Will Europe Bring Down Bank of America?

The European sovereign debt crisis is now well into its third year of bludgeoning the global economy and stoking fear and volatility in the markets. Just last week, the Dow Jones Industrial Average (INDEX: ^DJI) shot up when the European Central Bank promised to do "whatever it takes" to prop up the eurozone. Yet the trend has since reversed itself after investors were disappointed by the bank's half-hearted measures to fulfill its promise.

While the continent's woes have weighed down manufacturing and technology companies in the second quarter, the bigger concern is that a final resolution to the crisis will ignite a "Lehman-type" event if the monetary union dissolves. As many of you will likely recall, this is Wall Street code-speak for a seizing of credit markets and the consequent failure of financial firms.

In response to this, many of the nation's largest banks have started itemizing their credit exposure to Europe's most troubled economies, the so-called PIIGS: Portugal, Ireland, Italy, Greece, and Spain. Two weeks ago, I examined Citigroup's (NYS: C) multi-billion dollar exposure to these countries. I now extend the same critical eye to Bank of America (NYS: BAC) .

B of A's exposure to the PIIGS
In absolute terms, B of A's exposure to the five most troubled European economies is both worrisome and troubling. In its most recent earnings release, the company reported $14.5 billion in such exposure, exceeding its earnings for the last five years combined. As you can see below, this ranks the bank third among its peers on Wall Street, behind both Citigroup and JPMorgan Chase (NYS: JPM) though ahead of Morgan Stanley (NYS: MS) and Goldman Sachs.

Source: Quarterly financial statements.

On a country-by-country basis, much like Citigroup, B of A's single largest liability is Italy, where it has $8.2 billion in gross exposure. Alternatively, and also similar to Citigroup, its least significant exposure is to Portugal, where it has a mere $412 million of credit risk.

In terms of counterparties, approximately 58% of its gross credit exposure derives from corporate clients. Insurance companies, hedge funds, and other financial institutions account for 26% of the total. And the countries themselves account for 16%.

Source: Bank of America's 2Q12 Financial Supplement.

Although these figures can't be dismissed, there are two things to keep in mind. First, B of A has hedged a little over a third, or 34%, of its exposure to the PIIGS with collateral or insurance in the form of credit default swaps -- though, the effectiveness of these swaps assumes that B of A's counterparties remain willing and able to pay if called upon to do so. Once hedges are accounted for, in turn, B of A's net exposure drops to $9.6 billion.

In addition, holding all else equal, even if B of A were forced to write off its entire exposure to these countries, net or gross, it could do so and still stay afloat. At the end of the second quarter, the bank had a $2.2 trillion balance sheet, of which $164 billion consisted of tier 1 common capital, which itself consists of common stock contributions and retained earnings. Consequently, while a loss of this magnitude would further delay a dividend increase, it wouldn't necessarily mean a wholesale destruction of the company a la Lehman Brothers.

Bank of America beyond Europe
Europe or no Europe, I've spent many hours analyzing Bank of America in the last few years, and I always come to the same conclusion: Although it's unquestionably a risky investment, due to its questionable mortgage portfolio and liability for issues inherited from its Countrywide purchase, in light of its current valuation, the potential return from future dividend payments and share price appreciation makes it an exceptionally attractive stock for investors who are willing to wait a few years for the payout.

It's for these reasons, as well as a handful of additional ones, that Bank of America is one of the companies profiled in our free report about stocks Warren Buffett and other top investors are buying. And it's also why Anand Chokkavelu, our senior stock analyst and in-house Bank of America expert, concluded in his recent in-depth report on the bank that "for investors who are comfortable taking a real risk of up to 100% loss of capital, today's prices are attractive and could result in a double or triple within the next five years." You can find the rest of his premium report on Bank of America here.

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