Bank of America's (NYSE:BAC) earnings have been under siege since the financial crisis began five years ago. There have been many culprits for the decline in earnings, among them: a bloated retail presence, mortgage bets gone wrong, expensive Countrywide and Merrill Lynch acquisitions, the Federal Reserve's quantitative easing programs, and a general strategy to build excess capital in the wake of huge losses. BAC has largely addressed most of these issues and the stock has more than doubled off of its 2012 low as a result. However, with the Federal Reserve's QE efforts (hopefully) coming to an end at some point, the inherently higher interest rates that will follow should serve to boost BAC's (and all banks') ability to earn income on their interest-bearing asset bases.
Bank of America, as we see below, has seen fully taxable equivalent net interest yield (also referred to as net interest margin) fall from over 3.5% in early 2003 to just over 2.3% in the last quarter of 2012.
The reason this is important is because some of the decline in NIY for BAC is due to lower and lower interest rates due to the Fed's QE efforts to boost the economy. As interest rates decline, banks earn less and less on the spread between how much it costs them to finance loans versus how much interest income they can collect, all else equal. This graph is ugly if you are a shareholder however, there is a positive note to this data.
First, we can see that NIY is at the very bottom of the range for the last 10 years for BAC. This means that NIY could be bottoming soon and we may have seen the bottom in the middle of last year when 2nd quarter NIY came in at just 2.21%. Second, the Fed's QE Infinity program should be coming to an end either later this year or next year, based on strong economic trends we have seen including robust payroll numbers in recent months. As interest rates rise, it should become progressively easier for BAC to achieve NIY over 235 bps, as was the case in the second half of 2012.
The question then becomes, what is, say, 300 bps of NIY worth to the company if it can achieve such a level? To answer this, we need to derive a couple of numbers. First, BAC's full-year 2012 earnings press release states that net interest income, which is the numerator in the NIY calculation, totaled $10.6 billion for the fourth quarter. It also states that the same number in the third quarter was $10.2 billion. If we take these numbers for the second half of the year and double it to get a reasonable estimate of a full-year number, we have approximately $41.6 billion in net interest income. Now, the data I pulled from the Qs and Ks for BAC shown above has average NIY for 2012 at 2.36% and BAC says it was 2.35%; we will use BAC's number as it is lower. If we divide the $41.6 billion in estimated net interest income for a full year by the 2.35% NIY, we get an interest-bearing asset base (the denominator in the NIY calculation) of approximately $1.770 trillion.
Given this information and the fact that we know BAC was easily achieving 3.2% NIY pre-crisis, I believe it is reasonable to assume that BAC will eventually get back to 300 bps of NIY on average. If we assume this will happen and we assume that no growth occurs in the interest-bearing asset base, the extra 65 bps of NIY would produce something like $11.5 billion in extra interest income annually. This is extraordinary and it shows that, despite how well BAC is executing its turnaround, there is an enormous amount of earnings power that is still on the table for BAC. In addition, extra NIY doesn't really add incremental cost, so operating leverage is enormous in this situation. In other words, any increase in NIY will largely flow directly into operating income.
Speaking of interest-bearing assets, we can see in these two charts I produced from Q and K data that BAC's total loans and deposits have more than doubled in the past ten years off of an already large level of $400 billion.
We can see, however, that as a result of BAC's turnaround efforts, a large piece of which is strengthening the balance sheet, the nominal level of deposits has continued to grow but we see a divergence in loan growth. This divergence started in 2009, just as things were at their ugliest in the world of banking and has continued through today. First, this speaks to the ability of BAC to attract and retain depositors, which is the long-term lifeblood of any bank. Second, it also reveals the fact that CEO Brian Moynihan has been trimming BAC's risk profile, which includes loans, in order to strengthen the bank's capital position. Obviously, the measures are working as intended but this has come at the expense of interest income.
Seen another way, the ratio of loans to deposits is near the lowest level it has been over the past decade.
One can easily see the marked increase in risk-taking that started in 2005 and ramped into 2007, with loans actually exceeding deposits for about four years. While I'm not anticipating a return to 100%+ loan to deposit ratios, and indeed I am hoping we don't see those levels again, I am anticipating that once BAC is happy with its capital position, it will return to the 90% to 93% range. Since the ratio was around 84% at the end of 2012, that implies another $65 to $95 billion in additional loans that BAC could potentially initiate in the future, based on the most current deposit base number of $1.063 trillion. This increase in interest-bearing assets would serve to further increase NIY, provided the loans were to creditworthy borrowers. If NIY expansion occurs simultaneously, which it should, BAC's earnings could be off to the races.
I'm not suggesting that marked expansion in the interest-bearing asset base is near as BAC is still in turnaround mode and hoarding capital; however, eventually BAC will have its fortress balance sheet and will need to begin to lend again. Perhaps this change in strategy will occur in 2014 if BAC can post solid earnings this year. Additionally, if BAC's loan-to-deposit ratio eventually climbs into the 90% range again, interest-bearing asset base expansion combined with expanding NIY should serve to substantially boost BAC's earnings in the coming years. I believe BAC has learned its lessons from the financial crisis and it shows in BAC's continued building of capital. Moynihan and his team know what went wrong for BAC in the years prior to the financial crisis and I don't believe the same mistakes will occur again. When BAC begins to expand the interest-bearing asset base once more, and with a little help from the end of QE Infinity, BAC's interest income could be set to rise 25% to 50% in the not-too-distant future.