I've maintained over the past couple of years that Bank of America (NYSE:BAC) has been holding back on its ability to earn money from its asset base. This has happened as BAC and others in the space have tried to de-risk partially because of changes in the business model and partially because they felt compelled to by ever-stricter regulatory rules. The problem is that investors think that what BAC has done in the past few years is all it is capable of and are valuing the stock as such. But as we'll see, BAC's production has been based upon a proverbial hand tied behind its back and that means there is a lot left in the tank in the coming years.
To prove this point, I'll be using data from BAC's Qs and Ks to show how its loan-to-deposit ratio has morphed and changed over time. This data is tremendously interesting in helping tell the story of how BAC got here and why I think it has so much upside over time.
We'll begin with the chart I've put together, which shows BAC's average loans and average deposits for each year from 2006 through the first half of 2016 and its corresponding LTD ratio.
We can see that BAC's balance sheet was much smaller heading into the crisis than it was coming out of it. Part of this is because at that time, BAC was very much chasing yield and took on lots of debt to do so. It was in a race to take on as much risk as possible because things were good. The other part is because BAC of course purchased Merrill and Countrywide and thus, grew its balance sheet. But remember that this discussion is just about loans and deposits and those mergers brought lots of assets that are outside of that category. Still, they changed the way BAC thought about risk and helped mold its LTD ratio in their own ways.
On the eve of the crisis, BAC's LTD ratio hit 110% in 2008 after being nearly that high in the prior year as well. That is a truly extraordinary amount of risk for a bank as huge as BAC to be taking and of course, we all know this turned out extremely poorly in subsequent years. But that is the level to which BAC took its pursuit of yield and managed to make $1.10 in loans for $1 of deposits it had. That is not a recipe for success.
Since that time, however, we can see that the blue line (loans) has been very flat while the red line (deposits) continues to grow. BAC's focus in the past several years has been to make targeted, prudent lending decisions rather than lending to each homo sapien that walks in the door. That's a huge change in mentality and it has happened at other banks as well but we see the results of BAC's work in this chart.
BAC's LTD crested at 110% in 2008 and since that time, has been steadily making new lows. The number was 76% last year and is just 74% this year, low numbers by any standard for a big bank. I certainly don't want BAC going back to the days of 100%+ LTDs or even 90%+ but it has a lot of room to run from here. BAC is still at the point where it is taking a little risk off the table, allowing loan books to run off more quickly than it is adding new business and that is crimping its earnings potential. Where BAC will ultimately stop is anyone's guess but others like JPM have already begun to lend more freely. JPM has more work to do in this area so perhaps it is early on purpose but BAC can do something similar and goose earnings over time as well.
Looking forward, I'd really like to see BAC pick up lending in the back half of the year and in particular, if the Fed decides to raise rates. Nobody knows at this point if the Fed is going to raise and I'd extend that to the regulator itself; I truly believe the FOMC still doesn't know what to do. That isn't a knock on the FOMC - their job is incredibly difficult or impossible to get right - but it does lead to a lot of confusion among market participants. At any rate, if we get a bump in rates, BAC should feel more comfortable with the yields it can get and lend a little more freely. And if that happens, the stock will be a lot higher.
For this to play out, we need to see BAC at 75% or 76% LTD at the end of this year at a minimum. I'll be watching its progress on this in Q3 and Q4 very closely because this is the single biggest catalyst the company has to grow earnings. In the past few years, expense cuts have driven massive improvements in earnings but those have largely run their course; the low-hanging fruit has been picked. BAC is still certainly the least efficient big bank by an enormous margin but those gains are going to take time. And one way to improve efficiency ratio? Generate more revenue. Lending more freely would afford BAC that opportunity.
Over time, BAC could very easily add 10 points to its LTD without sniffing an area of undue risk and I think that's where we're headed. It will take time to be sure but we've known for a long time that BAC was holding back its firepower for higher rates and that is part of the reason why BAC's shares are more sensitive to rate-hiking chatter than the others. Rate hikes are central to the BAC bull thesis because it has billions upon billions of dollars to lend that it currently is letting sit idle, crimping NIM, fee generation and any other kind of revenue you can think of.
How big is the opportunity here? BAC's deposit base was $1.205 trillion during Q2 and at 85% LTD, that would imply just over a trillion dollars in loans. But BAC is at only $896B, meaning it could lend out another $129B and still be at just 85% LTD. It will take time to get there but that is the magnitude of the opportunity here; even 2.5% of NIM on half of that additional lending is $1.6B in additional NII without having to do anything else. That would equate to more than 10% of what BAC earned last year and while you can play with the variables in this scenario all day, we are talking about an enormous opportunity for BAC and that $1.6B is for a bump in the LTD ratio to just 79%. The amount of lending we've seen from BAC is not business as usual and at some point, when BAC turns the spigots on, we're going to see huge earnings growth. This is a long term story but it is powerful nonetheless and a big reason why I like BAC so much; don't be fooled by its recent reticence to lend its money because it won't last forever.
Disclosure: I am/we are 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.