Tapering appears to be the new "hot topic" for the U.S. macroeconomic framework. The low interest rate environment has substantially impacted the economy by supporting its recovery. On the other hand, the idea that this support from monetary expansion will, in time, begin to taper off, is being witnessed with a lot of caution as this macroeconomic event is expected to impact every industry. The performance of financial services industry has remained restricted in the low interest rate environment as the net interest margins for banks have been restrained. Therefore, the notion of tapering will introduce interesting dimensions in the financial services market. Similarly, the housing prices have shown a substantial improvement as the Case Schiller Housing Prices Index has shown a remarkable upswing. Going forward, the spillover effects of changes in the housing sector will also have far reaching consequences for the banking sector, specifically for the banks with a heavy exposure to the mortgage business.
In the last few days, S&P 500 has witnessed a relatively strong retreat which has resulted in a decrease in stock prices for the banking industry's major players as well. In the recent quarters, the financial services stocks have been soaring due to strong earnings reports by the large players. Bank of America (BAC) has been the strongest contender in terms of trade volume in the recent periods. In the last few days, the news regarding the company's $8.5 billion mortgage case has furthered the downward movement of the stock in comparison with other players as the stock price has declined by 5.35% since May 30th. In this analysis, I intend to review my recommendation of a long position in the stock.
Net Interest Margin Trend
The net interest margin has been a major concern for banking sector ever since the Federal Reserve introduced its monetary policy. Due to the lower interest rates, banks had to turn towards reserve releases and expense cuts in order to sustain their profitability in the face of low interest rates and stronger regulatory pressures. Bank of America's net interest income in FY12 also declined as compared to the previous years; however, the recent quarterly trends project a different picture.
Source: FY13Q1 Earnings Presentation
The above chart shows the net interest income and the net interest yield of Bank of America over the last five quarters. The bank's current net interest margin is still below the margin attained in the first quarter of FY12. However, in the last four quarters, the net margins have improved from 2.21% to 2.43%. At the same time, the net interest income has also improved over this period as long-term debt has been reduced and the commercial loans segment has shown a marked improvement. These facts show that the earnings of the bank cannot be entirely associated with their cost cutting measures. The improvement in bank's performance in key segments has also supported the overall earnings results.
Update on Litigation Cots
With the MBIA settlement, Bank of America was set to focus on its future strategies and operations. The settlement of that case resulted in a positive sentiment in the market as the stock price regained its momentum. However, recently the mortgage securities issue of Countrywide Financial Corp. has been brought to life again. Bank of America bought Countrywide in FY08 and proposed an $8.5 billion settlement for investors. Now the case has been opened as players like American International Group Inc. (AIG) contest that the settlement did not offer the full amount of their losses. The only certain aspect of this case is that it is expected to persist throughout the month of June.
Bearish analysts have proposed that the case could result in losses amounting $60 billion for Bank of America. A few of these analysts have also started to raise questions regarding the bank's balance sheet. In my opinion, these views are farfetched. It is too early to speculate regarding the possible losses, if any at all and the reduction of long-term debt over the last few years have substantially strengthened the balance sheet of the bank. The tier 1 capital proportion of the bank has improved over the last two years. Therefore, currently the only threat to Bank of America's future outlook is its legal issues which seem to continue despite utmost efforts of the bank.
The overall retreat of the market from the last month's upswing, coupled with the news regarding the opening of the mortgage securities case has reduced the stock price of Bank of America to $13.09. These two factors are the major sources of short-term risk for the bank. Therefore, in the short run, the downward price movement is expected to persist for a while. However, in my opinion, this is not a signal to surrender the long position in the bank. In fact, investors should consider this decline as a considerable buying opportunity and look for decent entry points. Therefore, I reiterate my buy recommendation on Bank of America for the long run as the fundamental indicators suggest that the company will benefit the most from the overall economic recovery.