What Drives A Bank of America Recovery?

By Stephen D. Simpson, CFA | October 20, 2010 AAA

Like most other major U.S. banks, Bank of America (NYSE:BAC) is managing to deliver successively less-worse quarterly reports. Credit is getting better and the securities markets are closer to back-to-normal. What is not so clear, though, is what horse Bank of America is going to ride back to prosperity. After all, less-bad can only power a turnaround story for so long.
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The Quarter That Was
Due in part to better credit conditions and sizable loan loss reserve releases, Bank of America beat on the bottom line while missing slightly on the top line. Revenue rose 2% from last year, but fell more than 8% on a sequential basis, led in part by a 4% sequential decline in net interest income. Although revenue from card services did drop sequentially, investment banking did a little better.

Within the numbers, the details for Bank of America are basically just as mixed as they were for Citigroup (NYSE:C) and likely will be for Wells Fargo (NYSE:WFC). On the positive, credit quality continues to improve, and the company released nearly $2 billion from reserves. Likewise, the company set aside less for anticipated repurchases of bad mortgages. On the other hand, total loans fell over 3% sequentially and the company saw less fee income as new banking regulations have gone into effect and reduced this revenue stream.

The Road Ahead
The real trick for Bank of America is to prove to investors that it can make money again in the future. That might not be as easy as it sounds. It is unlikely that the mortgage market is going to return to a semblance of normal for years, and there is the popular belief (as yet unproven) that consumers are going to be more responsible with personal debt in the future. Add to that the eternally competitive investment banking and trading markets (and fierce rivals like Morgan Stanley (NYSE:MS) and Goldman Sachs (NYSE:GS) and the fact that the U.S. is "over-banked", and suddenly that weak net interest income trend becomes a little more relevant. (For more, see The Evolution Of Banking.)

By the same token, it has to be seen as somewhat normal for banks to struggle while the economy struggles. Eventually businesses will get the loans they need to expand and eventually consumers will feel more comfortable about spending again. While new bank regulations are going to curtail some old sources of profits, bankers are creative, and it seems likely that they will find new ways to benefit from lower credit costs and drive expenses out of the business.

The Bottom Line
Bank of America probably will not see the sorts of returns on equity that they realized in the early 2000s soon, if ever again. That does not mean the stock is doomed, though. The current valuation on the stock seems to suggest that the bank is either going to lose a substantial piece of its equity to further writedowns or its future return on equity is going to be stuck in the 6-7% range. Even modest outperformance over the next three to five years (like, say, 9% ROE) could make Bank of America's stock a winner for patient investors, even if the near-term outlook is sluggish and uninspiring. (For related reading, check out How Do Banks Determine Risk?)

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