Bank of America (NYSE:BAC) shareholders have been on a wild ride since the financial crisis began. Thankfully, the wild ride has been going pretty much straight up for the past couple of years, leaving patient shareholders and new ones from the financial crisis with large recent gains. One of the ways that BAC has been able to make money, and there are many, is through more efficient usage of its loan portfolio. In this article, we'll take a look at BAC's ability to turn interest income into profit as a way to understand where BAC is in the cycle.
First off, for this exercise, I've pulled net interest income and interest expense from BAC's 10-Ks. Then I charted them to make the data easier to look at. In essence, this chart is showing how much net interest income BAC is pulling in versus what it is costing them to own the assets. In this way, we can determine how effective BAC is at owning productive assets. Also, I fully understand there may be other ways to look at this data but I found this to be most useful.
What we see here is interesting. As BAC grew both by acquisitions and organically in the run up to the financial crisis, we see both interest expense and NII spike, particularly before the bubble burst in 2007. But if you take a look at the columns more closely, you see that interest expense was taking up a progressively larger amount of the bank's NII and we'll see that more in a moment. You can also see that, in nominal terms, BAC's interest expense fell rapidly following the financial crisis (red bars) and is currently at its lowest amount in the dataset I've provided. The kicker is that NII appears to be pretty steady on a nominal basis so the end result is, of course, higher margins on that NII.
What we see here is the same data charted a different way, which is simply the NII for the year divided by the sum of NII and interest expense. This is a form of "gross margin" for a bank in the way that you would measure it for a retailer. The idea is that this metric shows how much of each dollar of NII goes to interest expense and how much of it can go to paying the bills and ultimately, profit.
What we see is quite telling because it shows that BAC has become infinitely more efficient at turning interest income into profit. Take, for example, year 2007, which we highlighted above as having the highest interest expense. NII spreads were very thin even though the bank was producing a lot of revenue, so profits on that revenue were very low on a relative basis. In fact, I'd argue that analysts should have seen diving profit margins in the run up to the financial crisis as a red flag but it was likely ignored since the banking world was "still dancing" at that point.
At any rate, since that time, we see BAC's cost of funding come down as a percentage of NII and the results have been spectacular. Years 2010 through 2012 saw margins in the 70% range while last year saw BAC produce a ridiculous 77% margin on its NII. This is nearly double what it was in 2007 and it means a couple of things for shareholders.
First, it means that BAC can much more easily convert revenue into profit, something it's had a hard time doing in the recent past. BAC, at these margins, doesn't need enormous loan portfolio growth in order to produce additional net income because its margins are absolutely huge. This means that at least for the medium term, BAC will continue to rake in large amounts of profit on its loan portfolios in relation to its funding costs.
In addition, I think it means that BAC's management has become markedly more responsible at managing the company's expenses while profitably growing the loan book. This is a very important development as it means that BAC is not only making a lot more money on a relative basis, but if something goes wrong again, BAC is much more able to absorb rough patches than it was in 2007. With leverage so high and margins so low, when things went south, BAC had no buffer for losses and the stock subsequently went to $5. This time, BAC has enormous margins that can absorb some losses and keep the bank afloat while it works through any potential issues it may come across.
Along the same lines, BAC has set itself up to take advantage of low rates we have seen since QE began several years ago. BAC has been hard at work retiring higher cost sources of funding and either replacing them with lower cost debt or simply reducing leverage. The great thing about this is not only the immediate benefit of lower leverage (for safety) and interest expense (for profits), but it also means that when rates do rise, BAC will be poised to even further expand its margins. As rates rise, BAC will be able to collect more NII on its loan book but with low cost sources of funding already locked in, BAC's interest expense won't rise as quickly as interest revenue. This creates a margin expansion scenario where BAC can become even more profitable on its loan book than it already is, accruing outsized gains to net income.
BAC has certainly come a long way in its margins, as seen by the data above. It has a few implications including higher net income and a strong signal that management "gets it" in terms of profitably managing the company's loan book while mitigating risk. BAC is much less susceptible to a blow up like what we saw during the crisis and at the same time, set up to accrue outsized gains on its loan book when rates do rise. This is an ideal scenario and even with margins at or near all-time highs, I still think there is room to expand them and along with that, profits and the share price.
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.