Can Brian Moynihan Catch Jamie Dimon? Bank Of America Warrants Seen As Best Bet

Investors bored with Fannie Mae and Freddie Mac common and preferred shares despite the involvement of hedge fund head honchos like Pershing Square's William Ackman are in luck! There's a zany new high-risk, high-reward banking trade circulating Wall Street to speculate on.

Earlier this week, Oppenheimer banking analyst Chris Kotowski left alone his Excel spreadsheets that project earnings per share figures and donned a financial quant hat in an attempt figure out the best way for investors to bet that Bank of America can plug a performance gap with JPMorgan Chase in coming years.

The result? Bank of America Corp. CW19 --  For those checking on Bloomberg go to: BAC/WS/A US

Those are outstanding Treasury Department warrants in Bank Of America that expire in January 2019. They were issued as part of the government's Troubled Asset Relief Program to inject $45 billion into the lender's coffers in 2009 as it tried to survive the financial crisis. If Bank of America CEO Brian Moynihan can get the firm operating in-line with its competitor JPMorgan, and trading at a similar premium-priced stock multiple, Kotowski says the warrants can pay off handsomely.

Kotowski believes Bank of America needs to find between $3-billion-to-$5 billion in annual cost savings to plug a wide performance gap with JPMorgan when it comes to profitability and efficiency. Currently, Bank of America trades at roughly 1.2 times its tangible book value, underscoring investor frustration with its relatively high expenses and meager profits versus other mega-cap lenders. JPMorgan, by contrast, trades at 1.5 times tangible book value.

If Bank of America were to hit JPMorgan's current 13.4% return on tangible common equity by 2018, from 11.4%, it would generate $2.57 in earnings per share and $20.07 in additional tangible book value, Kotowski calculates. That would put the company's stock at $30.10, the analyst calculates, a 19% investment rate of return. While that's not a bad trade if it comes to fruition, Kotowski finds more juice in Bank of America's TARP warrants.

If Moynihan can deliver rising profits, Kotowski calculates that the strike price on the 2019 warrants will drop to $11.55, meaning the difference between the common and the warrants would put investors in-the-money by $18.55. Since the warrants cost a little over $6 presently, that implies a $12.30 per share gain, or a return of about 200%. On an annualized basis, the IRR of the warrant trade would be about 36%.

There isn't too much downside to the trade, according to Kotowski. In a bear case where Bank of America earns a 6.5% ROTCE, he calculates Bank of America would trade at $19 a share, meaning that the warrants would be trade at roughly their cost.

One warning:

Skip Bank of America's 2018 warrants. Those would expire worthless in Kotowski's scenario.