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Bank of America (BAC) shareholders have been treated to some extraordinary gains in the past couple of years and the reasons for the gains are many. In a quest to put the puzzle together for why I think BAC is a buy, I've taken a look at several metrics including net interest margin and the company's loan to deposit ratio. In this piece, we'll take a look at the bank's loan loss allowances as a proxy for the quality of the credit the company is extending to see how things are progressing on that front.

For this exercise I selected BAC's provisions for credit losses on the balance sheet at the end of each year as a proxy for asset quality. BAC is required to accrue provisions for losses it feels are reasonably likely to occur and in doing so, provides a way to understand just how much the bank thinks it is likely to have to write off as a result of loans souring. I took this number and divided it by the amount of total loans and leases outstanding at the same time and calculated a credit loss provision number as a percentage of total loans and leases.

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There is a lot of information contained in this graph and it can really help us understand what happened to BAC during the crisis, what is happening now and what "normal" looks like in terms of credit losses for BAC. Leading up to the crisis, BAC was pretty steady at roughly 1.5% of loans provisioned for write downs. I believe this is likely the "normal" we can expect from BAC in terms of credit loss provisions and all told, that is a very acceptable number. There are always going to be credit losses regardless of how good BAC is at underwriting its loans and if it can get that number below 1.5%, I think that is adequate.

During the crisis, we see the loss rate skyrocket 100 basis points in 2008, followed by another 140 basis points the next year and another 45 basis points in 2010! All told, BAC's loan loss provisions as a percentage of total loans tripled from 2007 to 2010, an astounding figure that likely shocks most investors. Put into nominal terms, this is even more incredible as loan growth was also outpacing deposit growth during that period, meaning that in dollars, this figure is even worse.

The good news is that we see a rapid improvement in this metric in 2011 that continues through today. After steep drops in loan loss provisions in each of the past three years, that figure is now below 2% for the first time since 2007, providing some tangible evidence that BAC's turnaround effort, an effort that includes cleaning up its balance sheet, is working tremendously. Consider even that just at the midpoint of 2013, provisions were 2.3% percent of loans and that it is now under 2% only six months later; that is the rapidity with which BAC is making strides in improving its loan quality.

There are some benefits that accrue to shareholders from credit quality improving. First, loan loss provisions translate directly to the income statement via losses. As credit losses come down, so too do the earnings reductions we've seen in years past. This means that, all else equal, BAC makes more money as credit loss provisions come down. Using the 2013 average loan figure of $928 billion, if we provide for credit losses commensurate with BAC's reported loan loss provision of 1.9%, we get allowances of $17.4 billion. Just last year we saw provisions of 2.7% which, on the same loan amount, would produce $25 billion in provisions. That is a staggering difference and this is what I mean when I say that rapidly declining credit loss provisions translate into real earnings; $7.6 billion is material to anyone and I think we'll continue to see more of this in the future given BAC's current trajectory.

The other major impact on the financials is the increase in book value. Whenever BAC takes a credit loss provision it must reduce the value of its loan portfolio by the same amount. Thus, credit loss provisions translate directly into book value reductions. This means by reducing credit losses by the $7.6 billion in our example above, BAC is indirectly increasing its book value at the same time. We are all aware of the many ways book value increases help a bank stock so I won't rehash them here but just know that BAC's vastly improved loan portfolio quality is aiding in materially boosting the bank's book value.

Ever-declining loan loss provisions have provided BAC shareholders with tremendous gains over the past three years. While the company's headline revenue and earnings numbers receive the attention, don't forget about the company's loan loss provisions. As they come down, earnings and book value increase, thereby increasing the value of the company's shares. As we move forward, continued low credit loss provisions and even more declines in provisions will continue to indirectly boost BAC's earnings and book value, increasing shareholder wealth.

Source: Bank Of America: Huge Tailwind For Earnings And Book Value