Cost Cutting Not The Answer For Bank of America
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Bank of America (NYSE: BAC) recently released second quarter earnings. The bank did actually post earnings, which is the good news. The bad news? Almost everything else. Bank of America at one time was a highly profitable regional bank operating as NCNB. Over the years, NCNB's successor bought Bank of America, and adopted the name as its own. The problems of the current Bank of America go back to ill-timed acquisitions in the midst of last decade's banking recession.
Indeed, Bank of America did report earnings for the second quarter of $2.46 billion, or $0.19 per share. A year ago it reported a substantial loss due largely to onetime factors such as goodwill impairments and wholesale mortgage charges. Those onetime factors totaled over $22 billion pretax last year, forcing the quarterly loss. The current quarter's result not only turned around the year ago loss, it also beat analysts' expectations going into the quarter of $0.14 per share. Let's not get carried away though. The banking unit's 2.21% net interest margin is the lowest of any bank I have covered of late. The banking unit's 76.8% efficiency ratio remains atrocious despite a big drop in expenses. And the bank's 0.45% return on assets in the quarter is certainly below any reasonable standard. Let's take a closer look at the income statement for the quarter to see how Bank of America did it.
Interest income and credit costs both continued to fall from year ago levels in the quarter by healthy amounts. Specifically, interest income that had been over $17 billion in the second quarter of 2011, fell to just over $14 billion in the recent quarter. Credit costs fell from $5.8 billion a year ago to $4.44 billion in the recent quarter. Net interest income actually declined, from $11.25 billion a year ago to $9.55 billion in the recent quarter. Unimpressive, obviously.
But the non-interest side of the revenue stream showed some real improvements. Non-interest income came to $12.42 billion, whereas a year ago it was $1.99 billion due to big mortgage charges. Non-interest expense came to $17 billion, down substantially from the $22.9 billion of a year ago. The huge, nearly $6 billion quarterly drop came from the onetime factors of last year's report, such as a $2.6 billion goodwill impairment. Personnel costs did fall from $9.2 billion to $8.7 billion. The amorphous “all other non-interest expense” fell by some $3 billion, due to the absence of onetime factors in the current quarter.
The first thing I find troubling is that the provision for credit losses fell by about $1.5 billion from the second quarter of 2011, down to $1.77 billion. That accounted for some 60% of the quarter's profits. Second is the fact that revenues are steadily decreasing, and earnings gains are being made exclusively on the back of reduced expenses. This is not sustainable. Growth can be achieved by shrinking over the short run, but certainly, as banks competing with Bank of America are growing their loans outstanding in general and their mortgage portfolios in particular, Bank of America's loan portfolio has fallen from $941 million a year ago to $892 million as of June 30, 2012. Yet Bank of America has made it clear that for at least another two years, if not longer, it is more interested in cutting costs than in any sort of revenue enhancement.
Bank of America's large investment bank, operated as Merrill Lynch, is not the answer. Capital market activity is depressed across the industry due to reduced activity in North America and a near paralysis in Europe. And Bank of America is selling one of the crown jewels of the division, its foreign wealth management unit, possibly to Julius Baer, the large, Swiss private bank.
Mortgage purchase demands continue to bedevil all banks, but none more so than Bank of America. In the second quarter, mortgage warranty claims reached over $22 billion, a 40% jump from the first quarter.
Still, Bank of America is obsessed with cost cutting. In 2011, it began its first major initiative to reduce expenses by $5 billion per year by the end of 2014 from the consumer bank and information technology departments. Now, there are designs to do much the same thing in its investment bank, wealth management, and commercial lending units by the end of 2015. As large competitors like U.S. Bank (NYSE: USB) and Wells Fargo (NYSE: WFC) are growing their loan portfolios and asset levels, Bank of America has ignored this strategy. With the seemingly unending shrinkage in Bank of America's loans and assets, and with minimal apparent interest in anything other than cost cutting, where does that leave this once proud institution? Sure its capital levels have improved markedly, but over the long run, relying solely on cost cutting is a losers' game. I cannot endorse a purchase in Bank of America until a fundamental shift in management psychology occurs.
Wells Fargo is Bank of America's chief rival, especially since Wells Fargo's Wachovia purchase in 2009 gave Wells Fargo a toehold in Bank of America's North Carolina based Southeast retail bank system. Wells Fargo now writes over one third of domestic mortgages, and has increased its return on assets and successfully dropped its efficiency rate below 60% in the process. Perhaps Bank of America ought to try to follow Wells Fargo's methods.
U.S. Bank is statistically the most profitable and efficient among large banks. Over the past few years it has acquired roughly a dozen, mostly smaller banks, without so much as a hiccup. It continues to post annualized double digit annual profit growth, with returns on assets in the recent quarter of 1.67%, and an efficiency rate of 51.1. All banks should learn some lessons from U.S. Bank.
PNC Financial (NYSE: PNC) had a rough quarter too. As it digests the large recent purchase of Royal Bank of Canada's (RY) domestic branch system, it made a large addition to its reserves on account of a surge of mortgage warranty claims. It appears that in that deal Royal Bank of Canada just tired of the protracted downtown of the economy south of the border. PNC made a reserve addition of $438 million in the second quarter, which led to earnings falling 40% from the second quarter of 2011, to $546 million, or $0.98 per share. This represented a 0.74% return on assets, PNC's worst quarter since the end of the banking led recession. But aside from that extraordinary reserve addition, it was an excellent quarter for PNC.
On the strength of the RBC acquisition plus organic growth, PNC's loan portfolio grew by 20% from the second quarter of 2011, to about $180 billion. Net interest income was up from the year earlier quarter by $376 million, or 17%, to $2.53 billion. Non-interest income, were it not for the extraordinary warranty reserve, would have climbed about $100 million from the previous year, but instead came in down by $345 million, or 24%. Overall revenues increased by less than one percent, to $3.62 billion. But expenses, due to taking on over 400 branches in the RBC deal, also ballooned by $470 million. The conclusion: Despite the setback, PNC is growing, healthy and profitable.
The market barely seemed to notice the disappointing earnings, and with good reason. This is most unlikely to repeat itself, and I look for PNC to report earnings of close to $1 billion each of the last two quarters of this year. PNC's well covered dividend yield is 2.6%. I see PNC as a potential core holding in the financial sector for conservative investors.
StockCroc1 has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America, PNC Financial Services, and Wells Fargo & Company and has the following options: short APR 2012 $21.00 puts on Wells Fargo & Company, short APR 2012 $29.00 calls on Wells Fargo & Company, short OCT 2012 $33.00 puts on Wells Fargo & Company, and short OCT 2012 $36.00 calls on Wells Fargo & Company. Motley Fool newsletter services recommend Wells Fargo & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.