DBRS Comments on Bank of America’s 4Q10 Earnings; Senior Debt at “A” Unchanged

DBRS Inc. (DBRS) has commented today that its ratings for Bank of America Corp. (Bank of America or the Company) including its “A” Issuer & Senior Debt rating are unchanged following the announcement of the Company’s 4Q10 results. The trend on all ratings is Stable. The Company’s “A” Issuer & Senior Debt rating reflect its status as a Critically Important Banking organization (CIB) in the United States. CIBs benefit from DBRS’s floor rating of “A” for bank holding companies and A (high) for banks with short-term ratings of R-1 (middle). Given the nature of the rating floor, these ratings have Stable trends. Negative rating pressure on the final rating could result if DBRS concludes that any enacted U.S. legislation has a high likelihood of reducing the benefit of being a CIB. Some of this negative rating pressure may be mitigated, however, by stronger capital and liquidity levels.

Bank of America reported a 4Q10 net loss of $1.2 billion driven by a (previously announced) $2.0 billion (non-cash) goodwill impairment in the Home Loans & Insurance business segment from issues related to potential litigation exposure and related risks, higher servicing costs, foreclosure related issues and the redeployment of centralized sales resources to address servicing needs. Excluding the non-cash impairment charge, earnings of $756 million (before $321 million in preferred dividends) were substantially below the adjusted $3.1 billion in 3Q10 (excluding the $10.4 billion goodwill charge), but compared favorably to the $194 million loss in 4Q09. The $4.3 billion drop in total quarterly revenue to $22.4 billion primarily reflected the $4.1 billion in rep/warranty charges and the $1.2 billion negative FV adjustment on structured liabilities that were only partially offset by securities and asset sale gains. The 2010 full year total revenue decline of 7.9% was primarily driven by the $6.8 billion in rep/warranty charges, the absence of 2009 equity investment income from asset sales and the decline in trading profits. The unusual number of significant one-time items in 4Q10 distorted the quarterly results and make sequential quarterly comparisons less meaningful.

Taken in context, DBRS continues to see the Company’s quarterly financial results and overall financial profile as mixed. On one hand, core revenue trends reflected weakness due to overall economic conditions with weak loan growth and a low interest rate environment coupled with the high costs of the regulatory reform and legacy issues while absolute credit costs remain stubbornly high. On the other hand, steadily improving credit quality, balance sheet de-risking and deleveraging, enhanced focus on its core businesses and improved capital and liquidity levels were positive developments for fixed income investors. The underlying power and market share in its core businesses continues to underpin its franchise strength as one of the most dominant banks in the U.S. as most business segments appear fundamentally sound or improving in this environment. Earnings will continue to be constrained, however, by legacy issues in its mortgage business (particularly reps/warrant and litigation) and new regulatory dictates that continue to weigh on Bank of America’s card, mortgage and deposit businesses in the medium term as the Company works to restructure and rationalize those business models. For example, the Company estimates a $1 billion decline in interchange fees under the proposed interpretation of the Durbin Amendment before any mitigating actions. The legacy issues in its mortgage business are of particular note at this time given the uncertainty surrounding its potential liability, although Bank of America did indicate a $7 to $10 billion upper limit (over current accruals and) over time in its quarterly commentary. Despite the near to medium term headwinds, however, DBRS believes the Company is far better positioned for recovery and long-term success compared to one year ago.

Exposure to the repurchase of mortgages due to defects in representations and warranties is an area of current concern. The Company currently has 51% reserve coverage or $5.438 billion against $10.687 billion (including $1.7 billion in unqualified claims) in outstanding rep & warranty claims which improved from 34% in 3Q10 from the addition of $4.1 billion in provisions and a net $2.3 billion reduction in claims as a result of the GSE agreements. Now, only 26% of the claims are from GSE’s where Bank of America has considerable claim experience and a better ability to forecast loss expectations. The remaining 74% ($7.9 billion) of outstanding claims, however, are from private label securities wrapped by monolines, whole loan investors, private label securitizations and others. Positively, the GSE settlement puts most of the GSE repurchase claims behind the Company. Negatively, the lack of sufficient claim and legal precedent experience outside of the GSE’s and the possibility of higher loss severities make future losses difficult to predict. Moreover, the current foreclosure crisis and other issues involving the servicing of mortgages may further add to the costs of resolving residential mortgages. In 4Q10, Bank of America had $1.5 billion in litigation expense (up $1 billion from 3Q10) primarily driven by the consumer businesses, including home lending.

DBRS notes that credit quality improvement continued in the fourth quarter. Of note, this quarter’s results benefited from a $267 million (5%) reduction in the provision for credit losses which contributed to a $1.7 billion reduction in loan loss reserves. The reduction reflected the impact of a 5.8% reduction in net loan losses, a seven quarter decline in near-term delinquencies (excluding FHA-insured loans) and five quarter decline in reservable criticized utilized exposures.

DBRS still expects credit trends to continue to produce elevated yet declining credit costs into 2011 as the impact of a recessionary economy, stubbornly high unemployment and declining real estate values weigh on consumers and businesses. Nonperforming loans (including foreclosed properties) declined for the second consecutive quarter, declining 5.5%, or $1.9 billion, from 3Q10 to $32.7 billion (or 3.48% of total loans, leases and REO) at December 31, 2010, while 90 day past dues (but still accruing and excluding FHA insured loans) fell a modest $170 million, or 2.9%, in the same period. Thirty day past due consumer loans declined 4.5% in the quarter (excluding insured government loans and credit impaired loans) as Consumer Card declined for the seventh consecutive quarter and commercial utilized reservable criticized exposures fell 10.6%, the fifth straight quarterly decline.

Loan loss reserves decreased $1.7 billion for the second consecutive quarter to $41.9 billion (excluding the reserve for unfunded lending commitments) compared to 3Q10 and reflect the Company’s confidence that credit costs will continue to decline. The allowance for loan losses (excluding the reserve for unfunded lending commitments) was 1.28x nonperforming assets (including foreclosed properties) and 4.47% of total loans and leases. Company-wide net charge-offs (NCOs) were $6.8 billion for the fourth quarter (2.87% of average loans), a 5.8% decrease from 3Q10.

Bank of America’s capital ratios continued to improve over the quarter primarily from retained earnings that were only partially offset by the mark on some structured liabilities (TCE positive but regulatory neutral) and dividends. The Company also benefited from the conversion of $1.5 billion in preferred shares to common, a $75 billion decrease in its balance sheet and a $20+ billion decrease in risk weighted assets that were only partially offset by an increase in the DTA disallowance. Tier 1 capital increased 8 basis points (bps) in the quarter to 11.24% and Tier 1 common was up 15 bps to 8.60%, both providing comfortable cushions above regulatory requirements. The Company’s tangible common equity ratio also rose 25 bps over the quarter to 5.99% and is moving closer to the range of its similarly rated peers. DBRS notes that the Company had $21.4 billion of Trust Preferred Securities (corresponding to 145 basis points of Tier 1 capital as of 9/30/10) qualifying as Tier 1 capital that will be phased out over a three year period in accordance with the financial reform legislation beginning in 2013. Bank of America senior management has clearly stated that its Tier 1 common capital ratio will be above 8.0% as Basel II and Basel III become effective.

Liquidity and funding also continue to be enhanced with $336 billion in excess liquidity on its balance sheet (up approximately $12 billion in the quarter) and the benefit of strong deposit franchises within its diverse businesses. DBRS also notes that Bank of America has reduced its long-term debt by $74.5 billion in 2010 (adjusted for FAS 166/167) to $448.4 billion, and is on target for a 15% to 20% reduction (relative to 3Q10) by year-end 2011, and a total $150 to $200 billion reduction by the end of 2013. The Company’s continues to maintain its robust deposit base as total average deposits were up 3.5%, or $33.9 billion, over the quarter to $1.008 trillion. Positively, the deposit mix improved with an average $7.8 billion decline in U.S. consumer CDs and IRAs contributing to a 6 basis point yield reduction to U.S. interest-bearing deposit yields. Also noteworthy was the 6.5%, or $17.7 billion, growth in average non-interest bearing deposits to $288 billion, which benefited the earning asset net interest yield by 18bp.

Currently, Bank of America is one of the 19 banks subject to a second round of Federal Reserve stress tests to ensure capital adequacy. The stress tests will test a bank’s ability to absorb losses over the next two years under at least two scenarios (baseline and adverse) and will take the proposed Basel III capital requirements into account as well as TARP repayment (if applicable). Test results will also determine whether an institution may resume capital distributions (stock dividends and/or repurchases). The stress test results are expected to be communicated to BHCs (not publicly) no later than March 21, 2011.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The applicable methodologies are Global Methodology for Rating Banks and Banking Organizations, Enhanced Methodology for Bank Ratings – Intrinsic and Support Assessments, Rating Bank Subordinated Debt and Hybrid Instruments with Discretionary Payments, and Rating Bank Preferred Shares and Equivalent Hybrids which can be found on the DBRS website under Methodologies.

The sources of information used for this rating include the company documents, the Federal Reserve, the Federal Deposit Insurance Corporation and SNL Financial. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

Lead Analyst: William Schwartz

Initial Rating Date: 16 May 2001
Most Recent Rating Update: 18 June 2010

For additional information on this rating, please refer to the linking document below.