DBRS Comments on Bank of America’s 2Q12 Earnings; Senior Debt Unchanged at “A”

DBRS, Inc. (DBRS) has commented today that its ratings for Bank of America Corporation (Bank of America or the Company), including its “A” Issuer & Senior Debt rating are unchanged following the announcement of the Company’s 2Q12 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. Bank of America reported net income of $2.5 billion for the second quarter, up 277% compared to $653 million in 1Q12 and considerably improved from an $8.8 billion loss in 2Q11.

In DBRS’s opinion, Bank of America’s 1H12 and 2Q12 core financial performances have declined from 2H11 and 1Q12, respectively, highlighting the Company’s challenge to grow core revenue in a difficult operating environment featuring low interest rates, constrained capital markets activity, and continuing high costs related to its legacy residential mortgage business. Positively, the Company was able to materially reduce operating costs but has failed to generate positive operating leverage in the half and quarter (on an adjusted basis) due to the revenue headwinds. Net income improved over all comparative periods: quarter-over quarter (q-o-q), year-over-year (y-o-y) and half-over-half (h-o-h). The y-o-y and h-o-h comparisons benefitted from the absence of special rep/warranty and other mortgage charges, as well as goodwill impairment charges recorded in 2011. Meanwhile, the linked quarter comparison benefited from markedly lower expenses, higher fee income and lower loan loss provisions. Positively for fixed income investors, the Company continued to strengthen its balance sheet with improved capital levels, ample liquidity, better asset quality and reduced long-term debt.

Bank of America’s management continues to focus on improving its financial performance through consistent execution and its “New BAC” program. New BAC has a Phase 1 annual cost reduction goal of $5 billion by the end of 2014 (currently on track to exceed 20% of target by 2012 year-end) and a Phase 2 expected savings goal of $3 billion by mid-2015. The evolution of the Company’s business is taking place while uncertainty remains with regard to Bank of America’s exposure to securitized mortgages and associated litigation in various aspects of its mortgage origination and servicing businesses.

Given time, DBRS believes that Bank of America’s earnings power and resources could enable the Company to navigate its considerable challenges. DBRS is continuing to monitor these factors and their impact on Bank of America’s intrinsic assessment (IA), currently at one notch below its final rating, and will consider these risks versus the Company’s success in building its franchise, including having the resources to cope with the possibility of more adverse future outcomes.

DBRS-adjusted Company-wide net revenues were $20.9 billion, down 16% from 1Q12 and down 30% from 2Q11. Net adjustments for unusual or one-time charges in the quarter were modest relative to the past 6 quarters. Adjusted for one-time gains and unusual expenses, income before provisions and taxes (IBPT DBRS’s core net revenue metric) was $4.0 billion, or 138% below 2Q11, and 50% worse than the sequential quarter also highlighting the variability in quarterly earnings. DBRS notes that loan loss provision, although down materially in the quarter, accounted for 44% of the weaker core net revenue in the quarter and continues to indicate that further improvement is needed to return to a healthy and sustainable credit cost level.

Underscoring the struggle to improve financial fundamentals, revenue and net income worsened in every business segment in the quarter except for Consumer Real Estate Services where the quarterly loss improved 33% due to the lower loan loss provision ,while the Global Wealth segment was flat. Underlying the disappointing financial results, however, were some positive trends such as good commercial loan growth, increased consumer spending levels, and better mortgage servicing revenues. Moreover, Bank of America announced the completion of a single deposit platform serving 11 million customers across 18.5 million deposit accounts.

Further stoking concern about its repurchase liability, outstanding unsettled claims grew strongly (41%) in 2Q12, and more than 80% over two quarters, primarily from trustees on private-label securitization transactions not included in the BNY Mellon settlement. Moreover, FNMA claims behavior continues to be inconsistent with its past conduct. The rep/warranty reserve increased a modest 1.3% in 2Q12 to $15.9 billion and included the anticipated higher private label claims according to the Company’s management. Bank of America also disclosed that 72% of outstanding GSE claims relate to borrowers that have made at least 25 payments. DBRS believes that while the Company’s reserve is seen as adequate, the sharply higher level of claims will almost certainly result in higher litigation and/or repurchases thereby further increasing the drag on revenue and/or expense from this issue.

Bank of America continued to strengthen capital primarily through earnings retention and reduction of risk-weighted assets that benefited regulatory capital levels. The Company reported that its Tier 1 common ratio increased by 46 basis points (bps) to 11.24% while Tier 1 capital improved 43 bps to 13.80% in the quarter, exceeding expectations for the third consecutive quarter. The Company’s tangible common equity ratio increased 25 bps over the quarter to 6.83% and was up 96 bps from 5.87% at 2Q11. Bank of America also estimated its Basel III Tier 1 Common Equity Ratio to be 8.10% excluding the most recent proposal (NPR) that, if implemented as-is, would result in a 15 bps decline to 7.95%. With improving capital metrics, the Company is now on a solid path toward compliance with the new capital requirements.

Despite further declines in the Company-wide allowance for loan losses, Bank of America’s reserves remain adequate in DBRS’s view. Two less likely risk events, namely a double digit or larger decline in residential real estate values over the next 12 months, or a significantly deteriorating crisis in Europe could change that view. Loan loss reserves decreased for the eighth consecutive quarter to $30.3 billion (excluding the reserve for unfunded lending commitments) and were 119% of nonperforming assets (including foreclosed properties) and 3.43% of total loans and leases at 2Q12, up from 116% and down from 3.61% respectively at 1Q12. The Company disclosed $14.5 billion in total exposure (down 3.6% from 1Q12) to selected European countries (Greece, Ireland, Italy, Portugal and Spain) before $4.9 billion (down from $5.3 billion at 1Q12) in counterparty hedges and credit default protection, which equates to $9.6 billion in net exposure (down from $9.8 billion at 1Q12). DBRS perceives this risk as relatively manageable at current levels given that the exposure is primarily cross-border exposure to corporate entities.

DBRS notes that credit quality continued to improve in the quarter. Company-wide net charge-offs (NCOs) were down 10.6% over the quarter at $3.6 billion (1.64% of average loans, down 16 bps) and decreased almost 36% from 2Q11. As a result of the improving asset quality, this quarter’s results reflected a $645 million (26.7%) decrease in the provision for credit losses to $1.8 billion resulting in a $1.9 billion reserve release. Underscoring the continued improvement, Bank of America reported its thirteenth consecutive quarter of decline in near-term consumer delinquencies (excluding FHA-insured loans) and its eleventh consecutive quarterly decline in reservable criticized utilized exposures that declined steeply to 5.64% of exposure. Nonperforming loans (including foreclosed properties) declined 8.7%, or $2.4 billion, and 90 day past dues (but still accruing and excluding FHA insured loans) fell $432 million or 13.7% to $2.7 billion. DBRS also notes that residential mortgage and home equity NPAs and home equity 30 day past dues all improved over the quarter while 30+ day performing past due residential mortgages increased 0.1% to 2.3% (excluding PCI and FHA-insured loans).

Liquidity and funding also continue to be maintained at substantial levels with $378 billion in global excess liquidity on Bank of America’s balance sheet (down approximately $28 billion in the quarter) and the benefit of strong deposit franchises within its diverse businesses. At the same time, the time to required funding was extended from 31 to 37 months in the quarter (highest in the Company’s history) and unsecured short-term funding at the parent and broker/dealers remained at essentially zero for the fourth consecutive quarter. DBRS also notes that Bank of America has reduced its long-term debt by $53 billion in 2Q12 to $302 billion and is well ahead of target to achieve a total reduction of $150 billion to $200 billion (relative to $479 billion at 3Q10) by the end of 2013. The Company total average deposits increased slightly by 0.27%, or $2.8 billion over the quarter to $1.033 trillion and DBRS notes the continuing favorable mix shift, as higher yielding consumer CDs and IRAs as well as non-U.S. deposits declined and the average interest bearing deposit yield fell 2 bps in the quarter. Also noteworthy was the 2.85% or $9.5 billion growth q-o-q in average non-interest bearing deposits to over $343 billion which benefited the earning asset net interest yield by 24 bps, declining 1 bps over the quarter.

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

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organisations. Other methodologies used include the DBRS Criteria – Intrinsic and Support Assessments. Both can be found on the DBRS website under Methodologies.

The sources of information used for this rating include 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.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

Lead Analyst: William Schwartz
Approver: Alan G. Reid
Initial Rating Date: 16 May 2001
Most Recent Rating Update: 27 September 2011

For additional information on this rating, please refer to the linking document under Related Research.