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Bank of America just ended a weak quarter—but there were 3 little-noticed bright spots

October 18, 2020, 11:30 AM UTC

Around Christmas of last year, Bank of America looked as though it had clinched one of the biggest comebacks in banking history. After flirting with bankruptcy in the great financial crisis, BofA went on a half-decade tear to post $29 billion in net income for 2019, a 75% jump in just two years. CEO Brian Moynihan was doing what had seemed impossible: closing the profits gap with longtime universal banking champ, Jamie Dimon’s JPMorgan Chase, and BofA easily outracing another rival it has long lagged, Wells Fargo. In late 2016, Wells Fargo’s market cap was 40% bigger than BofA’s. Then BofA took off, and scandal-scarred Wells stalled. By the close of 2019, BofA’s share price had doubled to $35, and its $300-billion-plus valuation dwarfed Wells’ by the same 40%.

Then the COVID-19 crisis pummeled BofA’s profits and stock price. By deeply discounting what was, even before, a modest valuation, Wall Street is signaling that the bank will earn a lot less in the future than it made last year.

Its new earnings report is turning investors even more negative. On Oct. 14, BofA announced a steep drop in profits to levels far short of the numbers JPMorgan unveiled the day before. Net earnings for the third quarter fell to $4.9 billion, down from $5.8 billion in Q2 and $7.0 billion in Q4 of 2019. By contrast, JPMorgan earned $9.4 billion in Q3, notching the second-best quarterly number in its history. BofA’s results sorely disappointed Wall Street, sinking its shares by 5.33% to $23.62 at the close. That selloff was something of a surprise, since the numbers were more or less in line with analysts’ expectations. BofA narrowly beat the FactSet consensus for earnings. Revenues fell short by just 2%, and it way outperformed on credit costs, taking a hit of almost half-a-billion dollars or one-third below what Wall Street expected.

As he made clear on the call, Moynihan is doing nothing to change the steady course that looked like such a winner a few months ago. He’s deploying a compelling consumer strategy: Instead of aggressively pushing banking products, or even wooing new clients, he focuses on growing along with his existing customers by gaining a bigger “share of wallet” as their incomes and needs increase. The idea is that folks with checking accounts at BofA’s 4,300 branches will stick with the bank for credit cards, car loans, and mortgages, and managing their nest eggs via a private banker or Merrill Lynch financial adviser. That’s business that Moynihan says “sticks to your ribs.”

Because BofA funds its gigantic, nearly $1 trillion in loans almost entirely with ultra-low-cost deposits, it’s bound to generate big and growing profits, as long as it holds overhead and credit costs in check. So far, Moynihan has aced both goals, keeping overall expenses virtually flat. He’s holding defaults at among the lowest for any bank via his policy of granting credit card loans to people who are already solid customers, and avoiding high exposure to risky sectors such as commercial real estate.

What’s potentially troublesome is that profits didn’t fall because the COVID-19 crisis unleashed another wave of credit losses. Instead, BofA’s bedrock businesses throttled back. So the question arises: Will BofA quickly get back on track to earn around $30 billion a year, or will a low-rate, post-pandemic economy cause BofA to become durably less profitable than over the past few golden years?

One thing’s for sure: Wall Street’s now expecting BofA to earn even less in future quarters than the $4.9 billion posted in Q3. BofA’s current market cap is $205 billion, down from $305 billion at the end of 2019. Let’s say investors give its shares a price/earnings multiple of 15, well below the S&P 500 average of 21 over the past three decades. In that case, they’d be expecting BofA to be generating just $14 billion a year in earnings, or $3.5 billion a quarter, 29% below what it made in Q3. Talk about how-low-can-you-go expectations.

This writer—who praised Moynihan’s grow-with-your customers approach when he introduced it in 2011—is betting that BofA rebounds strongly.

Here are takeaways pointing to a resurgence in future quarters.

Credit costs dropped from huge back to normal, and Moynihan believes he’s booked all the damage upfront

As I described in my story on JPMorgan Chase’s report, a new accounting regime, in place since the start of 2020, requires that banks book all of their projected losses, over the entire life of all of their loans, in the current quarter. That applies even if the borrowers are still paying on time. So instead of taking those expenses gradually as credits actually go delinquent, banks now must take the entire wallop upfront.

As a result of the new rules, BofA shouldered $9.9 billion in provisions—a direct blow to earnings—in Q1 and Q2 of 2020. That’s almost triple the total for all of 2019. But in Q3, credit costs dropped to $1.4 billion. In the consumer bank that also makes small-business loans, the progress was particularly impressive, with provisions cratering from $2.55 billion in Q2 to just $479 million.

Of course, BofA took those big provisions in Q1 and Q2 because its models, based on extremely conservative assumptions on future GDP growth and unemployment, are forecasting that it will eventually need to charge off $9.9 billion in loans to businesses and people pounded by the pandemic. But as Moynihan noted on the conference call, we’re seeing little sign of damage so far. Only 0.54% of BofA’s over half-a-trillion dollars in consumer loans are more than 30 days past due. The mortgages, car loans, and the like no longer covered by forbearance are showing few defaults. As Moynihan put it, the charge-offs anticipated by the big provisions in the first half “have yet to materialize.”

Moynihan stated that he doesn’t expect to see a surge in charge-offs until mid-2021. “What we thought would happen in Q3 got pushed out, and keeps getting pushed out,” he said, attributing the delay in part to government assistance to families and small business, but also noting that consumers’ excellent payment record so far appears to signal that losses may not be as high as BofA anticipated.

Still, he says that there is “too much uncertainty” to begin lowering reserves, a move that would prove a windfall for profits, and could happen. In a statement that marks good news for future profits, Moynihan predicted that BofA now has all the reserves it needs to weather the crisis. If that’s the case, provisions in the next few quarters should be minimal.

But here’s the problem: Provisions were already low in Q3, yet BofA earned 16% less than in last year’s Q3, not to mention 30% less than in Q4. So what’s holding BofA back, and will the slowdown persist?

BofA is taking a one-two punch from low rates and a flatlining loan portfolio

A crucial source of growth is NII, or net interest income. Last year, BofA’s NII expanded by over $700 million to 1.5%. Although that’s a small increase, it enabled BofA to sustain its already high profitability, aided by Moynihan’s signature tight grip on expenses. But in Q2, NII dropped from $12.34 billion to $10.24 billion, or 17%. The decline has two sources. The first was a decline in interest rates that shrank the margin between what BofA collects on its loans and what it pays to depositors and savers. Second, BofA’s loan book not only stopped growing, but shrank a bit. Its total portfolio declined $18 billion or 1.85% over the past year.

In addition, total expenses at $14.4 billion were running almost 5% above the annualized rate in 2019. Moynihan and CFO Paul Donofrio ascribed the increase to a jump in one-time litigation costs, and $300 million to $400 million in extra expenses caused by the crisis, including the spending to process millions of PPP loans to small businesses, a burden just partially offset by fees.

To regain its pre-COVID pace, BofA needs to get NII growing again and wrestle down costs

As Moynihan acknowledged on the call, rates on his loan portfolio should remain extremely low going forward. As he also pointed out, BofA can offset that drag by growing the loan book that’s now treading water. In other words, attracting more borrowers will more than make up for the lower monthly payments it receives on its credit card loans and mortgages.

That’s just what BofA has been doing, and doing safely, for the past several years. Its total lending portfolio has waxed from by over $40 billion or 4.4% from 2017 to 2019, pretty much in line with the economy, including a $4 billion increase in credit card loans carrying average rates of 10.8%.

But can BofA get its loan book growing again? A bellwether is what’s happening with deposits. Gathering millions more checking account customers means that those extra households will add to revenues by taking out more credit card, car, and home loans over time. In the past year, BofA’s consumer deposits have surged by one-fifth, from $709 billion to $861 billion. By the way, the fall in rates is far from a total negative; the average BofA pays on those deposits has fallen from 0.11% to 0.05%. (The additional expense per dollar of deposits in manpower, real estate, and the like is an additional 0.8%, bringing the total to well under 1%. See why banking can be a great business?)

Hence, BofA appears to be fast gaining customers and expanding market share. That means its loan portfolio should wax a perhaps a point faster than the real growth in the economy. It’s also likely that Moynihan will put expenses back on the previous track of around $55 billion a year, and as in the past, hold the increases below the rate of inflation. The extra litigation expenses will phase out, and so will the extra spending on COVID.

Of course, BofA is essentially a machine designed to expand with the incomes of Americans and magnify profits by holding expenses constant, dollar for dollar. So if family incomes and GDP go flat for an extended period, BofA’s earnings will suffer. But a bet that the U.S. economy will come back is also a bet that BofA’s earnings will rebound, only faster.