“So nearly $5 billion in earnings, solid, very strong capital, very strong liquidity, continuing our responsible growth management.”
Brian Moynihan
President & CEO
New York | In this issue of The Institutional Risk Analyst, we assign a “neutral” risk rating to Bank of America (NYSE:BAC) for the reasons discussed below. At $2.7 trillion in assets, BAC is the second largest bank holding company in Peer Group 1 after JPMorgan Chase (NYSE:JPM) and arguably has the weakest management among the top five. BAC has two bank subsidiaries, a couple of large broker dealers and many hundreds of nonbank affiliates.
WGA LLC Risk Ratings
Bank Group: ALLY, AXP, BAC, BK, C, COF, DB, DFS, FRC, GS, HSBA, JPM, MS, OZK, PNC, SCHW, TD, TFC, USB, WFC
Quantitative Factors
The common equity of BAC closed at just over 1x book value at the end of Q4 2020, while the bank’s credit default swaps (CDS) ended the year below 50bp. Both indicators remain depressed compared with a year ago, this despite the fact of quantitative easing (QE) by the Federal Open Market Committee.
Compared with JPM at 1.6x book and U.S. Bancorp (NYSE:USB) at 1.5x, BAC is clearly an underperformer among the top 10 largest US banks by deposits and banking assets. For Q3 2020, net income was down 21% YOY. Suffice to say that even in and era of Fed-engineered asset scarcity, BAC common shares trade at par as this report is published.
The first performance metric to consider is net credit losses, where BAC is actually lower than better performing names such as USB and JPM. Under President & CEO Brian Moynihan, BAC consistently avoided risk – and shed revenue -- compared with its asset peers. Going back more than a decade ago to the decision to shutter the Countrywide correspondent lending and securitization business, Moynihan never misses an opportunity to avoid risk, often at the expense of revenue and shareholder returns.
The lower net loss metrics for BAC are well-above that of Peer Group 1, but still lower than those of other large banks. Notice that BAC trails both USB and BAC by a significant margin in terms of net loss, but above Wells Fargo & Co (NYSE:WFC). As we’ll see below, this lack of credit risk ultimately results in lower income in absolute terms and relative to the size of the bank.
Source: FFIEC
The next metric to consider is the bank’s gross spread on loans and leases, what it earns on average for all of its extensions of credit before expense for interest, sales and administration. As the FOMC has forced down interest rates it also forces the return on earning assets lower, resulting in a lower gross spread on earnings assets for all banks.
The gross spread tells you about a bank's internal default rate target and thus the business model. Notice that both WFC and BAC languish with gross spreads below the average for Peer Group 1. The subprime credit card and individual loan portfolio of Citigroup (NYSE:C), on the other hand, pushes up the gross spread on that bank’s loans & leases almost two percentage points above its less aggressive peers.
Source: FFIEC
In the chart above, we see that BAC has lower pricing on its credit products than its peers. In fact, BAC is in the bottom decile of Peer Group 1 when it comes to the gross yield on loans & leases. Part of this is a conscious decision to target a certain customer default profile, part the competitive dynamics in the marketplace. But BAC's loan pricing is part of a larger approach to balance sheet management that has to date produced poor results.
After considering the yield on the bank’s loans, the next factor to examine is funding costs, an area where the deposit heavy BAC should and does excel. Indeed, as of the third quarter of 2020, BAC had the lowest funding costs among the top banks and was even below the peer group average for the 130 largest US banks above $10 billion in assets.
The chart below shows interest expense as a % of average assets for the selected banks and Peer Group 1. Notice how much the cost of funds has fallen for market-facing institutions such as Citi and JPM. Notice too how low interest rates have fallen for the banking industry in absolute terms.
Source: FFIEC
Although BAC has lower funding costs than its large bank peers, the results do not make it down to the pre-tax line because of the bank’s relatively poor operating efficiency. As of Q3 2020, BAC had an efficiency ratio of 64.7 vs 62 for Peer Group 1, only 58 for JPM, 59 for Citi and an astounding 80 for WFC. The lower the efficiency ratio, the better the bank is at generating earnings vs expenses. Excepting the unusual case of WFC and of course Citi, which we assigned a negative risk rating, BAC is just tracking above Peer Group 1 in terms of net income, as shown in the chart below.
Source: FFIEC
In 2016, the BAC common began to run up sharply in value due to the reduction in operating expenses that resulted when the bank settled most of its legacy claims left over from the 2008 financial crisis. Annual operating expenses fell from over $70 billion in 2014 to less than $40 billion in 2019, generating a nice windfall for long-suffering BAC shareholders.
Yet since 2015, BAC has seen its interest income and non-interest income lines fall precipitously. The former is down 20% since 2015. More alarming, non-interest income is down by a third from $42 billion in 2015 to $32 billion in Q3 2020. Just about every major line item in non-interest income has seen a significant decline since 2017. During this same period, the bank has grown in asset size. More assets and less income is not a formula for generating value for shareholders.
While his traditional strength in cost-cutting is apparent, CEO Brian Moynihan has been singularly unsuccessful in retaining or generating new revenue. Indeed, as mentioned above, he has instead taken revenue and risk out of the business at Bank of America. The result is an equity market valuation that remains 1/3 below of pre-2008 peak above $50 per share.
One of the fascinating metrics for investors and risk managers to consider when assessing BAC is share repurchases. Under CEO Moynihan, BAC has recently spent more on share buybacks than have other large banks, but has seen little benefit in terms of the stock price. The table below shows total treasury stock repurchases for BAC and other large bank holding companies. Notice the relatively small share buybacks of USB, which trades at a 50% equity market premium to BAC.
Source: FFIEC
As is so often the case, the financial results from BAC tell the story when it comes to the mediocre performance of the stock. BAC has relatively low credit costs, lower funding costs than the broad group of large banks, but unexceptional pricing on earning assets and poor operating efficiency. The result is a sub-par performance that we attribute to the risk-averse strategy followed under Brian Moynihan. No wonder that the Street estimates for revenue growth at BAC are negative for this year and all of 2021.
Qualitative Factors
One specific qualitative measure of a bank’s management is operating efficiency, an area we have already identified as being weak at BAC. But the larger problem at BAC under Moynihan has been to use cost cutting as a panacea for deeper structural problems that management refuses to address. The human resources centric mindset that Moynihan brought to the bank a decade ago provides little in the way of vision for moving the business forward. Like Citi, we are concerned about the lack of a long-term plan for the business.
When Moynihan talks about “responsible growth,” this seems to be a catch phrase for failure and really avoiding opportunities to better lever the business. The obsession with avoiding credit risk and the poor operational performance, illustrate the fact that BAC is not taking enough risk to drive revenue and is doing a poor job managing efficiency. This shortcoming is magnified in the present interest rate environment.
Robert Armstrong wrote in The Financial Times in October:
“Falling interest rates took a painful toll on third-quarter profits at Bank of America and Wells Fargo, continuing to compress lending margins, overshadowing falling credit costs and improved results from the banks’ fee-based businesses.”
Aside from the particulars of BAC, the entire US banking industry faces a grave threat from the policy mix now embraced by the FOMC. Over the past half century, the chief tool of US monetary policy has been to lower interest rates to stimulate employment and aggregate demand, but at the expense of savers and capital.
While the Fed aggressively seeks to fulfill the full employment mandate of the Humphrey Hawkins legislation, it does so by pretending that inflation is not a problem. This unequal distribution of the cost of fulfilling the Fed’s dual mandate, between savers and creditors on the one hand and bank equity holders and the US Treasury on the other, illustrates the concept of financial repression in the US banking sector.
Source: WGA LLC
Banks benefit from lower interest rates, but are also hurt by lower asset returns due to QE. In the case of mortgage-backed securities (MBS), the Fed is now imposing capital losses on banks and investors due to high prepayment rates.
For BAC, the message from the Fed and the credit market is clear: run faster when it comes to generating revenue, but this is one notable area of weakness of the Moynihan regime. We are talking about a bank that keeps most of its securities portfolio in held to maturity rather than available for sale, the polar opposite of the practice at most banks, a symbolic as well as practical example of the risk-averse strategy at BAC.
Frankly, the expense driven bounce in the common equity after 2015, when legacy legal expenditures from the 2008 financial crisis began to fall, may be the only real positive for Bank America in the past decade. We always argued that a quick restructuring of the festering Bank of America/Countrywide estate would have been cheaper and quicker, but instead BAC equity holders suffered through years of misery. Management made ever more clever excuses for basic under-performance and massive remediation expenses related to mortgage servicing errors.
Brian Moynihan may have been the right person to clean up the mess left by his mentor Ken Lewis. And true to his background as a lawyer and personnel officer, Moynihan has de-risked and de-populated the bank to the point where it does not generate sufficient revenue for its size and compared to its peers. The average cost per employee at BAC fell from over $150k annually in 2017 to $117k in Q3 2020. Even as headcount and assets per employee grew, expenses declined, illustrating how Moynihan has achieved short-term earnings.
After a decade riding the tiger, Moynihan might want to take an example from Michael Corbat at Citi, declare victory and hand off the ball. The basic question that BAC must answer, however, is how it intends to manage its balance sheet and business mix in the age of QE forever. Today the mix between BAC’s net interest income and non-interest income is evenly split in the $65 billion in pretax income that BAC reported in the third quarter of 2020. Yet somehow BAC still manages to produce less in the way of earnings than its peers.
We note above that the aggregate funding cost of BAC is extremely low, a fact that comes from the $1.5 trillion in core deposits held by the bank. Matched against this funding base is a loan portfolio that is 35% real estate, 30% commercial and industrial exposures, 10% credit cards and the rest in various miscellaneous loan categories. The average real estate exposure for the 130 banks in Peer Group 1 is 50% of total loans, of note.
Trouble is, the asset mix currently chosen by Moynihan does not get the job done in terms of putting BAC in the top quartile of the peer group and close to JPM and USB, to be specific, in terms of asset returns. Instead, BAC is closer to Citi in terms of key bank performance benchmarks and thus market value.
Compare, for example, how JPM has created a powerful origination and sale operation for agency, government and private-label residential mortgages. At BAC, sales of 1-4s are down 66% over the past five years. More, the bank's mortgage servicing business remains unprofitable. In just the past year, Moynihan and the board of BAC have left billions of dollars on the table by withdrawing the bank and its $1.5 trillion in core deposits from conventional and government correspondent lending. If you want to know one big reason why banks like JPM and USB outperform BAC: Better asset turns.
Likewise, compare how JPM has managed its interest rate exposures over the past several years compared with the “responsible growth” of Brian Moynihan. The bank bet on rising rates after 2019, when rates were clearly going lower. BAC missed on revenue in Q3 2020 by $500 million.
More, Q3 saw rising expenses for that old evil, litigation “with respect to some older matters.” The more things seem to improve at BAC, the more they also seem to remind us with great frequency of the bad old days that are not yet truly gone.
Assessment
We assign a “neutral” risk rating to Bank of America. The bank’s funding base and liquidity are strong and credit expenses likewise are well under control, but our concern is that BAC does not seem to have the earnings potential commensurate with its size. The second largest US bank is a low-risk counterparty but also a mediocre equity investment. Given the risk averse nature of Mr. Moynihan and his board, BAC is unlikely to take the sort of tough decisions that would restore sustained profitability, including reducing the size of the bank and asset sales.
We think that a strong case can be made that to enhance shareholder value, Moynihan and the BAC board ought to spin-off Merrill Lynch as a competitor to Morgan Stanley (NYSE:MS) and Goldman Sachs (NYSE:GS). Then BAC could split into two separate commercial banks around $750 billion in assets, making two new super regionals to compete with USB, PNC Financial (NYSE:PNC) and Truist Financial (NYSE:TFC). The growth and competitive energy released by such a transaction, IOHO, would accrue to the great benefit of BAC shareholders.
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