 6, Revenue: 22.5 Billion
• 7, Legacy Wells Fargo revenue 13.6 billion
• 8, Net interest margin 4.30%
• 9, Core deposit: $765.7 billion
• 10, Tangible common equity: 54.9 billion, TCE ratio 5.24%
• 11, Tier 1 capital ratio 9.80%
• 12, –
• 13, Allowance for credit losses to $23.5 billion. 2.86 percent of total loans and 1.5 times nonperforming loans
• 14, $0.04 billion write-down of impairment on debt and equity security
• 15, Pre-tax pre-provision profit: 9.8 billion
• 16, Net interest income: $11.8 billion
• 17, Total loans were $833.9 billion
• 18, Noninterest income of $10.7 billion
• 19, $1 Billion MTM gain. $2.3 billion increase in the fair value of the MSRs offset by a $1.3 billion economic hedge loss in the quarter
• 20, Trust and investment fees of $2.4 billion
• 21, Service charges on deposit accounts of $1.4 billion
• 22, Card and other fees of $1.9 billion
• 23, Trading revenue of $0.75 billion
• 24,
  

  Net unrealized losses on securities available for sale reflected in equity of only $0.4 billion down from losses of $4.7 billion at March 31, 2009. “The net unrealized losses were virtually eliminated as credit spreads narrowed during the quarter and as unrealized gains emerged on new mortgage-backed securities (MBS, purchased during the quarter at the peak in MBS yields)”

• 25, Noninterest expense was $12.7 billion
• 26, $0.57 Billion FDIC assessment. $0.24 billion merger-related expenses
• 27, Wachovia’s total net charge-offs in first quarter were only $0.98 billion
• 28, Second quarter net charge-offs were $4.4 billion
• 29, Total nonperforming assets were $18.3 billion. $15.8 billion of nonaccrual loans (nonperforming loans)
• 30, Loans 90 days or more past due and still accruing totaled $16.7 billion
• 31, –

Wells Fargo 2009 First Quarter Earning Highlights

• 1, Net income: $3.05 billion
• 2, Net income applicable to common stock: $2.38 billion
• 3, Earning per common share: $0.56
• 4, $1.3 billion ($0.19/common share) credit reserve build.
• 5, $0.2 billion ($0.03/common share) merger-related expense. $0.34 billion FDIC assessment
• 6, Revenue: $21 billion
• 7, Legacy Well Fargo revenue: $12.3 billion
• 8, Net interest margin: 4.16%
• 9, Core deposit: $756.2 billion
• 10, Tangible common equity: $41.1 billion. TCE ratio 3.28%
• 11, Tier 1 Capital: $88.9 billion. Tier 1 capital ratio 8.28%
• 12, Credit write downs from the Wachovia acquisition: $40 billion
• 13, Allowance for credit losses: $22.8 Billion. 2.7% of total loans. 2.2 times nonperforming loans
• 14, $0.5 billion write-down of impairment on debt and equity security
• 15, Pre-tax. Pre-provision profit $9.2 billion
• 16, Net interest income: $11.4 billion
• 17, Total loans: $843.6 billion. $119.4 billion of consumer loans
• 18, Noninterest income: $9.6 billion
• 19, $0.88 Billion MTM gain. $2.8 Billion Reduction of (MSRs) mortgage servicing rights and $3.7 billion hedge gain.
• 20, Trust and investment fees of $2.2 billion
• 21, Service charges on deposit accounts of $1.4 billion
• 22, Card and other fees totaling $1.8 billion
• 23, Trading revenue of $0.79 Billion
• 24,
  

  The net unrealized loss on securities available for sale declined to $4.7 billion at March 31, 2009, from $9.9 billion at December 31, 2008. Approximately $850 million of the improvement was due to declining interest rates and narrower credit spreads. The remainder was due to the early adoption of FAS FSP 157-4, which clarified the use of trading prices in determining fair value for distressed securities in illiquid markets, thus moderating the need to use excessively distressed prices in valuing these securities in illiquid markets as we had done in prior periods.

• 25, Noninterest expense: $11.8 billion
• 26, FDIC assessments: $0.34 billion. $0.12 billion additional insurance reserve. $0.2 billion merger related costs. Total integration expense to be $7.94 billion and will be spread over the integration period
• 27, Wachovia’s total net charge-offs in first quarter were only $0.37 billion after a total of $40 billion of credit write-downs have already been taken through purchase accounting adjustments.
• 28, Net charge-offs for the combined Company were $3.3 billion
• 29, Total nonperforming assets: $12.6 billion. $10.5 billion of nonperforming loans
• 30, Loans 90 days or more past due and still accruing totaled $15.1 billion
• 31,
  

  “We have built reserves for six consecutive quarters, dating back to fourth quarter 2007 when credit deterioration became evident,” said Atkins. “These reserve builds have strengthened the balance sheet and position us for the future. We view a considerable portion of the $23 billion allowance to be essentially like capital since we won’t draw on this reserve until the credit crisis ends and loan losses decline. Current accounting policies will then require us to reduce the allowance, increasing profit and increasing capital ratios at that time.”

I don’t feel like to post my trades until I break my losing streak. I guess that is understandable. The more I want to guess bank earning right the more I want to understand what all the financial terms means. I almost read through Wells Fargo’s first quarter financial report. Wells Fargo Earns Record $3.05 Billion, $0.56 EPS. I found it was daunting to understand all the information there as I didn’t remember the meanings of all the financial terms in the report. So I am going to understand it bit by bit and understand it a few terms at a time.

TCE Ratio
It stands for Tangible common equity ratio. It equals total tangible common equity divided by total tangible assets.

Tangible Common Equity
Tangible common equity is the amount of tangible asset that common shareholders would receive if the company were closed. So it doesn’t include intangible asset

Intangible Asset
Assets that do not have a definite existence are called intangible assets. They have neither a physical form nor give their owner definite financial rights. Deferred tax assets, good will, patents and copyrights and capitalized R & D, trade names and franchises are intangible assets.

Intangible Asset
Assets that have a physical existence, or give the holders definite set of financial rights. Land, machinery, bank deposits and investments security are tangible assets.

Tier 1 Capital Ratio
The Tier 1 capital ratio is the ratio of a bank’s core equity capital to its total risk-weighted assets (Source: Wikipedia). Risk-weighted assets are the total of all assets held by the bank which are weighted for credit risk according to a formula determined by the Regulator. Assets like cash and coins usually have zero risk weight, while debentures (also called note or unsecured corporate bond) might have a risk weight of 100%. Core equity capital consists primarily common stock and retained earnings. Tier 1 capital ratio is seen as a metric of a bank’s ability to sustain future losses.

I don’t know what is deferred tax asset but it shouldn’t affect me to understand Wells Fargo’s financial report

I read many articles that talk about loan loss reserve, loan loss provision and net chargeoffs. I don’t really understand what they mean and all of a sudden I want to spend sometime to dig into their meanings. One thing I am clear is that loan loss provision, is like cost of good sold on income statement, should be subtracted from revenue to calculate net income. I did some research and find the following from A Loan Loss Reserve Primer: Beyond Simplistic Ratios

The loan loss reserve (or allowance for loan losses) is a contra-asset account on a bank’s balance sheet that is netted against gross loans. Each quarter the loan loss reserve rises by the amount of the loan loss provision (an expense item;) and reduced by the level of net chargeoffs.

I still remember this general accounting principle: Asset = Liability + Owner’s Equity. So loan loss reserve can be viewed as negative asset sitting on the asset side. The increase of loan loss reserve will decrease the total asset value. And this loss of asset value is reported on income statement as loan loss provision. Loan loss reserve on the balance sheet is similar to the stocks a company holds. Its value can fluctuate from time to time. But the stocks a company holds is normal asset type and the increase of stock price creates a gain item on income statement whereas the decrease of stock price creates a loss item on income statement. Loan loss preserve may go down and when it happen it will create negative loan loss provision and bring up net profit. It can happen when the management decides that they are over reserved for loan loss. It was the number 4 arguing point of the quote in this post The Reasoning Behind Bank of America’s Upgrade. I think he really means BOA has over 100 billion loan loss reserve(not provision) and at some point in the future when the economic turns around Bank of America may find it is over reserved. We can see loan loss preserve is a pretty flexible item where every banks can make its own decision to increase it or decrease it base on its own view on its own loan portfolio although some general guidelines apply

Net chargeoffs are loan amounts considered absolutely not collectible. It shouldn’t change the total value of asset as far as my understanding. People can look at net chargeoffs to evaluate whether loan loss is over or under reserved.

Bank of the Ozarks is one of the banks I followed. It is a very small region bank comparing to Bank of America. You may read Bank of Ozarks business profile here if interested. I have long believe that Bank of Ozarks is one of the well managed banks that is financial is much healthier than its bigger peers. Bank of the Ozarks reported earning today. So lets see if that believe still holds and see if we can get some hint about the earning of Bank of America from Bank of the Ozarks.

It reported record earning $9,501,000 and $0.56 per share. 10.4% higher than the same period last year. Q1 2009 had profit of $9,286,000 so Q2 was a bit higher. I summarized what was the change compared to Q2 2008 or Q1 2009.

• Loans and leases were 0.7% declined from last year
  
• Deposits 7.6% declined from last year
  
• Total assets 3.6% declined from last year
  
• Common stockholders’ equity and Book value per common share increased about 23% from last year but slightly decline from Q1 because of an unfavorable change during the quarter in the Company’s mark-to-market adjustment for unrealized gains and losses on AFS investment securities.
  
• Net interest income for the second quarter of 2009 increased 28.2% but slightly declined from Q1 2009
  
• Non-interest income for the second quarter of 2009 increased 306.9% to $22,610,000 compared to $5,557,000 for the comparable quarter of 2008. Q1 Non-interest income was about $9,000,000. his large increase in non-interest income was primarily attributable to significant gains on sales of investment securities during the most recent quarter.
  
• Service charges on deposit accounts were $3,047,000. Q1 was about $2,800,000. 2.7% increase from last year
  
• Mortgage lending income was $1,096,000 in the second quarter of 2009. Q1 was about $900,000. 72.3% increase from last year
  
• Trust income was a record $751,000. Q1 was about $650,000. 19.4% increase from last year
  
• Net gains on investment securities and from sales of other assets were $16,487,000. It was $206,000 last year and about $4,000,000 in Q1 2009
• Non-interest expense for the second quarter of 2009 was $17,945,000. 33% increase from last years. It includes $1.3 million for the special assessment levied by the FDIC on all insured institutions. It was about $16,000,000 in Q1 2009
  
• Nonperforming assets as a percent of total assets increased to 1.37%. It was 0.59% as of June 30, 2008 and 1.17% as of March 31, 2009
  
• the Company’s provisions to the allowance for loan and lease losses totaled $21.1 million. It was $4.0 million last year and $10.6 million the first quarter of 2009.
  

The source of this data is from
businesswire Bank of the Ozarks, Inc. Announces Record Second Quarter 2009 Earnings

What I saw from this summary is that business was about the same from Q1 to Q2. Provisions to the allowance for loan and lease losses almost doubled form Q1 to Q2. However Non-interest income, mainly the gain on sale of investment securities and other assets was able to more than offset the provisions for loans loss.

I don’t see this earning report a good news because the record income was not generated from its day to day business. Loan loss provision has huge increase and it doesn’t look good for the next quarter with employment rising. However stock price of OZRK went up 2.4% after report come out.

I kind of think we will see the same on Bank of America. Like the analysis I did on this post, “Bank of America Earning Forecast and Financial Statement Analysis”. Business may not have significant improvement compare to Q1. Loan loss provision will be huge. Mark to Market change is not favorable. And Bank of America has to rely on gain on asset sale to show a profit and most likely this gain is not able to offset loan loss provision and MTM changes. So it will likely to show loss. Book value may slightly decrease from last quarter.

Last quarter Bank of America earned 4.2 billion. That was before paying 1.4 billion prefer stock dividend including 0.4 billion paid to the US government. After paying prefer dividend earning was 2.8 Billion. Diluted earning per share was $0.44. There were about 6.4 billion common shares outstanding last quarter.

In second quarter there were about 1.45 billion new shares issued as a result of secondary offering and prefer to common share conversion. Suppose second quarter earning is the same as the first quarter diluted earning per share will be $0.36 with 7.85 billion common shares outstanding. That is P/E at 8.8 with current price at $12.60. It should be cheap and it worth to buy if Bank of America can generate 2.8 billion profit every quarter going forward. The Question is whether the earning shown in first quarter is sustainable. If the earning is sustainable given a P/E of 13 BAC should worth $18.72.

Prefer Share Dividend:
News was just released that BAC paid 0.7 billion dividend to government that was more than the 0.4 billion in first quarter. But this quarter BAC has less prefer shares so I expect there is no substantial change on prefer dividend payout.

Gain on Sale of Asset:
Gain on sale of China Construction Bank stake this quarter is expected to be 2 billion and it is about the same as last quarter.

Given the same earning for the rest of Bank of America’s operation lets consider three major factors that may cause major earning change: FDIC charges, marking to market value of Merrill lynch debt, and provision of loan loss.

FDIC Charges:
I remember JPM has 0.7 billion charged by FDIC and I believe BAC will be charged by around the same amount.

Marking to Market Change of Merrill Lynch Debt:
First quarter’s earning included gain of $2.2 billion pre-tax FVO positive adjustment on Merrill Lynch structured notes. That was because the marking to market adjustment on values of Merrill Lynch debt at a time when the debt was traded at substantial discount because our financial system was on the verge of collapse. This quarter the value of this debt will not go down so the 2.2 billions of gain will disappear. In fact the value of Merrill Lynch debt will be trading higher because the system is stabilized. That will incur a marking to market loss. Citi Group analyst Keith Horowitz predicted that loss is amount to 2 billion. So this single factor can cause Bank of America’s earning in second quarter 4 billions lower than the first quarter.

Provision of Loan Loss:
This is where Bank of America can do the trick. Last quarter loan loss provision was 13 billions. Many analysts believe that wasn’t enough. With unemployment rate higher and credit quality continue to deteriorate I expect provision for loan loss will increase. Let’s say increase by 5%. That is 0.65 billion.

So Bank of America’s second quarter earning is expected to be 5.35 (0.7 + 4 + 0.65) billions lower then the first quarter. And it will turn into 4.2 – 5.35 = -1.15 billion loss. That is -$0.12 per share with 7.85 billion common shares. You may think the expectation of loss is already built into current price.

So what is Bank of America’s earning beyond second quarter? FDIC charge shouldn’t be there and it shouldn’t be a factor in the third quarter. Suppose Merrill Lynch debt value will not change then 2 billions of gain is not there but there won’t be 2 billions of loss either so third quarter earning should be 2 billions lower compare to the first quarter given everything else not mentioned here is the same. That is 2.8 - 2 = 0.8 billion for common share. But again loan loss provision is the focus. Loan loss provision jumped from 8.5 billions in Q4 2008 to 13.4 billions in Q1 2009. It could go down or go up several billions depends on the economy and BAC’s earning can fluctuate in a wide range. I am not optimistic. US Bank executives mentioned that it will build up loan loss reserve for the rest of the year. I believe BAC needs to do so either. And that means loan loss provision will continue to increase even though Keith Horowitz predicted loan loss provision will be peak in second quarter. If that is the case BAC might be making zero profit for the rest of the year.

Fundamentally I don’t see stock price should appreciate but I believe BAC price will fluctuate between $9 and $15 base on outlook of the economy and how Bank of America report its loan loss provision going forward.

If loan loss provision trends down starting from Q3 then Bank of America may be able to generate 2.8 billions of profit quarter after quarter for at least 1 or 2 years. The number can be bigger if the other earning sources of Bank of America improve gradually. Looks like it all depends on the overall economy and Bank of America will have a beta higher then its peers meaning its earning and stock price will fluctuate in a wide range.

I feel I am a bit clear about what the market is going to go after writting this post. I feel the market recently turn bearish and worry about credit quality. I believe the finanical sector will pull the over all market lower after they report second quarter earning. Just my opinion we will probably see the DOW lower than 8000 in the comming weeks. Again credit quality and loan loss is the determining factors.

Reference:
http://newsroom.bankofamerica.com/index.php?s=43&item=8438
http://finapps.forbes.com/finapps/jsp/finance/compinfo/IncomeStatement.jsp?tkr=bac&period=qtr