Bank Of America Rallying On Strong Balance Sheet: The Road Ahead From Here

| About: Bank of (BAC)

Bank of America Corporation (NYSE:BAC) reported net income of $2.5 billion, or $0.19 per diluted share, for the second quarter of 2012, compared to a net loss of $8.8 billion, or $0.90 per diluted share in the second quarter of 2011. The company had solid contributions from the wealth management and corporate and commercial banking businesses, and improved credit quality across most major portfolios. Despite this solid financial performance we believe there are some hidden risks in the visibly strong balance sheet of the company.

Lending to commercial businesses increased for the sixth straight quarter -- with small business lending and commitments up 23% in a year -- and consumer credit is in the best shape in years. In the second quarter the bank surpassed 10 million mobile banking customers, up 34 percent in a year. With about 45,000 new mobile customers a week, the bank is adapting to meet customer needs and to do more with them.

Bank of America's strong capital generation through a combination of earnings growth and a reduction in risk-weighted assets helped to maintain a strong liquidity level even as they reduced their long-term debt by $125 billion. In one year, the bank's Tier 1 common capital ratios have gone from being the lowest of the major U.S. banks to among the highest.

Analyzing The Balance Sheet: What Are The Strengths

  • Regulatory capital ratios increased significantly, with the Tier 1 common capital ratio under Basel 1 increasing to 11.24 percent in the second quarter of 2012, up 46 bps from the first quarter of 2012 and 301 bps higher than the second quarter of 2011.
  • The Tier 1 common capital ratio under Basel 3 on a fully phased-in basis was estimated at 8.10 percent as of June 30, 2012. This compares with the company's previous guidance of achieving a Basel 3 Tier 1 common capital ratio of more than 7.50 percent on a fully phased-in basis at year-end 2012.
  • The company continued to maintain strong liquidity in the second quarter of 2012 while significantly reducing long-term debt. Global Excess Liquidity Sources totaled $378 billion at June 30, 2012, compared to $406 billion at March 31, 2012 and $402 billion at June 30, 2011. Long-term debt declined to $302 billion at June 30, 2012 from $355 billion at March 31, 2012 and $427 billion at June 30, 2011.
  • Time-to-required funding increased to a record 37 months at June 30, 2012, from 31 months at March 31, 2012 and 22 months at June 30, 2011.
  • Tangible book value per share increased to $13.22 at June 30, 2012, compared to $12.87 at March 31, 2012 and $12.65 at June 30, 2011. Book value per share was $20.16 at June 30, 2012, compared to $19.83 at March 31, 2012 and $20.29 at June 30, 2011.

Signs Of Weakness In The Financial Performance

Consumer and Business Banking: Consumer and Business Banking reported net income of $1.2 billion, down $1.3 billion from the year-ago quarter, due to lower revenue and higher credit costs. Revenue of $7.3 billion decreased $1.4 billion from the year-ago quarter. Net interest income of $4.7 billion decreased $845 million primarily from lower average loans and the continued low rate environment.

Global Banking: Global Markets revenue declined $1.0 billion from the year-ago quarter to $3.4 billion due to lower trading volumes, new issuance activity and client flows. Fixed Income, Currency and Commodities sales and trading revenue, excluding DVA, was $2.6 billion in the second quarter of 2012, flat from the year-ago quarter and $1.6 billion lower than the first quarter of 2012. Market uncertainty stemming from the eurozone crisis and slower economic growth contributed to a decline in trading volumes and a lower appetite for risk among investors. Equities sales and trading revenue was $759 million, a decline of $318 million from the year-ago quarter. Volumes remained at low levels impacting trading and commission revenues.

Hidden Risks In The Balance Sheet

Relative to the same quarter a year ago, the results for the second quarter of 2012 reflect higher mortgage banking income, driven by lower provisions for representations and warranties and the absence of the goodwill impairment charge, which are largely balance sheet adjustments based on improved macroeconomic outlook. This type of short-term adjustments could actually be very risky for the shareholders of the company.

Basel 3 Could Adversely Affect Capital Adequacy Ratio

Capital Adequacy Ratio or CAR = (Tier One Capital + Tier Two Capital) / Risk-Weighted Assets

This ratio is used to protect depositors and promote the stability and efficiency of financial systems around the world. Two types of capital are measured: tier one capital, which can absorb losses without a bank being required to cease trading, and tier two capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.

In late 2010, the Basel Committee on Banking Supervision proposed Basel 3 rules with an implementation date of January 2013. U.S. regulators issued proposed rules for Basel 3 and final market risk rules in June 2012. Among other things, Basel 3 would substantially raise minimum capital requirements, change the definition of regulatory capital, introduce new liquidity and coverage ratios and propose a phased implementation of these changes over several years, with full implementation targeted for 2019.

The final U.S. market risk rules and BIS Basel 3 guidelines require approval by banking regulators of certain models used as part of risk-weighted asset calculations. If these models are not approved, the company's Capital Adequacy Ratio would likely be adversely impacted, which could be significant.

The Road Ahead From Here

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The shares of Bank of America rallied this month and created a high of $9.79. The stock created a high of $10.10 earlier this year. From the one-year low of $4.92 the stock surged more than 100% in one year. Technically the stock is overbought as indicated by MACD and RSI. There is a strong possibility of a double-top formation this month.

We believe the strengths of the balance sheet of the company are priced in at $10 per share. The share price is expected to move in the range of $8 to $10 in the medium term. Long-term investors should accumulate the shares in every dip near $8.

Disclosure: I 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.