DBRS Comments on Bank of America’s 3Q12 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 3Q12 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’s intrinsic assessment (IA) is currently one notch below its final rating or A (low).

In what amounted to a noisy break-even third quarter, Bank of America reported net income of $340 million, substantially down from $2.5 billion in 2Q12 and $6.2 billion in 3Q11. In DBRS’s opinion, Bank of America’s 3Q12 core financial performance remains pressured, highlighting the Company’s challenge to grow core revenue in a difficult operating environment featuring low interest rates, constrained capital markets activity, increased competition and continuing high costs primarily related to its legacy residential mortgage business. Positively, the Company was able to generate positive operating leverage in the quarter (on an adjusted basis), but expenses, albeit lower over the quarter (adjusted), remain high despite a 6% reduction in full-time employees over the past year.

Net income was impacted by a series of pre-announced charges including a $1.3 billion fair value option adjustment and a $600 million in debit valuation adjustment (DVA) that were both related to improvement in the Company’s credit spreads. Additionally, Bank of America incurred $1.6 billion in litigation expenses (including the Merrill Lynch settlement) and a $781 million one-time tax expense. DBRS sees the serial nature of quarterly one-time charges, such as the high litigation expense, as primarily the legacy of troubled acquisitions and poor management. While each charge moves the Company closer to clearing all of its legacy issues, it remains unclear just how long it will take Bank of America to resolve all legacy issues and at what cost leading to considerable uncertainty. Positively, for fixed income investors, the Company continued to strengthen its balance sheet with improved capital levels, ample liquidity, better (adjusted) asset quality and reduced long-term debt.

DBRS-adjusted Company-wide net revenues were $21.8 billion, up 2.3% from 2Q12 but only 0.3% from 3Q11. Adjusted for one-time gains and unusual expenses, income before provisions and taxes (IBPT; DBRS’s core earnings power metric) was $4.8 billion, or 3.3% below 3Q11, but 10% better than the sequential quarter, reflecting the mixed nature of the results. DBRS notes that the loan loss provision, basically flat over the quarter (unadjusted), accounted for an elevated 37% of IBPT in the quarter and continues to indicate that further revenue generation improvement is needed to return to a healthier relationship with credit costs.

Underscoring the struggle to improve financial fundamentals, revenue worsened in four of the six business segments in the quarter with only Consumer Real Estate Services (CRES) and Global Markets growing revenues. Meanwhile, net income was up only in the Consumer & Business Banking and Global Markets (when adjusted for DVA and tax charge) segments. Positive trends included a stronger quarter in investment banking where a good fixed income business performance and good expense control were masked by the DVA and tax charges. Moreover, Bank of America defended its second place ranking in global fees and maintained top tier rankings across many products. Additionally, the Global Banking segment was able to grow period-end commercial loans by 2.5% and deposits by 7.7%, while reducing credit costs and expenses.

CRES results were mixed. Specifically, strong production (despite exiting correspondent originations) and servicing income coupled with a one-time $175 million gain on the sale of a business were more than offset by much higher litigation and servicing expenses and higher provisions. The $78 million provision increase was driven primarily by the new OCC guidance requiring banks to charge consumer loans down to collateral value where the borrower has gone through a Chapter 7 bankruptcy, irrespective of payment status. Also noteworthy in the Legacy Asset & Servicing business of CRES was the 12% drop in 60+ day delinquent mortgage servicing portfolio, as well as the first FTE headcount decline in 14 quarters with more reductions coming. While it appears the housing market has turned the corner, this positive development is being tempered by the risks of a Eurozone recession and the U.S. fiscal cliff.

Repurchase liability remains an area of uncertain liability and investor concern. At about $5 billion, new claims returned to their recent level of prior quarters after an outsized $8.2 billion in 2Q12 and continue to be primarily (73%) in the 2006 and 2007 vintages. Outstanding unsettled claims continued to grow briskly (up 12% in 3Q12 and 154% since 3Q11), as a dispute with FNMA and private label claims (from trustees not included in the BNY Mellon settlement) added to the total. At 3Q12, the Company had $9.2 billion, or 75% in unsettled GSE claims (90% of new claims in 2012) where the borrower had made at least 25 payments. Overall, the rep/warranty reserve increased 2.0% to $16.3 billion in 3Q12, while the provision declined $88 million to $307 million. Bank of America also updated its reasonable estimate of a range of possible loss (RPL; which now includes GSE exposures) for non-GSE rep/warranty exposures to be up to $6 billion above accruals or $1 billion higher than last quarter. DBRS notes that realization of a significant portion of the RPL alone would be material to annual earnings. Therefore, although DBRS sees the Company’s reserve as currently adequate, the higher level of claims and/or RPL could result in additional litigation, repurchase and settlement costs thereby further increasing the drag on revenue and/or expense from this issue.

Adjusted for the aforementioned new OCC guidance and the National Mortgage Settlement, credit quality continued to improve in the quarter, albeit more slowly. Adjusted Company-wide net charge-offs (NCOs) were down 11.5% over the quarter at $3.2 billion (1.45% of average loans, down 41 bps). As a result of the improving asset quality, this quarter’s adjusted results reflected a $338 million (19%) decrease in the provision for credit losses to $1.4 billion resulting in a $1.9 billion reserve release. Underscoring the continued improvement, Bank of America reported its fourteenth consecutive quarterly decline in near-term consumer delinquencies (excluding FHA-insured loans) and its twelfth consecutive quarterly decline in commercial reservable criticized utilized exposures, which were down 15%. Meanwhile, adjusted non-performing assets declined 5.7%, or $1.4 billion, and 90 day past dues (but still accruing and excluding FHA insured loans) fell $210 million or 7.7% to $2.5 billion.

Despite further declines in the allowance for loan losses, Bank of America’s reserves remain adequate in DBRS’s view. DBRS notes that 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, would likely change this view. Loan loss reserves decreased for the ninth consecutive quarter to $26.2 billion (unadjusted and excluding the reserve for unfunded lending commitments) and were 107% of non-performing assets and 2.96% of total loans and leases at 3Q12, down from 119% and 3.43%, respectively, at 2Q12. The Company disclosed $16.5 billion in total exposure (up 14% from 2Q12) to Greece, Ireland, Italy, Portugal and Spain with most of the increase to Italian and Spanish corporates. After considering $5.0 billion (up from $4.9 billion at 2Q12) in related counterparty hedges and credit default protection, the Company’s net exposure was $11.5 billion (up from $9.6 billion at 2Q12). DBRS perceives this risk as relatively manageable at current levels given that the exposure is primarily cross-border exposure to corporate entities. Nonetheless, a more severe European crisis would likely produce significant credit costs.

Bank of America continued to strengthen capital ratios primarily through reduced deductions to capital (improved numerator) and lower risk-weighted assets from a combination of retail credit improvement, lower derivative repurchase exposure (from actual, collateral or counterparty), and spread tightening. The Company’s reported Basel I Tier 1 common ratio increased by 17 bps to 11.41%. Meanwhile, the tangible common equity ratio increased 12 bps over the quarter to 6.95% and was up 70 bps from 6.25% at 3Q11. Bank of America also estimated its Basel III Tier 1 Common Equity Ratio to be 8.97% including the most recent proposal (NPR), a dramatic improvement from 2Q12’s 7.95%. With its improved capital metrics, the Company is now on a solid path toward compliance with the new capital requirements.

Liquidity and funding also continue to be maintained at substantial levels with $380 billion in global excess liquidity on Bank of America’s balance sheet (up approximately $2 billion in the quarter) and the benefit of having strong deposit franchises within its diverse businesses which continue to experience significant inflows. Additionally, the time to required funding declined to 35 months (or $102 billion) from 37 months in the quarter and the Company signaled that it will return to its $75 billion to $80 billion (21 to 24 month) target range over the next 6 to 8 quarters. DBRS also notes that Bank of America has reduced its long-term debt by $15 billion in 3Q12 to $287 billion and has almost achieved its high-side 2013 target to achieve a total long-term debt reduction of $200 billion (relative to $479 billion at 3Q10). The Company’s total average deposits increased 1.6%, or $16.8 billion over the quarter, to $1.05 trillion. In addition to average deposit growth, DBRS views positively the continuing favorable deposit 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 5.4%, or $18.5 billion, growth QoQ in average non-interest bearing deposits to over $361 billion.

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

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organizations. Other methodologies used include the DBRS Criteria – Intrinsic and Support Assessments, Rating Bank Subordinated Debt and Hybrid Instruments with Discretionary Payments, and Rating Bank Preferred Shares and Equivalent Hybrids. All 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: Roger Lister
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.