DBRS: BAC’s 2Q14 Positive Underlying Business Momentum Remains in the Shadow of Legacy Issues

Summary:
• 2Q14 net income (to common) of $2.3 billion driven by another sizable litigation expense of $4.0 billion.
• While legacy issues remain a challenge, the core businesses continue to generally show positive momentum reflected in underlying metrics.
• DBRS rates Bank of America Corporation’s Issuer & Senior Debt at A (low) with a Stable trend.

In DBRS, Inc.’s (DBRS) view, Bank of America Corporation’s (BAC or the Company) 2Q14 earnings demonstrate positive underlying business momentum, with the Global Wealth & Investment Management (GWIM) and the Global Banking and Global Markets businesses both growing revenue year-over-year (YoY). Moreover, the Consumer & Business Banking (CBB) and GWIM businesses have returns on allocated capital above 24% highlighting strong performance.

Overall, revenue (excluding net DVA and gains on sales of debt securities) was modestly lower quarter-over-quarter (QoQ) and YoY. Nonetheless, income before taxes and provisions (excluding DBRS-adjusted litigation costs) was up strongly both QoQ and YoY on strong expense control. Asset quality also reflected good progress precipitating a $662 million reserve release, but future releases are expected to moderate.

Overwhelming this quarter’s results was the litigation (pre-tax) expense of $4.0 billion following the $6 billion incurred in 1Q14 (FHFA settlement and litigation reserve build). The 2Q14 litigation expense was driven by $3.8 billion net increase in reserves for legacy mortgage-related matters, including a settlement with AIG. As part of the settlement, the Company has agreed to pay AIG $650 million in cash and the terms include a withdrawal of AIG’s objection to the Bank of New York Mellon private-label securities settlement. DBRS views positively the Company’s willingness to reduce the uncertainty factor around the potential cost of legacy issues by working through various settlements and taking steps to mitigate the potential future cost by adding to its reserves. Importantly, the Company stated that it has now resolved about 95% of the unpaid principal balance of all residential mortgage-backed securities where securities litigation has been filed or threatened. Despite the significant litigation expenses incurred to date, DBRS notes that capital levels remain solid.

Demonstrating the strength of its global banking franchise, BAC reported strong investment banking revenues where record equity underwriting fees more than offset the QoQ decline in debt underwriting. Markets businesses were weaker QoQ, but were above expectations reflecting the difficult environment. Indeed, lower volatility, volume and client activity resulted in softer equities revenues. Meanwhile, FICC revenue was improved QoQ, but still constrained. Looking ahead, DBRS expects that lower client activity levels will likely continue to pressure net revenues sector-wide.

CBB had a robust quarter from the customer activity perspective with strong credit improvement, but revenue was roughly stable. GWIM continued to post solid results driven by record asset management fees, as client balances of nearly $2.5 trillion reached record levels. With controlled expenses, the Company maintained a solid pre-tax margin of 25.1% in GWIM.

Supporting its funding profile, the Company continues to attract deposits, which reached a sizable $1.13 trillion (close to 59% of total liabilities). However, the challenge remains in deploying these deposits, as loans declined to $912 billion in the quarter (nearly half of the decline was due to a bulk nonperforming loan sale).

BAC’s financial profile remains solid with growing liquidity and an estimated fully phased-in Basel III Common Equity Tier 1 ratio of 9.5% under the standardized approach, and an estimated supplementary leverage ratio in excess of the 5% requirement at the holding company-level and 6% at the bank level.

DBRS rates Bank of America Corporation’s Issuer & Senior Debt at A (low) with a Stable trend.

Note:
All figures are in U.S. Dollars unless otherwise noted.