Shares in Bank of America (NYSE:BAC) have risen sharply over the last week as it passed the Federal Reserve's stress test. Investors are cheering as Bank of America seems to be in a stronger position than its main competitor, Citigroup (NYSE:C), which came as a surprise to many investors and analysts.
Shareholders in Bank of America have enjoyed a good ride so far this year. Shares are up 76% since the beginning of January, and briefly breached the $10 barrier in Monday's trading session. A rumor about a possible secondary equity offering pushed shares below that mark. In a time frame of merely a week, shares rose 25% after Bank of America was the "biggest winner" of the stress tests, which fueled the global stock market rally.
Stress tests results
Bank of America reported a 8.7% common capital ratio in the third quarter of 2011 which could fall to 5.7% in the Federal Reserve's stress test scenario. As such it would remain comfortably above the 5% minimum that the Federal Board requires for the thirtieth largest US bank holding companies. Assumptions of the test include a severe recession in the US, unemployment peaking at 12%, a continuing decline in home prices and increased equity and credit market volatility.
Such an environment would trigger massive losses across Bank of America's portfolio. The Federal Reserve assumes loan losses for the entire year of 2012 and 2013 at $70 billion for Bank of America (in the stress test scenario), equivalent to 8.3% of Bank of America's portfolio assets. Average losses across the portfolio would come in above average as it would incur high losses on its credit card and first lien mortgages.
Bank of America has continued to de-lever its balance sheet. For the full year of 2011 the balance sheet shrank 6% to $2.13 trillion. Bank of America also reduced the "riskiness" of its assets as risk-weighted assets fell 12.3% to $1.28 trillion. In the meantime, the bank increased its tangible shareholder equity from $131 billion to $136 billion after issuing new shares. The reduction in liabilities and increase in capital increased the tangible common equity ratio from 6.0% to 6.6%, the common equity ratio rose from 9.3% to 10.0%.
Will remain under pressure as divestures lead to a continuing smaller asset base which continues to put pressure on revenues which came in at $94 billion in 2011, down 17% on the year. Furthermore, net interest margins are declining as longer term higher yielding products are maturing and have to be reinvested at lower yields. Profitability has remained stable as charges on credit cards, mortgages and commercial real estate have more than halved compared to 2010 and came in at $13 billion for the full year, preventing the bank from reporting a loss. Revenue pressure will remain in the foreseeable future, explaining the relentless focus on reduction of the operational costs of the bank.
With a substantial increase in the capital ratios over the last year and the surprising strength in the Federal Reserve's Board stress-test, rumors about a possible secondary equity offering seem unjustified. There is little need for an urgent capital increase at the moment, instead the bank is focusing on the operational performance of the bank which could increase operational profitability and thereby steadily increase the capital base over time. The bank has increased its focus on cutting costs by replacing tellers with ATMs but moreover by focusing on mobile banking according to CEO Moynihan.
Despite the 74% increase in its share price, shares still trade 23% below its tangible book value of around $12.70. The contraction of the discount to the book value is a sign that investors are more confident about the valuation of the bank's assets and possibilities for operational profit improvements. It will be hard to see Bank of America trading around its book value any time soon given the generous optimism in equity and credit markets at the moment. Furthermore operational profitability will continue to remain under pressure as costs of new regulation will depress the bottom line. Shareholders have seen some wonderful returns in a short period of time, but upside remains limited from this point.