- Bank of America's pre-crisis mismanagement is a thing of the past.
- Leverage is at its decade low, signaling increased safety and soundness.
- Lower funding costs will drive higher margins and profits in the coming years.
It is no secret that Bank of America (NYSE:BAC) was gravely mismanaged in the years leading up to the crisis. The bank took on too much risk, its cost structure was suboptimal and too much leverage was applied. This cocktail of bad decisions subsequently led to BAC shares' nadir at only $3 during the worst part of the crisis in 2009, and of course, a government-led bailout. In this article, we'll take a look at BAC's leverage and its ability to withstand another crisis, as I believe it has important implications for investors.
To begin, we'll define what I'm using to look at "leverage", as there are a few options. For the purpose of this exercise, we'll be looking at BAC's time to require funding metric, the data for which I've retrieved from its 10-K filings for the past 10 years. BAC defines this metric, which I'll henceforth refer to as TTRF, as a "debt coverage measure [that] indicates the number of months that the parent company can continue to meet its unsecured contractual obligations as they come due using only its Global Excess Liquidity Sources without issuing any new debt or accessing any additional liquidity sources." In other words, this is the amount of liquidity BAC has at its disposal at any particular point in time, sufficient to pay its upcoming obligations without having to raise new capital.
This is an important metric for BAC shareholders to understand and watch, because it shows a couple of things. First, it gives you a sense of how much leverage BAC has at any particular point, and second, it gives you an idea of how BAC would fare in another crisis scenario. These are both critical for BAC shareholders to understand, as it has implications for how the bank is being managed as well.
The chart below, created from 10-K data, shows BAC's TTRF at year-end for the past 10 years. The columns are BAC's actual TTRF, and the red line is BAC's goal of 21 months.
As you can see, BAC has seen enormous volatility in its TTRF over the past decade. We can see in the run-up to the crisis that BAC was responsibly holding around 28 months in funds until the mortgage boom party reached its zenith in 2007, when BAC held only 19 months' worth of funds. Then, after the deleveraging process began in 2008, BAC's TTRF has subsequently risen to the value of 38 months today.
So, what does this mean for shareholders? First, it means that BAC has far less leverage today than it had at any point in the past decade. This is desirable for a couple of reasons. First, funding costs will be lower with less leverage, as BAC is funding its earning assets with a higher mix of deposits than it had in the past. This means that less interest expense is flying out the door, because BAC isn't borrowing to make money; it is taking in deposits the old-fashioned way. This results in higher net income, all else equal, as less revenue is spent paying creditors. The second implication of lower leverage is that BAC is far more able to withstand exogenous shocks, like the financial crisis. We see the TTRF reach only 19 months before the crisis, and as we all know, the horrendous environment required BAC to raise massive amounts of additional capital from various sources to stay alive. BAC is in the position now that if some shock to the banking system were to occur again, it is able to fund itself for much longer than was previously the case.
The second major implication for shareholders is that I find TTRF to be a great way to see if the bank is being managed properly from a risk-control perspective. TTRF is a great proxy for how much risk the bank is taking on, and as we can see in the chart, history shows us that this is a very important metric to watch. Anyone watching TTRF leading up to the crisis would have known BAC's risk controls were lacking and that a dreadful situation was lurking on the horizon. Conversely, we see today that BAC is still in the process of deleveraging, and is at nearly twice its TTRF goal as of the end of last year. BAC is still producing a tremendous amount of profit growth, while simultaneously deleveraging and increasing safety and soundness, as evidenced by TTRF, indicating that management is really hitting a home run.
BAC has made mistakes in the past, as evidenced by any number of metrics, including TTRF, but I believe a strong case can be made that CEO Moynihan has really taken control of this banking behemoth and has it on the road to sustained, safe profitability. TTRF shows that BAC has the ability to grow its earnings safely, without the profligate risk-taking of the pre-crisis years, and that should another crisis set upon the banking world, BAC will be much better suited to withstanding such a shock. For shareholders, there is no better scenario, and it means more upside for BAC shares in the future as the discount on BAC shares' price to book value dissipates and more earnings accrue to the bottom line.