Bank Of America's Profit Growth Driven By Its Capital Structure

Apr.21.14 | About: Bank of (BAC)


Bank Of America's capital structure was a mess leading up to the crisis.

BAC's cleanup of its capital structure is leading to higher profit margins.

Future profit growth will be driven by capital structure changes, driving EPS higher over the medium term.

With Bank of America's (NYSE:BAC) push to decrease its reliance on debt and preferred equity financing, I thought it would be instructive to understand BAC's historical mix of each kind of financing and where it stands today. In this way, we can understand how BAC uses each type of financing and how it is working to reduce its reliance on the higher cost sources of funding, namely debt and preferred equity.

To do this, I've charted BAC's data for each funding source, deposits, preferred equity, common equity and long-term debt, from its SEC filings.

Click to enlarge

A couple of things are quite evident from this chart. First, BAC's funding grew exponentially from 2004 until the crisis hit due to excessive risk taking and a few high profile acquisitions. This increased the sheer size of the company at a very rapid rate as you can see from the chart. In 2004 BAC had around $750 billion in total financing whereas 2009 saw that number jump to nearly $1.7 trillion. In other words, BAC more than doubled its financing base in only five years. That is an astounding feat as BAC is not some $10 million community bank; it's one of the largest banks in the world.

However, this growth did not come without a price. I think we can all agree that BAC grew too much, too quickly in the years leading up to the crisis and the results were ugly. BAC was mismanaged, as evidenced by the explosion in long-term debt financing.

This leads us to the second thing that is striking about this chart; long-term debt financing became an integral part of BAC's capital structure instead of what it should be for a bank, which is a stopgap when funds are needed. Debt is a very expensive way for a bank to obtain money and as such, when things go wrong, it is debt that contributes to a liquidity crisis. BAC had such a crisis a few years ago, requiring a bailout to maintain its capital requirements. BAC took on far too much debt in the years leading up to the crisis and this chart shows just how bad things got.

Now, the positives we see here are quite encouraging. First, preferred stock is an extremely expensive source of funds for a bank and BAC loaded up on them during the crisis. The good news is that preferred stock is being whittled down every quarter and it is barely visible on this chart for 2013. BAC is making a point of retiring preferred stock as a part of its capital return plan and it is doing a great job, eliminating the most expensive source of funds possible.

The next point is that we can see the long-term debt amount decreasing at a rapid rate as well, with 2013's level coming in just over what we saw in 2008. While BAC still has a lot of debt, it pales in comparison to what we saw in 2010 and we should applaud BAC for this. Debt not only costs more than equity or deposit financing but it is a great way to get yourself into a liquidity crunch when things go badly. BAC management isn't interested in ever requiring a bailout again and it is busy replacing debt with other, lower cost sources of funding.

The final point I'd like to make is that the total funding for BAC's balance sheet has stayed roughly steady since 2009 but the composition has changed somewhat drastically since then. BAC has been hard at work replacing debt and preferred equity financing with deposits and common equity financing, both of which have very low explicit costs. I understand common equity financing isn't "free" but that is outside the scope of this discussion.

The jump in common equity financing was largely a result of the bailout when common shareholders were massively diluted and while nobody wants to see that, it is still cheaper than issuing notes or preferred stock. And the fact is that it's done now so there is nothing we can do about it. In hindsight, it was probably still the best move given that the alternatives were more debt or preferreds BAC couldn't afford.

We also see deposit funding increase very steadily since the crisis, with this of course being the preferred funding method for a bank as it is undoubtedly the cheapest. Depositors typically don't expect much in the way of returns and with deposit rates slow to react to interest rate increases, BAC stands to gain further margin expansion as rates rise over the medium term.

We have heard anecdotal evidence that Project New BAC is working to reduce funding costs but this data puts it into perspective. Management has done a terrific job cleaning up the mess the previous C-suite team made and it shows. BAC's sources of funding are getting back in line with what you'd expect to see for a bank and while we aren't there yet, we should see debt and preferred equity continue to diminish as a percentage of BAC's capital structure and thus, margins should continue to increase in the future regardless of what interest rates look like, driving profitability growth.

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.