Rising Star Trade: What We're Doing With Bank of America

This article is part of ourRising Star Portfolios series. You can read about the Dada Portfoliohere.

It's been a bumpy ride, but mostly a good one, for Bank of America (NYS: BAC) shorts like the Dada Portfolio. That is to say, down.

Since the time the Dada Portfolio bet B of A would fall, investors have become particularly wary of the megabank:

Source: Yahoo! Finance.

A portion of the performance disparity is due to operational issues. Of the four, B of A is the only bank that produced a slight operating loss over the past 12 months, mostly due to lower interest and non-interest revenue and rising employee compensation. It and Citigroup are the two that haven't yet gotten the go-ahead from regulators to reinstate meaningful dividends.

But the main part of our thesis was that investors underappreciated the extent of Bank of America's exposure to liabilities from potentially improper securitization practices and alleged foreclosure fraud, compounded by its disastrous acquisition of Countrywide.

Countrywide has been a pinata for litigants including Pimco, the New York Fed, BlackRock (NYS: BLK) , and now AIG (NYS: AIG) , who claim it misrepresented the quality of loans it sold them.

Bank of America thought it had put much of these issues behind it with a fast settlement. David Dayen notes the New York attorney general's intervening into Bank of America's attempted settlement. The AG's allegations span the gamut of the potential problems we identified in our initial short, including:

• Countrywide and the trustee (Bank of New York Mellon (NYS: BK) ) failed to ensure the quality of the mortgage-backed securities that were sold to investors.

• The mortgage notes, the legal IOUs that investors need to foreclose, were never transferred to the trusts. This would effectively mean the mortgage-backed securities investors thought they were buying, were not, in fact, mortgage-backed.

After its 48% decline, Bank of America now trades for 0.6 times its tangible book value of $125 billion. If a reasonable multiple for a low-to-medium-quality large bank is around 1.2 times, then the stock is priced for a loss on the magnitude of $60 billion in book value beyond what the bank has provisioned. Is this plausible?

Absolutely, given the scope of the bank's legal and operational difficulties. Just as a side note, if such a loss were to occur all at once today, the bank would be left with a leverage ratio of 22-to-1 -- not exactly comforting. Maybe someone should have insisted the bank raise more capital during those stress tests, raise more capital soonish, or retain more employee compensation. Good thing it wasn't allowed to restore its dividend.

The losses could also be smaller, or larger. It's incredibly uncertain. When the stock was twice as high as it is today, we were fairly confident the market wasn't pricing in the bank's risky outlook. Today, the market is more fairly valuing Bank of America for its liabilities, so we will cover our position.

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This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks.Click hereto see all of our Rising Star analysts (and their portfolios). You can follow the Dada portfolio on Twitter@TMFDada.

At the time thisarticle was published Ilan Moscovitzdoesn't own shares of any company mentioned. The Motley Fool owns shares of American International Group and JPMorgan Chase. The Fool owns shares of and has opened a short position on Bank of America. The Fool owns shares of and has created a ratio put spread position on Wells Fargo.Motley Fool newsletter serviceshave recommended buying shares of BlackRock. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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