Bank of America: Strong Position, Similar Industry Challenges

Summary:

• The turmoil in the financial industry has surprised smaller and specialized players recently.
• Big banks might benefit from deposit inflows from smaller banks, as they have sufficient earnings power to raise deposit rates.
• All this make me cautious on the entire sector, as all banks have large unrealized losses, making liquidity key and a stable deposit base key.
• A small silver lining: lower interest rates narrow the gap with the deposit base being paid, although the gap is still huge.

Shares of Bank of America (NYSE:BAC) have seen quite a pullback over the past week as many banks took a beating during the week in the aftermath of the SVB Financial Group (SIVB) drama unfolding.

Let me be very clear, many banks have seen declines over the week including the big banks like Bank of America, but shares recovered towards the end of the week (certainly on a relative basis) as concerns on depositors fleeing might even make that the big banks might even be beneficiaries of this trend.

My last take on the business was April 2020, far from a pretty time either. First quarter earnings fell amidst ballooning credit losses, following the outbreak of the pandemic, causing shares to fall from $35 to $22 at the time of writing. The company incurred credit loss provisions at a rate of nearly $20 billion, raising some question marks given a $2.6 trillion balance sheet, on which it has $1.5 trillion which carries credit risk.

Given the rate at which the company provided for credit losses, I feared the bank might be too conservative with these provisions, as I feared that the pandemic took longer than expected, as the recovery was very strong of course with credit loss provisions turning out to be more than sufficient.

And Now?

Since my initial take in spring of 2020, shares have traded around the $25 mark for most of the remainder of that year, as a relentless rally followed with shares peaking at $50 early in 2022. Shares fell to the $30 mark last year as investors feared the impact of higher interest rates, inflation and perhaps some credit losses given the fast moving development in the economy. Shares fell from $34 to $30 over the last couple of days on the back of the SVB developments.

Early this year, the company posted its 2022 results as these are very interesting to look at. The company grew 2022 sales in a modest fashion to $95 billion with net interest income up nearly ten billion to $52 billion while non-interest income fell roughly 10% to $42 billion and change. Income before taxes actually fell by about three billion to $31 billion, as the company took $2.5 billion in provision for credit losses, with 2021 results being aided by $4.6 billion on the back of a reversal of these provisions.

Of interest are the fourth quarter results in which the trends of higher net interest income and lower non-interest income were seen more pronounced, with credit loss provisions for the quarter accelerating to $1.1 billion, increasing rapidly as Bank of America feared a slower economy in 2023.

Let me be clear, this is not a bad loan situation as the situation boils down to two items. For starters is that banks typically pay depositors low interest rates, trailing treasury rates by a huge margin. This could be tackled by forfeiting earnings by raising deposit rates, as deposit outflows are crucial to avoid. After all, higher interest rates made loans and investments less valuable, as deposit outflows might actually trigger banks to lock in these losses. Hence, a stable deposit base is key to hold the securities which the company intends to hold until maturity, avoiding a situation in which the bank has to sell these at losses.

Bank of America has a $3.1 trillion balance sheet which is largely financed by $1.9 trillion in deposits. The company has seen a modest decline in its deposit base throughout 2022, which I would not read in too much, although that the composition into interest-bearing deposits was increasing during the year. The company actually paid these depositors $3.0 billion in the final quarter of 2022 alone (and a mere $4.7 billion for all of 2022).

The $3 billion number annualised works down to $12 billion, or about 60 basis points, a very modest rate of course with T-bills trading at 4% and change. Fortunately, net interest income trends at $60 billion a year, as the company has quite some margin to raise deposit rates, if necessary, albeit at a huge expense to earnings power.

The company has much liquidity to offset some deposit requests, if they were even to happen currently, as the latest news seems that big banks see an influx of depositors. The bank ended the year with over $230 billion in cash and equivalents. There are two major asset categories which face some risks including $862 billion in debt securities, of which $633 billion held-to-maturity, at cost. There is furthermore a $1.03 trillion in loans apparent on the asset side of the balance sheet.

Zooming further into the fourth quarter earnings report, we see that the company has realized a $113 billion gross unrealized loss on these debt maturities held to maturity, a huge number of course, as this actually came down a bit from the third quarter, all while equity was reported at $273 billion.

What Now?

The truth is that this is an earnings issue in all reality, with many big banks having sufficient earnings power to raise deposit rates, as the best case is that bank profitability will only be impacted by narrowing interest rate spreads. Keeping deposit bases flat is key, as quite frankly banks sit on a lot of losses on many assets if they mark to market them, certainly in case of fixed rate products, especially if they have long durations attached to them.

While Bank of America has a stable deposit base and substantial liquidity position, the issue is that even banks like Bank of America do not like to arrive at a position in which they are forced to sell some of the held-to-maturity securities, as the company has incurred losses in excess of $100 billion on these.

Quite ironic, interest rates have fallen quite a bit over the last week on the back of the situation as this has narrowed the gap with deposit rates, without having to raise deposit rates being paid, creating less pressure for asset outflows. On the other hand, awareness with customers has risen, so perhaps the industry as a whole might see deposit outflows.

I have traditionally shied away from investing a lot in the financial sector, but quality and size clearly matter if we look at the lessons of the past. Let me be very clear, the big names including Bank of America are likely to manage this situation well, or could be a beneficiary from deposit inflows, although the overall impact on the sector is largely negative, likely driving another round of consolidation (if not by M&A, than through deposit base migration).

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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

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