Bank Of America: Huge Gains From Rising Rates Likely

| About: Bank of (BAC)
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Ever since the financial crisis when rates fell to historic lows, banks have been suffering at the hands of low net interest margins. Bank of America (NYSE:BAC) is no exception as NIM has fallen substantially since the crisis, as evidenced below.

In this piece, we'll take a quick look at how much BAC stands to gain when interest rates begin to rise and what it means for the valuation of the stock.

With rates at historic lows BAC, like any other bank, must take what it can get in terms of interest rates on loans it makes in order to keep the lights on while things improve. However, since the rates it pays depositors cannot go below zero when rates get as low as they are now, margin compression ensues. If we take a look at the chart above we can see that even as recently as 2008, the year the crisis really took hold, BAC was earning nearly 3% of NIM. However, as rates have plummeted that ratio has fallen precipitously in recent years to about 2.4% this year.

The implication of this is that BAC is likely at a trough in its NIM. In fact, if we look at 2012's number I believe that will prove to be the bottom of NIM for BAC as rates and returns have already begun to move back up. Once the Fed begins its tapering of QE and eventual end of QE, rates will normalize and banks, including BAC, stand to benefit a great deal from higher rates.

So what does this mean for BAC's share price in the future? In short, it means there is significant potential upside to BAC's earnings based upon a rising interest rate environment. With rates still near historic lows it is a safe bet that rates will rise at some point and materially at that. With BAC's average earning assets pretty stable around $1.7 trillion over the past few quarters, we can calculate any potential impact of increases in interest rates and NIM.

If we see rates begin to move up BAC would see margin expansion with its current funding sources and asset base. In addition to rates rising the fact that BAC is working diligently to improve its capital structure which will serve to increase NIM as funding becomes cheaper in addition to rising rates. This is a terrific combination for shareholders as interest expense is coming down each quarter and interest income rises. This results in outsized NIM expansion which will greatly improve profitability. I'm confident that the improvements in BAC's interest expense and rising rates will eventually push NIM past 3% over the medium term. In fact, BAC's interest expense profile is much stronger than it was when BAC was producing 3.2% NIM in the mid-2000's because the bank had levered up in order to keep pace with loan demand. With interest expense coming down from those levels, a long term goal of 3.5% NIM isn't unreasonable.

Below, I've outlined what would happen to BAC's net interest income under several scenarios regarding its current average earning assets base and NIM assumptions.


NII ($B)













As you can see, even if BAC manages not to expand its earning asset base at all over the next few years it can still see an enormous increase in NII. The beautiful thing about increases in interest rates is that banks need not hire new staff, build new facilities, etc. in order to take advantage in terms of earnings leverage. Most of this benefit will accrue to net income as there is little in the way of incremental expenditures in order to reap the benefit. Whether a loan is made at a NIM of 2% or 3%, the process and commensurate costs are the same; employees don't get paid based on margins and this offers tremendous operating leverage for BAC.

With noninterest expense coming down even as revenues increase (10-Q) BAC stands to reap enormous earnings leverage from a rising interest rate environment. If NIM increases by 20 basis points per year, a very reasonable goal given the facts we've seen here, even a stagnant earning asset base would produce an additional $3.4 billion in NII each year. As virtually all of this would be captured without incremental expenditures it is safe to assume that BAC would reap close to the entirety of the benefit after taxes in the form of net income. This would amount to an additional ~$2.2 billion in net income for each 20 basis point rise in NIM, assuming BAC's 2013E tax rate of 35%. This amounts to roughly 21 cents per share of earnings that will accrue to BAC shareholders, or 15% EPS growth based on 2014 consensus numbers.

The bottom line is that it is relatively easy to find scenarios where BAC is accruing enormous gains to profitability through NIM expansion and even simply expanding its earning asset base. With profitability strongly out of the crisis-induced trough and continued NIM expansion virtually assured, BAC stands to reap enormous EPS gains for the foreseeable future.

Disclosure: I am 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.