Update: Bank of America

November 8, 2023 | Premium Service | In this edition of the Institutional Risk Analyst, we return to Bank of America (BAC) and take a look at the bank’s Q3 2023 results. BAC has been trading near the bottom of the top-five US depositories, though thankfully above Citigroup (C) at 0.4x book value. BAC is trading at 0.8x book value, but is actually underperforming Citi in terms of total return for the past year. Our bank surveillance list is shown below.

Bank Equity

Source: Bloomberg (11/08/23)

The first thing to notice is that BAC has a very low net interest margin vs its large bank peers. The bank’s net spread was just 1.15% in Q3 and 1.7% for the first nine months. In other words, BAC's NIM has been shrinking as the year has progressed, in line with the rest of the industry. BAC was in the bottom decile of Peer Group 1 in Q2 2023 in terms of the yield on earning assets.

Source: FFIEC

The poor earnings performance of BAC is largely attributable to below-peer asset returns and also above peer funding costs. Given that the industry is currently experiencing a compression of net interest income due to the shape of the Treasury yield curve, BAC is in a particularly bad position vis-à-vis its large bank peers. Compare the treasury management of BAC with its large bank peers and it is difficult to avoid the conclusion that the bank's duration management is sorely lacking.

If you examine Table 6 in BAC's most recent Form 10-Q, what you see is that the bank's return on earning assets is just 4.9%. The $750 billion in debt securities (down from $901 billion a year before) yielded just 2.47% at the end of Q3 2023. The bank's $300 billion in 1-4 family mortgages yielded just over 3%. At the same time, BAC’s cost of funds has risen 5x over the past year, while interest earnings have merely doubled. The chart below shows BAC’s funding costs vs total average assets through Q3 2023.

Source: FFIEC, EDGAR

Notice that Wells Fargo (WFC) has the lowest cost of funds among the top five depositories, one reason why we are relatively positive about that name compared with the rest of the group. That said, all of the top banks do their best not to show or discuss total interest expense in their financial presentations. Many of the large banks don’t show the components of net interest income in their press releases and investor presentations, yet the rate of change in this key operating metric is higher than the others. Does that make it material to investors?

BAC was one of the few large banks that reported higher credit loss provisions in Q3 2023. Provision for credit losses of $1.4 billion increased $659 million. The bank’s net reserve build of $486 million in Q3 2023 was driven primarily by the credit card portfolio. Net charge-offs of $911 million increased $399 million driven by credit card, but thankfully remained below Q4-19 pre-pandemic level, a shown in the table below.

With net interest revenue flat and operating expenses essentially unchanged, BAC reported an efficiency ratio of 62 for Q3 2023. Note that JPMorgan (JPM) is seeing its efficiency ratio slowly rise to the high 50s as the positive impact of the acquisition of First Republic Bank dissipates. Notice also that Citi's operating efficiency is deteriorating as the bank continues to restructure its business. Meanwhile, WFC steadily improves its operating leverage and profitability and we expect this trend to continue.

Source: FFIEC, EDGAR

At the end of Q3 2023, BAC's accumulated other comprehensive income (AOCI) was -$21.8 billion, up slightly from the year before. If you conduct a fire sale analysis of BAC's balance sheet as of Q3 2023, the result more than wipes out the bank's tangible equity and leaves a negative balance of over $100 billion, as shown below.

Source: EDGAR, WGA LLC

The 20% mark-to-market adjustment factor is relatively conservative and reflects the current market pricing for legacy securities and loans at September 30, 2023. With the rally in the 10-year Treasury since the end of the quarter, these numbers will improve to roughly 12/31/2022 levels, but that does not fix the solvency problem for BAC and other large banks.

In November the Federal Reserve Bank of New York published a commentary on the degree to which US banks remain vulnerable to failure in the wake of the collapse of three banks in Q1 2023. Strangley, the economists at the FRBNY do not seem able to conduct a basic fire sale analysis of a bank-- even though they refer to precisely this type of assessment in the Liberty Street blog. The Fed seems incapable of publishing a truly forthright analysis of the solvency of major US banks.

Source: FRBNY

One of the obvious flaws in the FRBNY analysis is that they are looking at risk weighted assets instead of the current market value of nominal bank assets, which is all that really matters in a fire sale analysis of a depository. Those low-coupon Treasury, agency and mortgage-backed securities on the books of BAC may have zero risk weights for Basel capital purposes, but they are also incrediby dangerous assets for banks and other buy-and-hold investors.

The solvency problems affecting US banks illustrate the shortcomings of US rwgulatory policy. If federal bank regulators truly understood real world bank risk, the capital weights for Ginnie Mae MBS would be 100% instead of zero and the risk weights for mortgage servicing assets would be say 100% instead of 250% as is the case under current regulation. With interest rates at a two-decade high, MBS are profoundly volatile and risky assets for banks, but MSRs trading at 4x cap rates are perhaps the most stable assets in the markets today.

In any credible analysis of a bank's net assets, the only thing that matters is the current market price. So with the 10-year Treasury yielding 4.5% and Ginnie Mae 3s bid at 81, the only conclusion possible is that BAC and other large banks are profoundly insolvent. Interest rates need to fall 200-300bp in yield to fix the problem created by the FOMC.

Bottom line on BAC is that the bank's asset mix and funding costs represent a substantial risk to the bank. If the credit side of the ledger begins to show signs of deterioration, then asset and equity returns will come under further pressure. The low yields on many of the bank's assets suggest that BAC is illiquid and that management does not have a great deal of lattitude in managing the bank's duration profile, especially compared with JPM.

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