While Bank of America (NYSE:BAC) discloses its sensitivity to interest rates, there is generally limited discussion on the specific components that result in this impact. In this article, we look at the key element that drives Bank of America's net interest income - residential mortgage-backed securities.
What is a mortgage-backed security?
The U.S. Securities and Exchange Commission gives us the following definition
Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity. The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization.
Accounting for bonds purchased at a premium
With declines in medium- and long-term rates in recent years, most banks have been buying securities at premiums. This premium gets amortized into (i.e. reduces) net interest income/net interest margin over the expected remaining life of the bond. For instance, a bank owns a residential mortgage-backed security, that matures in 20 years, with a face amount of $1000 and a 5% coupon (i.e. a coupon of $50 per year). Because rates are low, a bank bought this security for $1200 with a $200 premium to its face value. Accounting principles require that bank amortize this premium of $200 over the next 20 years. So, roughly speaking, each year bank gets a $50 in cash interest, but reduces its interest income by $10 to account for the $200 premium over the remaining average life of the bond. However, as rates and prepayment speeds change, banks have to adjust their assumptions on the remaining life of their bond book. As underlying mortgages in the pool prepay (lower rates accelerate prepayments), the average life of the bond declines and the premium amortization needs to be written off over a shorter period. In some cases, banks take hits on the expectation that prepays will increase before it actually happens. So, for example, now accounting principles requires a bank to amortize the $200 premium over 10 years instead of 20, doubling the charge it takes against its interest income.
Bank of America is the most exposed to RMBS pass-throughs.
At Bank of America, when the expected life of a bond declines, for example (as it has in recent periods), they catch up on the required higher bond premium amortization all at once in the current period per FAS91. This compares to most banks incurring higher amortization levels over the remaining life of the bonds. Given high exposure to residential mortgage-backed securities (more than 16% of BAC's interest-earning assets), accelerating bond premium amortization is the biggest near-term risk for Bank of America, in our view. According to Deutsche Bank, each 10bps drop in long rates results in a one-time hit to BAC's net interest income of $100-150mn.
What does management expect?
BAC notes that a 100 bps parallel shift in interest rate yield curve is estimated to benefit its net interest income by $6.0bn over the next 12 months. We estimate that of the $6.0bn boost about 25% should come from RMBS, hence higher long-term rates are crucial for BAC
We acknowledge that RMBS pass-throughs are not the only reason of BAC's high sensitivity to interest rates. BAC also has a relatively larger commercial loan book that should reprice fairly quickly, and a lower reliance on market funding vs the other three large Universal banks: Citigroup (NYSE:C), JPMorgan (NYSE:JPM) and Wells Fargo (NYSE:WFC). Having said that, with U.S. long-term rates continue to decline and high exposure to RMBS (more than 16% of interest-earning assets), accelerating bond premium amortization is the biggest near-term risk for Bank of America, in our view.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.