- History suggests Bank of America's lending margins will expand in a rising rate environment.
- Enhanced margins mean billions in additional profits on BAC's existing asset base.
- The opportunity is for 100+ basis points in margin expansion as rates rise.
One of the central tenets to my bullishness on Bank of America (NYSE:BAC) is that it is well positioned to take advantage of rising rates, a condition that is widely expected to descend upon us in the next year or so, depending on whom you ask. This is an important point to understand and in this article, we'll take a quick look at BAC's cost of funds as it relates to an interest rate proxy, in this case, the 10-year Treasury. In this way we can see where BAC's cost of funds has come from and where it can reasonably be expected to go in the coming years as interest rates rise.
For this analysis I used the 10-Year yield as quoted by Yahoo! and computed a simple average yield for each year in the chart. Then, I pulled BAC's cost of funds, computed as interest expense divided by average earning assets for each year, from the company's SEC Filings. The result is the chart below where we see cost of funds in blue and the 10-Year average yield in the red line. I'm fully aware there are many interest rate proxies available for this kind of analysis but the 10-Year is the best proxy for the broader interest rate market in my view.
During the pre-crisis years in particular, we see that BAC's cost of funds was particularly favorable in relation to the 10-Year yield, with an enormous spread of 260 basis points in 2004. As time wore on and rates drifted higher BAC's cost of funding did as well as we see the spread reduced to 82 basis points in 2007. As you can see, as interest rates began to decline BAC's cost of funds declined even more quickly than rates did, with the spread widening back to 193 basis points in 2010. After declining once more as rates crashed in 2012, the spread has again widened to 161 basis points for 2013. Now, I understand BAC cannot lend at the 10-Year rate but the point of depicting the spreads is to show the relationship between the broader interest rate market and BAC's cost of funds. The lessons are interesting and we'll take a look at their implications now.
The main take away from this information is that BAC's cost of funds is slow to react to upward pressure on rates and quick to react on downward pressure. This is ideal and necessary because if it were the other way around, the bank would suffer mightily in a rising rate environment, likely losing billions of dollars yearly on razor-thin or non-existent net interest margins and then make very little of it back as rates moved down and the cost of funds remained elevated. This situation would produce an enormous amount of bank failures through each rate cycle so it's fortunate for all of us that this does not happen.
So where do the losses in interest go when cost of funds move up slowly but down quickly as interest rates move? The short answer is savers as it implies your money market and savings accounts are the most affected by this behavior. That is how BAC is keeping its cost of funds low when it needs to and raising it only begrudgingly, but then cutting deposit rates at the drop of a hat. While you don't want your deposits to experience this type of rate movement, it is terrific for BAC shareholders.
What it means is that with interest rates still relatively near their respective historic lows and deposit accounts still paying next to nothing, we can fully expect BAC to increase its cost of funding, specifically on deposit accounts over which it has a lot of control, very slowly with respect to the rates at which it can make loans. This will produce much higher net interest margins than we've seen from BAC in the recent past and allow for higher net income even absent revenue growth, which has been hard to come by for banks in general. And given analyst estimates for revenue growth in the coming year, BAC needs to squeeze every dollar from its revenue it can.
Given the information above, it is reasonable to expect that BAC investors should not only not fear a rising rate environment, but embrace it. As we saw with the last interest rate uptrend it benefited BAC tremendously and that is exactly what we'll see again. BAC has the ability to raise deposit rates at very slow rates while rates it can charge on loans increase much more quickly. This is not unique to BAC of course as any depository institution is going to do the same thing but in BAC's case, I think we have some definitive evidence that rising rates will be great for BAC's net interest margins. Given the last cycle up and the margins that were attained, BAC should see net interest margins expand at least 100 basis points but likely more given BAC's dramatically lower leverage this time around. BAC has retired tens of billions of dollars of debt since the pre-crisis days and thus, stands to further benefit from rising rates. The bottom line is we as BAC shareholders should be writing to the FOMC begging them to raise rates yesterday.