DBRS Comments on Bank of America’s 4Q12 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 4Q12 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 another noisy quarter, Bank of America reported weak net income of $732 million, up modestly from $340 million in 3Q12, but down from $2.0 billion in 4Q11. In DBRS’s opinion, Bank of America’s 4Q12 financial performance remained pressured primarily by issues in its legacy mortgage business. Positively, the Company continues to make progress putting its legacy issues behind it. Nonetheless, DBRS believes that Bank of America will continue to absorb elevated costs primarily related to its legacy mortgage business over the medium term. Meanwhile, the Company’s challenge is to grow core revenue in a difficult operating environment featuring low interest rates, constrained capital markets activity, increased competition, and expense pressure. The Company was able to generate positive operating leverage in the quarter (adjusted to exclude one-time items) and the “New BAC” expense reductions are gaining visibility. While DBRS is cognizant also of the improvement in Bank of America’s balance sheet, the Company’s core earnings power and franchise strength remain key rating level drivers.

Net income was impacted by a series of pre-announced charges associated with its mortgage business including a $2.5 billion FNMA rep/warranty provision, a $1.1 billion Independent Foreclosure Review settlement, a $500 million mortgage insurance rescission obligation provision, and a $300 million provision for FNMA compensatory fees. Results also included a $700 million fair value option adjustment and a debit valuation adjustment (DVA) related to improvement in the Company’s credit spreads. One-time gains were also recorded including $400 million from the sale of the Japan JV, a $300 million MSR valuation increase from servicing sales, and a $1.3 billion net tax benefit primarily from foreign tax credits. DBRS sees the serial nature of quarterly one-time charges, such as the high litigation expense and settlements, as primarily the legacy of troubled acquisitions and prior poor management. While each charge moves the Company closer to resolving its legacy issues, it remains unclear just how long it will take Bank of America to clear all legacy issues and at what cost. 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. In DBRS’s opinion, the FNMA settlement; while costly, does reduce some uncertainty for the Company and should help it to move forward.

DBRS-adjusted Company-wide net revenues were $21.5 billion, down 1.4% from 3Q12, but up 1.4% from 4Q11. Adjusted for one-time gains and unusual expenses, income before provisions and taxes (IBPT; DBRS’s core earnings power metric) was $4.5 billion, a 6.8% improvement from 3Q12 and 99% better than 4Q11, reflecting the impact of the excluded one-time items. Moreover, FY12 IBPT at $18.2 billion was 13% below the FY11 level. DBRS notes that the loan loss provision, up over the quarter, accounted for an elevated 49% of IBPT in 4Q12 and continues to indicate that further revenue generation and asset quality improvement is needed to return to a healthier relationship between revenue and credit costs.

Reflecting positively on underlying business trends, revenue improved in four of the six business segments in the quarter with declines only in Consumer Real Estate Services (CRES) due to the settlement charges and Global Markets (ex-DVA) from FICC revenue seasonality. Moreover, net income was up QoQ in every segment and YoY in all segments except All Other. Positive trends included continued good deposit growth in Consumer & Business Banking, another quarter of strong client activity, growth in Global Wealth & Investment Management, and solid Global Banking results from strong commercial loan and deposit growth. Bank of America also defended its second place ranking in global investment banking fees during 2012 and maintained top tier rankings across many products.

The $3.7 billion CRES segment net loss in the quarter from the FNMA settlement financial masked some improved results. Specifically, strong production (despite exiting correspondent originations in 4Q11) and servicing income were overwhelmed by an almost $3 billion rep/warranty provision. Also noteworthy in the Legacy Asset & Servicing business of CRES was the 17% drop in 60+ day delinquent mortgage servicing portfolio, as well as the 15% (9,000) headcount decline. With agreements to sell $306 billion in MSRs and performance improvement, management expects 60+ day delinquencies to improve by 48% by year-end and expenses to drop by $1 billion.

The FNMA settlement eliminates over 90% of outstanding GSE claims and eliminates the uncertainty associated with that exposure. Overall, the rep/warranty reserve increased $2.7 billion, or 17%, to $19 billion in 4Q12. The drivers of the $3 billion rep/warranty provision were the aforementioned $2.5 billion FNMA settlement and $500 million related to mortgage insurance rescissions. With the settlement behind it, Bank of America also updated its reasonable estimate of a range of possible loss (RPL) for rep/warranty exposures to be up to $4 billion (primarily for non-GSE exposure) above accruals, or $2 billion lower than last quarter. DBRS notes that while uncertainly remains as to the final cost of resolving the remaining private and monoline exposures, the Company has removed the uncertainty around the GSE exposure.

Credit quality continued to improve modestly in the quarter even adjusted for the OCC guidance on Chapter 7 bankruptcies and National Mortgage Settlement implemented in 3Q12. Adjusted Company-wide net charge-offs (NCOs) were down 3.3% over the quarter at $3.1 billion (1.40% of average loans, down 5 bps). Despite the improvement, the provision for credit loss increased $769 million on an adjusted basis (54%) to $2.2 billion, which is at the upper part of the Company-guided $1.8 billion to $2.2 billion range for 2013 quarterly provisions. DBRS speculates that the Company’s credit quality may be normalizing for some portions of the loan book (i.e. commercial and credit cards) that are performing at unsustainably favorable levels. Bank of America reported its fifteenth consecutive quarterly decline in near-term consumer delinquencies (excluding FHA-insured loans) and its thirteenth consecutive quarterly decline in commercial reservable criticized utilized exposures, which were down 8%. Meanwhile, unadjusted non-performing assets declined 5.5%, or $1.4 billion, and 90 day past dues (but still accruing and excluding fully-insured loans) fell $77 million or 3.1% to $2.4 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 tenth consecutive quarter to $24.2 billion (unadjusted and excluding the reserve for unfunded lending commitments) and were 107% of non-performing assets and 2.69% of total loans and leases at 4Q12, down from 111% and 2.96%, respectively, at 3Q12. The Company disclosed $14.5 billion in total exposure (down 12% from 3Q12) to Greece, Ireland, Italy, Portugal and Spain with most of the decrease to Italy and Irish corporates. After considering $5.1 billion (up from $5.0 billion at 3Q12) in related counterparty hedges and credit default protection, the Company’s net exposure was $9.5 billion (down from $11.5 billion at 3Q12). 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 maintain strong capital ratios. However, the $1.9 billion pre-tax loss and dividends lowered its Tier 1 Common Capital ratio. Specifically, the Company’s Basel I Tier 1 common ratio decreased by 35 bps to 11.06%, while the tangible common equity ratio decreased 21 bps over the quarter to 6.74%, but was up 10 bps from 6.64% at 4Q11. Bank of America also estimated its fully phased-in Basel III Tier 1 Common Equity Ratio to be 9.25% including the most recent proposal (NPR), a dramatic improvement from 2Q12’s 7.95% (from increased common equity and RWA reductions) and already well-above the 8.5% requirement by 2019.

Liquidity and funding also continue to be maintained at substantial levels with $372 billion in global excess liquidity on Bank of America’s balance sheet (down approximately $8 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 33 months (with parent company excess liquidity at $103 billion) from 35 months in the quarter and the Company signalled that it intends to maintain it above 24 months. DBRS also notes that Bank of America reduced its long-term debt by $11 billion in 4Q12 to $276 billion and has virtually achieved its high-side 2013 target for a total long-term debt reduction of $200 billion (relative to $479 billion at 3Q10). The Company’s total average deposits increased 2.7%, or $28.4 billion, over the quarter to $1.08 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 3 bps in the quarter. Also noteworthy was the 5.1%, or $18.4 billion, growth QoQ in average non-interest bearing deposits to nearly $380 billion.

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

[Amended on May the 23rd, 2014 to remove unnecessary disclosures.]