Bank of America's Long Road Ahead

By Chad Henage - July 31, 2012 | Tickers: BAC, DFS, JPM, WFC | 0 Comments

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In the past, I've taken Bank of America (NYSE: BAC) to task, over the fact that the company has some scary numbers behind their reported headline earnings. The challenge for investors is, to guess whether these “scary” numbers will improve over time. While Bank of America's management is moving the company towards improved performance in multiple areas, the scary behind the scenes issues still remain.

Headline Earnings & The Smaller New BAC?

With reported net income of $.19 per share, the bank posted results that were better than expectations. Even more impressive was the provision for credit losses declined to its lowest level since the first quarter 2007. The company also expects that phase 2 of its project “new BAC” should yield cost savings of about $3 billion annually by mid-2015. In the past, Bank of America seemed destined to place the banking center or ATM on every corner in America. However, in the last year the company has decreased its number of banking centers by 148, and closed nearly 1600 ATMs. While these maneuvers make the bank slightly less accessible, they also cut down expenses. Unfortunately for the company, what is being cut down even faster is the company's balances in multiple divisions.

Deposits and Where They are Going:

As a good example of the underperformance by Bank of America, consider in the same quarter the company saw average deposits increase 2%, JPMorgan Chase (NYSE: JPM) saw average deposits increase 8%. Wells Fargo (NYSE: WFC) saw a similar increase in average deposits, and Discover Financial (NYSE: DFS) saw a jump in deposits of 18%. There's no clearer picture of Bank of America's struggles than their consumer and business banking unit. In this division alone revenue decreased over 15%, and net income was down over 50%. Much of this decrease was due to lower loan balances.

Lending = What BAC is Not Doing Enough Of:

While the bank reported net interest income down almost 15%, non-interest income rose by more than 500%. This tells investors that the bank had less loans, but the bank generated significant fee income from its other operations. On the lending side of the house, residential mortgage balances dropped almost 4%, home equity balances declined over 9%, U.S. commercial loans dropped almost 5%, and commercial real estate lending was down nearly 18%. With these significant decreases in multiple areas, it's not hard to understand why the company saw such a significant drop in net income for this division. The bank's second worst lending division was actually their credit card unit.

Bank of America Credit Card Balances Disappearing:

Bank of America saw U.S. credit card balances decrease 10.5%, and non-US credit card balances were cut in half. It's not surprising that new U.S. credit card accounts opened increased by 7% year-over-year. Clearly the company is pushing to regain some of these lost credit card holders, and in particular regain these balances. The numbers in this division are particularly troubling when compared to their competitor JPMorgan. The company saw a 12% increase in sales volume, and signed up 1.6 million new cardholders during the last quarter. Only time will tell if this short-term increase of 7% new cardholders at Bank of America, is a longer-term trend, or just a blip on the radar. Of course, the biggest challenge for Bank of America remains their mortgage division.

Competition is Eating BAC's Mortgage Division Alive:

While Bank of America mortgage did see positive revenue this year, the remainder of the numbers are horrible. Mortgage loans serviced decreased over 22%, first mortgage loan production was down 55%, and home equity production decreased 11.76%. When you consider that Wells Fargo saw an increase of 1.5% in mortgage originations, and JPMorgan saw a 29% increase in the same measure, the drop at Bank of America means these two companies are stealing business from the beleaguered banking giant. Even more interesting, is the bank said that 19% of funded first mortgages were for purchases and 81% were refinances. Given the massive decrease in mortgage loans being serviced and lower production, one can only wonder how bad things would've been without this over 80% refinancing population.

Credit Quality is Better! Or is it?

When it comes to credit quality, the numbers show a confusing pattern. The company cut its provision for credit losses by 90%, but there were $3.26 billion of new nonperforming loans. While these new non-performers were somewhat offset by $1.27 billion of loans returned to performing status, the majority of the offset was $1.54 billion worth of charge-offs. Without these charge-offs, the bank would've seen a nearly $2 billion increase in nonperforming loans, which makes me question why would a provision for credit losses be cut by such a dramatic amount? The only logical conclusion is, the bank expects to charge off more and leave less as nonperforming loans. The company also holds about 8.4 million in first mortgage loans that are considered as legacy assets. In plain English, this means the company does not want these loans. You can see why, as just over 1 million are at least 60 days past due. This is the equivalent of over 12% of these legacy assets. With the allowance for losses at 119% of nonperforming loans the question is, did Bank of America set aside enough money for future lending issues? Given these multiple challenges, what should investors do?

Better Options Abound:

If investors are looking for a large bank to put their money into, at this point Bank of America seems like a fool's errand. While the company will benefit from its size and scope should the economy continue to recover, their competitors are already beginning to see the benefits of stronger operations. Investors could choose to pay about 12.5 times 2012 earnings for Bank of America and wait to see if the company can resolve its problems. The alternative is to purchase JPMorgan at just 7.4 times its 2012 estimates. JPMorgan has some short-term challenges, but they appear isolated. Both Bank of America and JPMorgan are expected to grow earnings at around 7%. JPMorgan's dividend yield of 3.4% is just another reason to choose this company over Bank of America. The other huge differences are JPMorgan is capitalizing on: heavy mortgage demand, increased deposits, and higher credit card balances. Bank of America by contrast, has seen a small increase in deposits, but is poorly positioned to capitalize on current market opportunities. When the choices are: a strong bank with a good dividend, or a weaker bank with a small dividend, the decision for investors should be obvious.

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