New Trade: BofA (BAC) Cheap Puts for Stress Test Results

by CC March 12, 2012 10:21 am • Commentary

Later this week the Fed is expected to release results of the latest round of Bank stress tests. Here’s what they will entail, from the New York Times:

Under the tests, Federal Reserve specialists are trying to predict how capital levels at the 19 largest banks would withstand an economic downturn even more severe than the one that followed the Lehman collapse.

In addition to a 50 percent stock market decline and an 8 percent contraction in real gross domestic product, the tests envision an unemployment rate of 13 percent, well above the 10.2 percent peak recorded in October 2009. A surge in unemployment would increase losses for banks on mortgage and credit card debt.

If all that were not enough, the Federal Reserve is considering what would happen to bank assets if a market shock hit Europe and reverberated in the United States, gauging the extent of losses that have not loomed large for American institutions, despite the continuing problems in Greece and weaker European borrowers.

Regulators are walking a fine line: if they permit the banks to return too much capital now, that might leave the industry vulnerable in the event of a downturn and lead others to think the industry was returning to its risky ways. On the other hand, a raft of negative results would alarm investors just as calm seems to be returning to the markets.

It sounds like everyone wants to avoid making headlines on this and most analysts believe the Fed will find the major banks healthy. But some slightly bad news from some of the more stressed banks isn’t completely out of the question. Given that, March options in the banks, and especially Bank of America and Citi look a little too cheap.

C is the most controversial we think – much better capital levels, low U.S. mortgage exposure, but trades more with the European banks given its international exposure, and earnings have been weak, particularly in capital markets businesses. The ATM straddle, currently trading around 1.25 is tempting but we like the chance in BAC to pick a direction with a cheap option and basically get a 50/50 chance on a move in a stock that is trading at the top of its range from the past year.

Barclays Capital analysts predict that the average payout ratio for banks, excluding broker-dealers such as Morgan Stanley and Goldman Sachs, “will rise from 24 per cent of earnings in 2011 to 48 per cent this year.”

We don’t think this is correct and think the Fed is more likely to keep that number below 35%.

BAC is probably one of the banks that won’t be allowed to raise their dividend. So here’s the trade:

Trade: BAC (8.05) Bought the MARCH 8 put at .13

We like this trade because the option is dollar cheap and with any negative news either out of the FOMC meeting or the Stress Tests results that are likely to follow.