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The banking industry, over the last decade has undergone significant change. Industry regulation such as Dodd-Frank, Basel 3, and international capital requirements have now made the industry safer and more transparent. However, due primarily to the crisis of 2008, some banks are more stable than others. In many instance, due to unethical practices of the past, many banks are now suffering as they struggle to attract market share and consumer acceptance.
To begin, let's start by dispelling many myths associated with Bank of America. First, the bank did not single-handedly start the financial crisis as many pundits believe. They much like many of the other large banks did have a part in the crisis. However, they were not the sole owners of the problems that resulted from it. This is an important distinction as Bank of America's market valuation and profitability have been significantly effected by perception rather than reality. The perception that the bank will become insolvent has led to many of the low financial metrics used throughout this document. In addition, due to negative consumer sentiment, the bank's overall evaluation is significantly lower than those of its peers in the industry (Unknown, 2008).Second; Bank of America did not partake in many of the subprime lending behaviors that many of the banks peers did. However, it acquired a firm that did indeed participate, in a substantial manner, in subprime mortgage lending. Countrywide, was a large player in the subprime market and as a result of the BAC acquisition, the overall company was pierced to have single-handedly cause the crisis (Hector, 1988). These two myths will provide the foundation by which a large portion of this document is based on. Perception vs. reality will be a common theme in this document as I juxtapose the actual financial results of those of many of the banks peers in the industry.
To begin, BAC's performance in regards to profitability directly corresponds to that of the overall economy. This is particularly true, as the mortgage market has declined so substantially from its 2008 peak. In many markets around the world, home prices have yet to catch up to their 2006 peaks. This bodes well for the overall economy as there is substantial demand for housing related products. As such BAC stands to profit substantially from this trend. First, the company has 10.3 billion shares outstanding. Recently, the Fed approved a $5 billion dollar buy back for the company's shares. At an approximate market price of $14 (The stock today is at roughly $12), the company could purchase approximately 356 million shares or 3.6% of the company. Historically, the company has been able to earn $20 billion annually. This equates to roughly $2 a share in earnings power for a company that is trading in the market for $12. This seems almost too good to be true, and it is. Investors and the community at large believe that BAC will be unprofitable for years to come as indicated by the lower market price relative to the company's earnings power. However, the company is poised to deliver strong profitability numbers for years to come.
Bank profitability is determined in large part by interest rates. Currently interest rates are at historic lows. To aid the economy, the Fed has been keeping its target rate for overnight loans between banks near zero. The effects of the accommodative policy can be seen in the latest quarterly reports. Net interest margins -- the difference between what it costs banks to raise money and what they get for lending and investing it -- fell by 26 basis points, to 3.06%, at JPMorgan from the first to second quarter; 17 basis points, to 3.15%, at Citigroup; and 16 basis points, to 2.77%, at Bank of America, according to company reports. These declines in a margin are directly correlated to profitability. The reduced margins contributed to a drop in net interest income of $1.02 billion at JPMorgan, the second-largest U.S. bank by assets. It fell $849 million at Bank of America, the biggest lender, and $522 million at Citigroup, which is third. Wells Fargo, the fourth-largest bank, reported that net interest margin actually increased by 11 basis points, to 4.38%. This could be attributed to the large volume of mortgages at WFC.
Bank of America Chief Executive Officer Brian T. Moynihan told analysts on a July 16 call that the sustained low-rate environment was hitting revenue and earnings and will continue to affect margins. JPMorgan CEO Jamie Dimon told analysts the day before that the bank's net interest margin will continue "coming down a bit as we reposition the portfolio." Furthermore, the Federal Reserve has pledged to keep interest rates down near zero until 2015. The banks may be coping with the low-rate problem for some time. The Fed has signaled that slowing inflation and a sluggish economy will push any interest rate increase into 2011.
After the Fed brought down short-term interest rates in 2008, banks slashed the rates they offered depositors. The average rate paid on checking accounts was 0.53% on July 27, the lowest since February 2005, according to Bankrate.com. Overall, the industry's average cost of funds fell to 1.03% in the first quarter of 2010, the lowest on record, according to the Federal Deposit Insurance Corp., down from 3.58% in late 2007.
The relatively wide spread between what banks were paying to raise money and what they earned on it helped boost bank profits even as the economy remained weak. JPMorgan's profit on loans and other interest-bearing investments increased to a record $51.2 billion last year after the Fed dropped its target rate to current levels, up 32% from 2008 and nearly double the bank's net interest income in 2007, when the Fed's target rate was 5.25%. That lucrative spread narrowed as the Fed kept rates low. The average yield banks earn on their investments and loans has dropped to 4.86% from 6.93% in late 2007. Depicted below is the bench market federal funds rate. Immediately following the graph is BAC's profitability over the last 5 years. Notice that although the interest rate is relatively constant, BAC's earnings have been sporadic on a quarterly basis. This is due primarily to the bank shifting its focus to a more consumer centric approach. In addition, costs associated with the countrywide acquisition and divestitures also contribute to the sporadic movements (Johnston, 1990).
Another concern for bank profits is a drop in the volume of lending. Banks have tightened their standards and demand has dropped, according to the Fed's senior lender survey. This has been due primarily to regulation such as Dodd-Frank and Basel requirements. In many instances, the rules for the regulation have yet to be written. This uncertainly has caused pause among institutions in regards to lending activity.
Now in regards to the overall future of Bank of America in the context of this low interest rate environment, the bank seems poised to return to profitability. According to the company's annual reports, the mission is very clear. First, the company wants to return to a more customer centric culture. It has done this through a series of divestitures that will ultimately streamline the company. Under Moynihan, the company has eliminated holdings in China Construction Co., private equity businesses, subprime lending, and other non-core functions. The company has used technology such as online banking, mobile banking, and ATM's to boost its overall ROI (Eads, 2011).In addition, the company has settled claims for mortgage put backs, reps and warranties associated with the subprime lending crisis. The company has also made the overall business more cohesive as it attempts to leverage its market leading franchise. The company now relies on cross-sell and is committed to three core customers: companies, institutions, and clients. Through a reliance of core customers, the bank has returned to profitability over the last few quarters. The macro environment is well poised for an economic recovery in regards to housing. Particularly for the middle class, housing is very important as it accounts for roughly 60% of a families net worth. With 33% market share, a low cost deposit franchise, and prudent risk management policies, BAC is well positioned to take advantage of this impending trend.
Consumers are deleveraging. They are saving more, paying down debt, and postponing large amounts of consumption. Housing inventory is declining while household formation is increasing. In many of the more prominent housing areas (Nevada, Miami, Phoenix) housing prices have now recovered. In many areas, it is now cheaper to purchase a home than it is to rent an apartment. Homes are now at more affordable with the 30-year rate at roughly 3.34%. Consumer confidence is rising while jobs are becoming more bountiful. All of these factors bode well for a housing recovery in 2013 or 2014. With a large market share and locations in all 50 states, I believe BAC can capitalize substantially on this trend in the future.
In addition, the company also wants to comply with Basel 3 requirements for risk…[continue]
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