While Brain Moynihan has done a good job of projecting Bank of America (NYSE:BAC) as a small, hometown, people friendly bank, as opposed to the "too big to fail" ominous mortgage lending fiasco it had been, the best move he has made was to settle the issue with the Department of Justice.
The article noted made these two distinct achievements to support its opinion:
- Moynihan set those goals, and first unveiled his highly original philosophy of banking, at an investor conference in March 2011. During that event at the baroque ballroom of the Plaza Hotel in Manhattan, Moynihan extolled a model that's a throwback to the conservative practices of the 1950s. He stated that the problem with banks is that they make tons of money in good years, and give it all back in credit losses when times get tough. The problem, he said, is that in a heady market, banks make far too many risky mortgage, credit card, and commercial real estate loans in a headlong drive for growth.
- It's time for Wall Street to accord Moynihan the Dimon-sized respect. He's just taken his biggest step yet towards the goal so seemingly implausible that most of the investment community dismissed it long ago: making BofA one of the world's most profitable companies. This may sound like an odd thing to say in the wake of what many described as a monster government sanction. (On Aug. 21, the bank reached a $16.65 billion settlement with the U.S. Department of Justice, the SEC, and the attorneys general of six states, including New York and California, for abuses in originating, securitizing, and selling residential mortgages during in the run-up to the financial crisis.) But that's precisely why I'm saying it.
The Settlement Is Huge, But Even That Will Help BAC
Bank of America has paid more in fines than any of the other banks. So much more, in fact, that one wonders if BAC was the only bank giving mortgages that were less than acceptable. Just take a look at this breakdown:
The fact the latest settlement is so huge disguises the fact that a very good portion of the fines and penalties will be a bottom line tax break for the bank.
With some $7 billion of the total likely to come in the form of relief measures for homeowners, such as loan forgiveness, reduction of principal and rebates, the bank will likely be allowed under federal income tax rules to deduct that $7 billion as a business expense. Such a deduction translates into money in the bank's pocket, and reduces significantly the bottom-line impact of the total fine, especially because the bank has already written down losses on a lot of soured mortgages, according to its filings with the Securities and Exchange Commission.
"There's no question they will get this deduction and that it will help" them, Robert Willens, a tax and accounting expert in New York, told Newsweek on Friday.....Losses from soured mortgages have already produced a silver lining for the bank, in the form of lower taxable income that has generated future tax deductions. Bank of America has some $30 billion in those future tax deductions, known as deferred tax assets. While that $30 billion can't be converted directly into cash, it has allowed the bank to boost its dividends to investors without triggering for the bank ordinary tax bills on those dividends.
Mortgage Lending Going Forward
Glancing at some overlooked recent events puts BAC in the middle of yet another government program which will actually assist veterans to obtain a mortgage, which once again will launch BAC well up the ladder as a go to mortgage lender, with hopefully a higher standard of lending.
What do Wells Fargo, Quicken, Citi, Ocwen, and Bank of America have in common? They are all part of a mortgage program announced by the Obama Administration yesterday focused on members of the military. Quicken, for example, sent out a press release saying, "Quicken Loans Partners with the Obama Administration to Ensure Military Members Receive Mortgage Protections...The nation's largest VA lender and second largest retail lender immediately begins notifying service members of the flexible financial protections that their active duty triggers under federal law...a partnership with the Obama Administration to make sure active-duty military members receive the benefits their service entitles them...has agreed to enhance the financial protections that active military members are granted under the Service Members Civil Relief Act (OTCQB:SCRA). The SCRA is a federal law that assures protection for military members as they enter active duty. In addition to other financial protections, the law allows flexibility for active military members related to their mortgage interest rates, mortgage late fees and mortgage foreclosure protection."
Those five lenders will be reviewing their entire servicing portfolios, monthly, and compare them to the Department of Defense's current database to proactively identify borrowers that are also active duty members of the military. They will then reach out to the active-duty homeowner or their closest available relative and inform them that (Quicken/BofA/Wells/Citi/Ocwen) will be applying any of the special benefits they are entitled to receive under the SCRA.
As a side note, servicing values are critical. Any lender with servicing on its books, bank or non-bank, can never rule out a transaction if servicing values were to reach levels that management thought were abnormally high that would mitigate the negative effects of a tax hit or (for a bank) potentially losing the continuing relationship between the depository and its customers, such as capturing refinancings.
Now add this to the recent turnaround in the profitability of actually writing mortgages, from a loss of $194 per transaction to a profit of $954 in the second quarter of 2014 (simply for the transaction itself), and one should be able to see that BAC is headed into even more profitable waters.
As noted in this report, profits were not the only item that improved in the second quarter. The actual costs associated with handling these loans have been dramatically reduced.
"The gains seen in the second quarter come after first quarter losses that were likely triggered by a variety of factors including the implementation of new Dodd-Frank regulations and extremely low origination volumes," said Marina Walsh, MBA's Vice President of Industry Analysis. "Some loan closings may have been pushed into the second quarter, resulting in an increase in profitability as per-loan production costs declined."
Those total loan production expenses - commissions, compensation, occupancy, equipment, and other production expenses and corporate allocations - decreased to $6,932 per loan in the second quarter of 2014, from $8,025 in the first quarter. The $1,093 reduction was the largest in any single quarter since the inception of the MBA's Quarterly Mortgage Bankers Performance Report in the first quarter of 2008.
Now that the major issue with the DOJ has been settled, BAC can focus on generating greater revenues and profits from the mortgage business once again.
The outcome could be that BAC will gain ground on the other large mortgage lending banks:
More room to grow in all areas that will count towards shareholder value going forward. It does not take any deep analysis here to see why several major analysts have just increased their ratings of BAC.
Deutsche Bank upgraded BAC from Hold to Buy (Jul 2, 2014). Previously, MKM Partners Initiated BAC at to Buy.
The Bullish Case Now Makes Sense
I personally would expect even more upgrades, and add these to the consistent bullish case made by TheStreet and we might have a confluence of positives that will lead us through the next few earnings periods.
"We rate BANK OF AMERICA CORP a BUY. This is driven by a few notable strengths, which we believe should have a greater impact than any weaknesses, and should give investors a better performance opportunity than most stocks we cover. The company's strengths can be seen in multiple areas, such as its expanding profit margins, notable return on equity and increase in stock price during the past year. We feel these strengths outweigh the fact that the company has had sub par growth in net income."
Highlights from the analysis by TheStreet Ratings Team goes as follows:
- The gross profit margin for BANK OF AMERICA CORP is currently very high, coming in at 86.47%. It has increased from the same quarter the previous year. Regardless of the strong results of the gross profit margin, the net profit margin of 9.28% trails the industry average.
- Regardless of the drop in revenue, the company managed to outperform against the industry average of 11.7%. Since the same quarter one year prior, revenues slightly dropped by 5.1%. Weakness in the company's revenue seems to have hurt the bottom line, decreasing earnings per share.
- The return on equity has improved slightly when compared to the same quarter one year prior. This can be construed as a modest strength in the organization. Compared to other companies in the Commercial Banks industry and the overall market on the basis of return on equity, BANK OF AMERICA CORP underperformed against that of the industry average and is significantly less than that of the S&P 500.
- Compared to where it was 12 months ago, the stock is up, but it has so far lagged the appreciation in the S&P 500. Looking ahead, the stock's rise over the last year has already helped drive it to a level which is relatively expensive compared to the rest of its industry. We feel, however, that the other strengths this company displays justify these higher price levels.
- BANK OF AMERICA CORP's earnings per share declined by 40.6% in the most recent quarter compared to the same quarter a year ago. This company has reported somewhat volatile earnings recently. We feel it is likely to report a decline in earnings in the coming year. During the past fiscal year, BANK OF AMERICA CORP increased its bottom line by earning $0.91 versus $0.25 in the prior year. For the next year, the market is expecting a contraction of 12.1% in earnings ($0.80 versus $0.91).
Keep in mind that investors who buy stocks for dividends might also be looking at BAC for income as well. With the increase to $.05/share in the dividend, the bank is signaling that it intends on returning shareholder value in the form of income, while the shares appreciate over time.
The recent payout ratio of under 10% should give dividend growth investors food for thought to make room for shares of BAC within their DGI portfolios.
Headwinds Are Always Lurking
As with any other security, an investor needs to monitor the economic and geo-political environment that could be cause for this stock to stagnate, or even drop. In no special order let me outline what I would watch for:
- Escalation of tensions in Ukraine, which could lead to more of a global issue.
- Global recession issues having an impact on the stock market after the extended bull run, including here in the USA.
- A return to the very loose mortgage lending standards that created the crisis in the first place.
- Another wave of foreclosures that could impact future revenue and earnings to some extent.
The Bottom Line
Nothing is ever risk free; however, the recent events lift the curtain of uncertainty to a level that makes an investment in BAC over the long term a smart move. I have no idea as to where the share price of BAC will wind up 2 years from now, but in the short term, I believe that the 52 week highs can be reached before the end of this year.
That would equate to roughly a 17% increase from the current share price of $16.05.
Disclaimer: The opinions of the author are not recommendations to either buy or sell any security. Please remember to do your own research prior to making any investment decision.
Disclosure: The author is long WFC, BAC.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.