Update: Bank of America & Charles Schwab

April 17, 2024 | Premium Service | In this edition of The Institutional Risk Analyst, we review the results for Charles Schwab (SCHW) and Bank of America (BAC). We told our readers last year that SCHW would survive the liquidity storm and get smaller, and they did. We also told readers that BAC is in big trouble, not due to credit but because sub-par asset returns have left the bank underwater. Over the past year, BAC’s return on assets has fallen from 1.07% in Q1 2023 to 0.83% in Q1 2024. Hello. What happens in a rising rate scenario Brian? 

The Street fixated on the increase in credit provision expenses by BAC, but credit is really a blissful problem compared to the fact that the bank’s portfolio is two points under water and sinking. BAC’s net interest spread has dropped from 1.43% in Q1 2023 to 1.02% in Q1 2024.  Total interest bearing assets yielded just over 5% in Q1 2024 while interest bearing liabilities averaged 4.1%.

Source: FFIEC

The yield on BAC’s $840 billion securities portfolio is still below 3%. In a rising rate environment, BAC could get into serious problems because of the bank’s poor asset returns and related liquidity issues. The chart below shows the BAC securities portfolio from the bank's Q1 2024 earnings presentation.

Some analysts were impressed by the fact that BAC saw fee income rise in Q1 2024, yet it is important to note that the Q1 2024 number for non-interest income was down YOY vs Q1 2023. The fantasyland atmosphere on the BAC earnings call is illustrated by this statement from CEO Brian Moynihan:

“This balance sheet performance along with our continued pricing discipline allowed us to deliver better than expected NII performance. We told you last quarter that we expected NII to decline from the fourth quarter of 2023 to the first quarter of 2024, a decline of about $100 million to $200 million. We actually reported today NII of $14.2 billion - that was $100 million higher than quarter four, exceeding our guidance.”

None of the analysts on the call asked Moynihan any remotely tough questions. Mike Mayo of Wells Fargo did ask about operating leverage and the fact that BAC is 10 points higher than market leader JPMorgan (JPM) in terms of efficiency. Moynihan’s answer is more layoffs, but BAC already has the lowest compensation per head of the top five banks.  Moynihan is at his best when he is cutting headcount, but BAC cannot cut enough people to avoid liquidity issues due to poor asset returns.

Moynihan: “Our focus is really on deploying expenses in operating leverage, and as we get through the twist in NII, you should start to see us return to that again, and that would then obviously drive down the efficiency ratio.”

The “twist” in NII was in fact poor balance sheet management by the BAC team. The 2s and 3s that BAC originated in 2020-2022 should have been sold at a premium, but in fact were retained in portfolio. This was a monumental mistake. By choosing to retain production from the 2019-2022 period, BAC has essentially crippled its asset returns for years to come. The two and three percent MBS on BAC's balance sheet have projected average lives of more than 15 years.

“In Q2, we’ll have a little more of a challenge,” said Moynihan about NII next quarter. This is a considerable understatement.

Besides asset returns, the other big headline from BAC was rising credit expenses, an area we have highlighted in past comments.  If your asset returns are below peer and your credit losses are above peer, then where does that leave you? In a very bad place.  The chart below is from the Q1 2024 BAC earnings presentation.

“Net charge-offs of $1.5 billion increased $306 million from the fourth quarter, driven by continued credit card seasoning and commercial real estate office exposures as swift revaluations from current appraisals and resolutions drove higher charge-offs,” noted CFO Alastair Borthwick. “The net charge-off ratio was 58 basis points, a 13 basis point increase from the fourth quarter.”

BAC’s net loss was, in fact, the second highest among the top five banks after Citigroup (C).  Our concern continues to be that as credit loss rates grow in 2024, BAC will not have the income to deal with the cost of loss mitigation because of the interest rate mismatch. 

When Betsy Graseck of Morgan Stanley (MS) asked about NII over the year, Borthwick again said that results would deteriorate in Q2 2024. Note that on the $BAC call yesterday, nobody -- including Betsy Gracek or Mike Mayo -- asked about the $840 billion securities book yielding less than 3%.

If interest rates rise from here, how does BAC look in Q1 2025?  The table below comes from the BAC earnings release. The first column at left shows the amount of liability as of Q1 2024, the second shows the amount of the cost of the exposure in dollars and the third shows the cost in percent. Note that the average cost of BAC's LT debt is 6.35%. The cost of all liabilities was 4.1%.

Charles Schwab & Co

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