DBRS Comments on Bank of America’s 2Q13 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 Issuer & Senior Debt Rating of “A” and its R-1 (middle) Short-Term Instruments Rating, are unchanged following the announcement of the Company’s 2Q13 results. Bank of America’s ratings continue to 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 operating banks with short-term ratings of R-1 (middle). DBRS’s intrinsic rating for Bank of America remains at A (low) indicating that it benefits by one notch as a result of the application of the rating floor in the U.S. On July 8, 2013, DBRS announced that it is assessing the applicability of rating floors for CIBs on a country by country basis over the next 90 days.

Bank of America reported higher net income of $4.0 billion for the quarter, up substantially from $1.5 billion in 1Q13 and $2.5 billion in 2Q12. Improved net income over the quarter primarily reflected good expense discipline, the absence of large legal settlements and their associated expense, security sales gains, and lower credit costs that were only partially offset by lower net interest income and noninterest income.

In DBRS’s opinion, Bank of America’s 2Q13 financial performance reflected good underlying business line momentum, improved credit metrics, strong commercial loan growth and reasonable average deposit growth. Quarterly disclosures also underscored, however, that the Company’s performance remains pressured by improving, yet still high expenses, elevated legacy costs, and a slowing mortgage business. Positively, the Company continues to make incremental progress in putting its legacy issues behind it. DBRS believes that Bank of America will continue to absorb elevated costs primarily related to its legacy mortgage business over the medium term through earnings. Meanwhile, the Company’s challenge remains growing core revenue in a difficult operating environment featuring low interest rates, constrained capital markets activity, increased competition, and expense pressures. The Company was able to generate positive operating leverage in the quarter and year-over-year (on a DBRS-adjusted basis), as the Project New BAC expense reductions appear to be effective. While DBRS is also cognizant of improvements in Bank of America’s balance sheet, the Company’s core recurrent earnings power and franchise strength are key drivers for its intrinsic rating level. Positively, for fixed income investors, the Company continued to strengthen its balance sheet with mostly improved capital levels, ample liquidity, better asset quality, and reduced litigation exposure.

DBRS-adjusted Company-wide net 2Q13 revenues were $22.2 billion, down 2% from 1Q13, but up 3.5% from 2Q12. Income before provisions and taxes (IBPT; DBRS’s core earnings power metric adjusted for DVA, FVO, securities gain/loss, one-time gains, and unusual expenses) was $6.2 billion, a 15.5% improvement from 1Q13 and 46.6% better than 2Q12, primarily reflecting expense savings. DBRS notes that the loan loss provision, down to $1.2 billion in the quarter, accounted for a normalized 20% of IBPT in 2Q13 and highlights the healthiest relationship between revenue and credit costs since 1Q08.

Reflecting positively on underlying business trends, revenue improved in four of the six business segments in the quarter with only the Global Market (GM) segment declining 14% or $680 million, coming off a strong 1Q13. Moreover, GM experienced challenging market conditions for the FICC business in the latter part of the quarter given higher interest rates. Sequentially, net income was mixed with four segments reporting improvements (CRES still loss-making but improved), while the GM and Consumer & Business Banking segments were down.

DBRS notes that Global Wealth & Investment Management had record net income, another quarter of long-term AUM inflows, and increased FA productivity. Consumer & Business Banking reported continued good deposit growth, higher auto balances, and increased credit/debit card volume, while CRES LAS had lower expenses. Global Banking results were solid with strong commercial loan growth and investment banking fees. Lastly, GM saw gains in its equity business, was able to reduce expenses, and took less risk overall with lower VaR in the quarter. In terms of global 1H13 net investment banking revenue, Bank of America retained its second place ranking. Within the U.S., performance was mixed among products 1H13 vs. 1H12, but the Company continues to maintain top tier rankings across many products.

DBRS-adjusted expenses declined 12% over the quarter and 6.0% over the year primarily reflecting cost savings from Project New BAC. Management continues to guide for material savings by FYE2013 including an estimated 4Q13 Legacy Assets & Servicing expenses (excluding litigation) of $2.0 billion or less compared to $2.3 billion in this quarter. DBRS notes that some other tangible indicators of cost cuts include a 2.1% reduction in FTE headcount over the quarter (primarily LAS and consumer deliver network) and a 61, or 1.1%, branch decline through closings or sales.

Mortgage banking income declined 6.7% quarter-over-quarter (QoQ) to $1.2 billion in 2Q13, as the $128 million decline in servicing income from the sale of MSRs and the $97 million decline in MSR valuation were only partially offset by the $53 million decrease in the rep/warranty provision and $45 million increase in core production revenue. Loan production continued to ramp up, growing 5.7% over the quarter and 40% over the year, but the industry experienced margin compression impacting production revenue and a slowdown is expected as the pipeline decreased 5%. Given the rise in interest rates and competitive dynamic, DBRS expect further pressure on production and margins, but notes that the Company has employed more mortgage loan officers to generate volume. Following the aforementioned MSR sales, the servicing portfolio of $759 billion (5.3 million loans) was down 20% from 1Q13 and 38% from 2Q12.

Overall, the rep/warranty reserve decreased $100 million, to $14.0 billion in 2Q13, relatively stable after the May 2013 MBIA settlement. Bank of America’s new and outstanding rep/warranty claims have dropped precipitously after the January FNMA and MBIA settlements, which should reduce future rep/warranty provisioning needs. Nonetheless, with $16.6 billion in outstanding claims (84% private label), additional future settlements could still generate lumpy results. Additionally, the Company maintained its reasonable estimate of a range of possible loss (RPL) for rep/warranty exposures at up to $4 billion (primarily for non-GSE exposure) above current accruals. DBRS notes that while uncertainly remains as to the final cost of resolving the remaining private, monoline and GSE exposures, litigation and pending settlements, the Company has removed a substantial amount of uncertainty around its litigation and rep/warranty exposures.

During the quarter, credit quality continued to improve at a good pace across nearly all asset classes. Moreover, Company-wide net charge-offs (NCOs) were down over 16% during the quarter to $2.1 billion, or 0.94% of average loans, down 20 bps from 1Q13. DBRS notes that NCOs were below 100bps for the first time since 2006. Given the improvement, Bank of America released $900 million in reserves, as the provision for credit loss decreased $502 million (29%) to $1.2 billion. DBRS notes that the Company guided to a $2.0 billion or less 3Q13 NCO level and anticipates more reserve releases particularly on consumer real estate assets. Bank of America reported another quarterly decline in near-term U.S. credit card delinquencies and its fifteenth consecutive quarterly decline in commercial reservable criticized utilized exposures, which were down 0.5%. Meanwhile, non-performing assets declined 6.8%, or $1.6 billion, to $21.3 billion, and 90 day past dues (but still accruing and excluding fully-insured loans) fell $209 million or 9.5% to $2.0 billion.

Liquidity and funding also continue to be maintained at substantial levels with $342 billion in global excess liquidity on Bank of America’s balance sheet (down $30 billion over the quarter). Moreover, the Company benefits from having strong deposit franchises within its diverse businesses, which generally continue to generate significant inflows. Lastly, the time to required funding increased to 32 months in the quarter (with parent company excess liquidity at $95 billion) from 29 months. The Company indicated that it expects to remain above the 24 month level over the next 4 to 6 quarters, which should help bolster profitability with more assets deployed. DBRS also notes that Bank of America reduced its 2Q13 long-term debt (LTD) by $18 billion to $262 billion, as maturities continue to outpace issuance, and management expects this dynamic to continue through the end of 2014.

Bank of America continued to grow its capital metrics through retained earnings and lower risk-weighted assets. Specifically, the Company’s Basel I Tier 1 common ratio was 10.83% at 2Q13, or 34 bps above the 1Q13 figure. Meanwhile, Bank of America estimated its fully phased-in Basel III Tier 1 Common Equity Ratio to be 9.60% (based on the Advanced Approach under rules issued July 2, 2013), an improvement from 1Q13’s 9.52%. Positively, the tangible common equity ratio also increased 10 bps over the quarter to 6.98%, which was notable given the 32 bps negative impact of higher interest rates on OCI. Separately, DBRS also notes that due to the redemption of $5.5 billion in preferred shares this quarter, preferred dividends are expected to decline from $441 in 2Q13 to $280 million in 3Q13 and then $260 million per quarter going forward.

On July 9th, U.S. regulatory agencies proposed a rule requiring a supplementary leverage ratio of 5% for the largest bank holding companies and 6% for their banking subsidiaries to be considered “well capitalized” phasing in to be fully effective on January 1, 2018. Bank of America estimates its supplementary ratio at 4.9% to 5.0% at 2Q13. Additionally, the Company’s primary bank and credit card subsidiaries were both in excess of the proposed 6% minimum.

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

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