With Bank of America's (BAC) earnings report last week we received a fresh look into the company's capital structure. While shareholders' equity ticked down from the year ago period, so did the company's debt securities. In addition, total assets declined as deposits moved up a couple of percentage points, all as a result of the bank's perpetual effort to deleverage its balance sheet and reduce risk. This is all great but there is another piece of the balance sheet I'd like to focus on and that is the company's preferred securities.
Before the financial crisis and the advent of new bank regulatory rules, preferred stock was all the rage among banks as a way to raise capital. Since preferred securities have no maturity date, they are counted as "capital" on the company's balance sheet. While I don't disagree with that logic, preferred securities should be treated as investors as what they really are; debt. Even though preferreds have no maturity date many of them are eventually paid back due to retirements when that particular source of funding becomes more expensive than others. In addition, apart from the lack of a stated maturity date, preferreds are virtually identical to any other long term debt security. There is a stated coupon rate and interest is paid at stated intervals. And to top it off, preferreds trade more like debt than equity because preferreds typically have no interest in the actual business; they are simply a way to raise money.
Thus, BAC has made it a mission to reduce expenses of all kinds and included in those expenses are preferred security dividend payments. BAC made preferred stock redemptions a priority in its CCAR plan as approved by the Federal Reserve this past spring and so far, the bank has made good on its promises. At last count, BAC had no less than 17 different preferreds still outstanding (which is actually down from where it had been, unbelievably) and these securities carry a face value of about $16.2 billion as of September 30th. While BAC has been busy redeeming certain preferreds, as laid out in the CCAR capital return plan, the company's YTD dividends paid on its preferreds is still instructive for our purposes. In the first nine months of the year BAC paid out $1.1 billion in preferred dividends, which includes $279 million in the third quarter. Since the balance of preferreds is steadily declining we'll use the third quarter number as a proxy for how much interest BAC is paying on its preferreds in a year. Using this, my calculations indicate that BAC's average dividend rate on its preferreds is about 6.9%. Since some of BAC's preferreds are floating rate securities the average rate paid each quarter will vary but this will be close enough to make the point I'm trying to convey.
If we assume BAC continues to use retained earnings to pay down preferred securities, as they are expensive sources of funding in our QE-Infinity world, the company could accrue another $1.2 billion or so in savings from redeeming its preferreds and replacing them with deposits or some other source of cheap funding. While I know deposits aren't counted as capital, Basel III rules don't count preferreds either so BAC will do well to ditch the preferreds and find some other way to bring in funding. In addition, even if BAC were to issue term debt in order to replace the preferreds, which I personally don't feel would be necessary, it could likely cut its interest expense in half (or greater) from the 6.9% it is currently saddled with on the preferreds.
The bottom line is BAC will incur no real penalties in redeeming its preferred securities in exchange for some cheaper funding source, including new debt. While I'd prefer these securities be redeemed using retained earnings and new deposits used as a source of funds, debt would still be cheaper on an after tax basis than the company's current preferreds. In terms of the stock, the stated savings on the company's preferreds would amount to over 11 cents of operating income each year at the current share count. At the company's current forward PE of 11, you could reasonably expect that shares would accrue $1.21 in capital appreciation (or 8%+) over time due simply to retiring these expensive sources of funding. While the world isn't that simple, the point stands; BAC has come a long, long way in the past two years but there is still much to be done and the rally to $14 is not the end of the move for long term holders of the stock.