Over the past couple of years Bank of America (BAC) has made tremendous strides in many facets of its business. And if you don't believe me, simply take a look at the chart below; the stock is hitting multi-year highs. This is not by accident, however, as management has been making sure BAC is focused on cutting extraneous costs and going after profitable revenue. To that end, this article will take a look at BAC's cost of funds as a way to measure just how efficient BAC has become at obtaining and lending its funds in relation to how much revenue it can derive from these funds.
To start, for the purpose of this article I've defined "cost of funds" simply as interest expense divided by average earning assets. In this way we can determine how much of the company's earning assets are being spent solely to fund the asset base. In other words, the lower the number here, the better as it means BAC is becoming more and more efficient and thereby deriving higher and higher margins from its loans.
As you can see, there are a couple of interesting things at play here. First, the run up to the financial crisis saw BAC's cost of funds more than double from 1.7% to 3.7%. This was due to BAC's tremendous leverage that was built up in its quest to lend as much as possible during the housing boom. BAC took on large amounts of long term debt, some of which it is still paying off to this day. Needless to say, getting away from the core business of taking deposits and lending them is what got BAC into trouble and this chart shows one big way that happened.
However, since the unmitigated disaster that was the financial crisis BAC has done an exemplary job of remedying this most unpleasant situation by reducing its cost of funds down to a microscopic ~75 basis points in 2013. I don't have to tell you what that can do for a bank's profitability and we are seeing it in spades with BAC. In short, the way to interpret this chart is that during the financial crisis, BAC was spending $3.75 to finance $100 in earning assets; that number is now $0.75. That leaves an enormous amount of room for additional margin and outsized earnings expansion.
BAC's debt reduction and commensurate cost of funds reduction, as I've defined it, show that BAC is not only on the road to sustainable profitability but growing profitability. After leveraging itself to the moon and back again BAC has come to its senses and is once again operating like a bank. The fruits of this labor can be seen in its cost of funds as that metric has plummeted at a staggering rate since the financial crisis. Not only is BAC leaner, meaner and smarter than it was during the crisis, it is also able to lend its assets that are financed much more cheaply than before, making it even easier to expand margins and profitability in the coming years. Factor in the likelihood of rising rates and you've got a recipe for tremendous earnings growth in the future.