Bank Of America: Substantial Upside From Earnings Leverage

Oct.29.13 | About: Bank of (BAC)

Bank of America (NYSE:BAC) has had some very well publicized issues since the financial crisis. Among them, the company lost enormous sums of money in the aftermath of the crisis but has since rebounded strongly even amid staggeringly expensive legal issues. Apart from that, CEO Brian Moynihan and the management team have made a concerted effort at turning BAC around, an initiative referred to as Project New BAC. Part of this turnaround has been to deleverage BAC's balance sheet, which had grown far too risky in the years before the financial crisis. We'll take a look now at one way that BAC has chosen to deleverage and its potential impact on the long term future of BAC.

If we take a look below, this graph depicts BAC's loan-to-deposit ratio (columns, right scale) versus its outstanding loans and leases and deposits by year. A couple of notes: loans/leases and deposits are average figures for the year (not spot figures) and all data came from company 10-Ks.

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There are some very interesting points that come from this chart. First, the company's loans and leases actually outpaced deposits in 2007 and 2008. That can give you a sense of just how risky BAC's balance sheet really was because "safe" banking practices would generally dictate that you don't lend out more money than your customers have deposited with you. Of course, BAC has other sources of money to lend out but the simple fact that more money was loaned out than was on deposit is staggering and very telling, in my view, of the kind of lax risk controls that were present at BAC leading up to the financial crisis.

Second, the company's loan-to-deposit ratio has been steadily decreasing ever since 2008 and pretty rapidly at that. We see the columns' values diving down to about 85% in the first half of this year but the way BAC has done this is also telling. Not only has BAC been downsizing its risk as defined by average loans and leases outstanding, but it has been growing deposits pretty rapidly as well. You can see the green line has a pretty steep upward slope in comparison to the virtually flat red line indicating that BAC has been bringing in large amounts of new deposits without lending the money out in order to de-risk itself. This strategy is a direct result of the company's cautious new position on risk and as a shareholder, you have to love that BAC is growing profits while simultaneously making its balance sheet less risky.

So what does this mean for earnings? In my view, BAC is likely where it wants to be in terms of its loan-to-deposit ratio. Given that the years before the profligate risk taking of the financial crisis saw LTD ratios of around 85%, I think the bottom is near. Whether management decides to stop at 85% or 80% is unknown but the point is I think the majority of the de-risking of the balance sheet in terms of the LTD ratio is complete. Now, I think a couple of things could happen from here that could impact earnings. First, BAC could begin lending out its money at the pace it is bringing on new deposits in order to maintain its LTD ratio in the mid-80s. This would mean that BAC could still grow its lending business every year as long as it continues to do a fantastic job at attracting new deposits. Just for reference, the past three full years have seen average yearly deposit growth of about 3%; this is the amount BAC could increase its lending portfolio without altering the LTD ratio.

Second, it could begin taking on opportunistic lending risks as it sees fit since the LTD ratio is near its lows for the past decade. This means that BAC could choose to have lending growth outpace deposit growth again as we saw in the mid-2000s. However, this time, the management team will not allow the LTD ratio to run away to 100%+ plus again; I'm simply saying that if BAC began to see loan demand pick up, it could certainly take advantage without taking undue risk. This depends on many things including loan demand, credit worthiness of borrowers and net interest yield. However, BAC is well positioned to take advantage of any opportunities that do arise because of the great work that has been done since Moynihan came into the CEO seat.

The most impressive takeaway regarding the LTD ratio for me is that BAC has been able to grow earnings so quickly following 2010's financial crisis induced losses while simultaneously de-risking its balance sheet. Now that BAC has done the work of growing deposits while restraining loan portfolio growth, the company is extremely well positioned for the future. When loan demand picks up and/or interest rate spreads widen, BAC will be able to seize every opportunity in order to create value for shareholders. If we continue to see the LTD ratio decline, consider it an investment in the long term for BAC shareholders as it means that the company isn't seeing the loan conditions it wants and has the discipline to wait it out until conditions are favorable. That is something the old BAC would not have done, as we saw in the mid-2000s. However, this BAC is more mature than that and is once again a great steward of the balance sheet. As important as generating returns for shareholders is avoiding losses and that is exactly what BAC has done for the past few years; this portends well for the long term health of the bank.

If BAC simply grows its loan portfolio at 3% per year, the average rate of its deposit growth for the past 3 years, at the current net interest margin of 2.44%, as reported at the end of June, the company could see another ~$650 million in net interest income per year without taking on additional risk. This gives you a sense of the earnings leverage BAC possesses with respect to its LTD ratio given that it has built in so much capacity in the past few years. Consider the ease with which additional lending income could reach into the billions if BAC decides to have its loan portfolio outpace deposits growth once again and you can understand why I'm so bullish. According to my calculations, BAC should see roughly $265 million of additional net interest income on each 100 basis point increase in its loan portfolio; that is a lot of earnings leverage. This also assumes no upside in the company's net interest margins which will almost certainly rise as interest rates begin to normalize. The point is, we haven't even begun to realize the earnings power of BAC yet and the huge returns from the past couple of years are likely just the beginning.

Disclosure: I am long BAC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.