DBRS: BAC Cleaner Quarter Gives Visibility to Improved Core Earnings; Expenses Still Declining

Summary:
• 2Q net income (to common) of $5.0 billion significantly improved from 2Q14’s $2.0 billion and 1Q15’s $3.0 billion primarily driven by lower legal costs and overall expenses.
• Reduction of long-term legal risk was evidenced by dramatically lower rep/warranty outstanding claims, new claims, and range of possible loss due to a favorable court decision confirming the starting point of the statute of limitations.
• 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) 2Q15 financial results reflected further progress in reducing expense and litigation costs, while putting legacy issues behind. Importantly, after years of focusing on the cleanup of legacy issues, DBRS now believes that BAC’s core businesses are well-positioned for growth. DBRS notes, however, that the consistent generation of revenue, asset, and earnings growth remains the primary challenge for the Company, especially given a slow growth economy featuring low interest rates and high regulatory costs. In 2Q15, expenses were well-controlled, credit performed well and the balance sheet strengthened with higher levels of both capital and liquidity. These trends are more pronounced when viewed on a multi-year basis and could be positive rating drivers if the Company is able to produce consistent revenue growth from its businesses.

DBRS continues to see BAC’s primary challenge as generating organic revenue growth. Total revenues (DBRS adjusted to exclude securities and equity investment gains, market-related NII and DVA adjustments) declined 1.3% compared to 1Q15 and were flat relative to 2Q14. Total loans and leases were up modestly over the quarter with solid increases in C&I and CRE, somewhat offset by a reduction in the discretionary mortgage loan portfolio, as well as runoff in Legacy Assets & Servicing (LAS). Also noteworthy in the quarter was the 2.5% ($8.1 billion) increase in debt securities (fair value) continuing the trend over the year of shifting investment assets from whole loans to HQLA-eligible securities and contributing to liquidity. BAC also reported 0.99% ROA, 8.75% ROCE and 12.78% ROTCE metrics in the quarter that also signal the Company is moving to more normalized performance levels.

For the 18th consecutive quarter, BAC reported lower core expenses (ex-litigation), which has been the primary driver for the improved results including positive operating leverage and core net revenue growth both year-on-year (YoY) and quarter-on-quarter (QoQ). At $13.8 billion in the quarter, expenses were well-controlled falling (ex-litigation) 6.2% over the prior year period and 11.1% over the quarter from further optimization benefits and reduced LAS costs. FTE staffing levels that have declined 7% over the year and 1.4% over the quarter and continued branch reductions contributed to the cost saves. Litigation also declined from $4 billion in 2Q14 to $0.2 billion in 2Q14. While the downward expense trend in LAS is expected to continue, the Company continues to invest in its businesses and the upcoming CCAR resubmission is expected to temporarily elevate some costs.

Asset quality generally continued to improve, but DBRS views credit as having likely bottomed and therefore provisioning needs are expected to modestly increase in 2H15. Also relating to risk, DBRS notes that average trading-related assets in Global Markets were relatively flat over the quarter at $443 million, but average VaR declined 11% to $55 million in the same period. Another signal of receding risk was the 27% reduction in rep/warranty outstanding claims and 93% decline in new claims. This was due to a NY Court of Appeals ruling during the quarter confirming when the statute of limitation claim period begins. As a result, BAC also halved the upper end of its range of possible loss estimate to $2 billion at 2Q15.

BAC’s financial profile remains solid with growing liquidity. Specifically, the Company’s estimated fully phased-in Basel III Common Equity Tier 1 ratio was stable at 10.3% under the standardized approach and increased from 10.1% to 10.4% under the advanced approach. Modifications to its credit models requested by regulators in order to exit the parallel run are estimated to reduce the advanced approach CET1 ratio to 9.3% and DBRS believes will likely precipitate further capital retention and/or RWA reduction to raise the ratio. DBRS also notes that long-term debt rose a modest $5 billion to $243 billion in 2Q15 with well-laddered future maturities. On the liquidity front, BAC’s global excess liquidity sources rose $6 billion to a record $484 billion and represented a 40 month time to required funding.

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.