Bank of America (NYSE:BAC) presented in Mid-June at the Morgan Stanley Financial Services Conference. The presentation, given by Chief Financial Officer Bruce Thompson, did an admirable job of answering some of the issues I have held about the nation's second largest bank by assets.
In recent quarters, Bank of America's quarterly earnings have been a string of onetime factors. To increase its capital ratios and avoid what would otherwise be awful earnings reports, Bank of America has reported, virtually every quarter, a series of onetime events, typically in the form of debit valuation restatements and asset sales, reaching into the billions of dollars at a time. Eventually, Bank of America is going to have to earn its money as a traditional, albeit very large bank. It is making some steps toward sustained profitability, though hardly enough.
At the conference, it was nothing but good news. Equity and liquidity levels are increasing dramatically. Cost savings projects are underway, some by luck such as lower credit costs, and some by design, such as the New BAC plan that was to have reduced annual expenses by $5 billion. Credit quality continues to improve, and the provision for loan losses in the first quarter of 2012 was the lowest by the bank in any quarter in five years. And finally, with a bullet point, Bank of America is "focused on core earnings."
Tier One common equity reached $132 billion as of March 31, 2012, growing from $124 billion a year earlier. Tier One common equity as a proportion of assets grew to 10.78%, up from 8.64% a year earlier. The percentage increase was not just a function of the equity total. Assets and especially risk weighted assets at the company have been falling for the last three years. Assets that at the end of 2009 were up over $2.5 trillion, and have since declined to less than $2.2 trillion at the close of the first quarter of 2012. In the process, Bank of America ceded its title as the nation's largest bank to JPMorgan Chase (NYSE:JPM).
Bank of America's liquidity at the close of the first quarter of 2012 was an impressive $406 billion. Yet the reason for that is less impressive. Bank of America will no longer accept third party mortgage loans. As loans are being paid off or refinanced, Bank of America is denying itself a major source of loans and its loan portfolio is shrinking steadily, from $950 billion in the first quarter of 2009, to $870 billion at the close of the first quarter. Where is the excess cash going? Well some it is going toward the increased liquidity. Some of that cash is also going toward long term debt extinguishment. Long term debt stood at about $450 billion in 2010, and at the end of the first quarter of this year, had fallen to $355 billion. The company plans to pay the debt level down by $40 billion over the course of this year.
Growing its deposits and reducing its long term debt are both measures toward reducing the funding costs. While overall deposits have actually fallen slightly the past two quarters, the amount of interest free deposits have been growing steadily, if modestly from quarter to quarter. Total interest expense in the first quarter fell to $4.61 billion, down from $5.74 billion in the first quarter of 2011, and $4.71 billion in the fourth quarter of 2011. But interest income, especially from loans and leases, is falling even faster than credit costs. The net interest margin fell to 2.51% in the first quarter, the lowest of any bank holding company I have covered. It stood at 2.67% a year earlier.
Under the Federal Reserve's extension of the Twist program, along with a sluggish domestic economy, long term interest rates are not going to go up any time soon. The only way for Bank of America to grow its interest income is to grow its loan portfolio, which it seems disinclined to do. Many banks, like Fifth Third (NASDAQ:FITB) and U.S. Bancorp (NYSE:USB) had spectacular quarters with plenty of revenue growth built on the backs of huge boosts in mortgage loans. Bank of America's notion to retreat from this market is not doing its income statement any favors.
Because Bank of America has been marginally profitable at best, its efficiency ratios, and returns on assets, have been dismal. The cost reduction program, highlighted by personal layoffs and branch closings, will help in that regard. But again, until the revenues are allowed to grow on the back of a larger balance sheet and loan portfolio, Bank of America will never be as consistently profitable as its predecessors, NCNB and NationsBank, both of which routinely posted earnings in the 1980's and 1990's of 1.5% and higher. Even Bank of America posted fine returns of 1.2% to 1.4% on assets annually prior to the bank led recession last decade.
Bank of America in its literature makes much of focusing on its core, presumably retail and commercial banking units. The Merrill Lynch purchase in 2008, while rocky at first, is returning profits of about $2 billion a year back to its parent. But the brokerage is also losing many of its star managers, and I view the long term viability of Merrill Lynch when under the Bank of America banner as questionable.
In addition to mortgage repurchase demands, the other downside (apart from lack of growth and profitability) I see is the enormous amount of goodwill Bank of America carries on its books. At the close of the first quarter of this year, it held $77 billion of goodwill and intangible assets. At some point, it is going to have to deal with those amounts.
Moody's (NYSE:MCO) recently lowered Bank of America's credit rating by one notch, to Baa2, and maintained the negative outlook. The rating is still several notches above "junk" status, but in lowering the rating Moody's mentioned Bank of America's questionable history, and the fact that the bank is undergoing a new direction, but the profitability of that direction is not yet known.
There are so many question marks, and I am sure there will be more one time valuation measurements when Bank of America reports its second quarter earnings. I will need to see some sort of commitment to something other than retrenchment before I can recommend this company for investors.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.