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TheStreet Open House

6 Reasons to Buy Bank of America, Reality Checked

Stocks in this article: BACJPMWFCC

NEW YORK ( TheStreet)-- Bank of America (BAC) received an upgrade to "Overweight" from London-based analyst Richard Staite of Atlantic Equities, who raised his price target to $12 from $8 and announced six reasons to buy the stock in a 15 page report published Wednesday.

"After several years of disappointment, we believe that Bank of America has turned a corner and will see stronger pre-provision profitability in 2013, helped by lower costs and a strengthening housing market. NIM trends look better than peers and capital ratios have improved significantly, making a capital return in 2013 a real possibility," Staite states.

In TheStreet's view, some of Staite's six reasons are new, and fairly persuasive, while others are less so. As a result, we have assigned a grade to each of the reasons.

1. Staite believes Bank of America's $10 billion of "abnormal" legacy mortgage servicing costs, from "robosigning" and related blunders will start to decline.

This refers "to the cost of employing the 42,000 people plus 17,000 outside contractors" who work in a division of the bank called Legacy Asset Servicing (LAS). This army of workers deals with the nearly one million delinquent mortgage loans that are either on Bank of America's own balance sheet or serviced for others, according to Staite.

Staite believes the market is waiting for clear signs this cost is coming down, though he argues the third quarter was a turning point as the total number of delinquent loans went down by 12%.

While staffing costs went up, Staite sees this as a temporary issue related to complying with a new agreement with regulators.

TheStreetGrade: B+. While we knew these costs were high and we'd heard something like this 59,000 number before, it may have taken a while to sink in. That's a lot of people--and a lot of fat to eventually cut. Still, cutting people is always easier said than done, and Bank of America is a massive institution, so maybe cutting 59,000 people--or however many Bank of America eventually manages to cut--won't have as big an impact as one might expect.

2. A $8 billion cost-cutting plan dubbed "New BAC" "will start to deliver," Staite writes.

Staite admits to some skepticism about cost savings plans in general as they tend to be offset by investment in other areas. Nonetheless, Staite argues Bank of America hasn't gotten full credit for these savings as they've been masked by increased legacy asset servicing expenditures, which he sees coming down (see point one.)

TheStreetGrade: D. Staite sounds a bit like he is trying to convince himself when he writes, "nevertheless, we are hopeful that greater cost savings will be made in 2013 and that these will start flowing to the bottom line once LAS costs also start to decline."

3. Reduced funding costs should cause Bank of America's fourth quarter net interest margin (NIM) to improve.

Net interest margin is measured by subtracting the cost of capital from asset yields. While asset yields are declining due to lower interest rates, Bank of America's improving credit picture will lower its cost of funding, Staite argues. Other "high quality" banks won't have this luxury. That's why NIM should rise for Bank of America while it declines for JPMorgan Chase (JPM), Wells Fargo (WFC) and others, according to Staite. The analyst calculates Bank of America pays $6 billion more that JPMorgan in annual funding costs.

TheStreetGrade: A-. Who knew that Bank of America paid $6 billion more in funding costs than JPMorgan? Assuming Staite has managed to calculate this number accurately, which doesn't sound like the easiest of tasks , this is meaningful.

4. "Loan growth is turning a corner," according to Staite.

Bank of America has been shrinking its loan book until very recently, but has finally started growing it. This is in contrast to other banks, including JPMorgan and Citigroup (C), where Staite recently noted declines.

TheStreetGrade: C. Why would JPMorgan and Citigroup be shrinking their loan books? It sounds like there may be some factors Staite isn't taking into account. Still, when you've been so focused on shrinking for so long, as Bank of America has, it should make an impact when you start to grow.

5. With Bank of America's Basel III ratio--an important measure of the bank's balance sheet strength near 9%, Staite sees a capital return in the form of buyback or dividends as "increasingly likely" in 2013.

Several analysts remarked on this "dramatic improvement"--Staite's words-- following Bank of America's third quarter earnings release.

Staite also notes, however, that Basel I ratios have improved for Bank of America. It went to 11.4% in the third quarter from 8.2% in the second quarter of 2011.

Both Basel III and Basel I are used by the Fed in determining whether it will give a bank the green light to return capital to shareholders.

TheStreetGrade: D. Old news.

6. Finally, Staite sees the "probable settlement" legal claims issues Bank of America of so-called mortgage "rep and warranty" issues. These largely relate to bonds Bank of America sold between 2006 and 2008 to government sponsored enterprises Fannie Mae (FNMA) and Fannie Mae (FMCC)--as well as private investors--that were stuffed with fraudulent mortgages.

Staite calls this issue "one of the big concerns that still hangs over " Bank of America. The level of unresolved claims reached $25 billion in the third quarter, up another $2.8 billion from the second quarter and "a significantly higher number" than for wither Wells Fargo of JPMorgan. Bank of America has just $16 billion of reserves against this, up by only $326m during the quarter.

Bank of America has said it is working with Freddie Mac to resolve claims, but it is further apart with Fannie Mae.

Staite writes that he "ultimately," expects a settlement of all these claims, which he believes "would probably provoke a positive share price reaction, particularly if investors are confident that underlying pre-provision profitability is on an improving trend." He adds that he sees "a large settlement" as "likely in 2013, which would impact reported results but would be treated as a one-off by the market."

TheStreetGrade: D-. Of course Bank of America will settle. The question is when, how much and how will the market react. There may be no one alive able to properly handicap this.

Skeptics might argue that many of these factors are already priced into Bank of America shares. However, Staite notes that Bank of America shares trade at just 0.7% of tangible book value, versus 1.14% for JPMorgan. The difference, he argues, is due to lower profitability at Bank of America. He sees Bank of America closing that gap "over the next three to four years." If Bank of America traded at JPMorgan's multiple, the shares would be worth $15.50. They closed Tuesday at $9.36 and were up slightly in pre-market trading Wednesday, as were shares of JPMorgan, Citigroup and Wells Fargo.

-- Written by Dan Freed in New York.

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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