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As investors in Bank of America (BAC -0.13%) watch its stock continue to drop in the wake of the U.K.'s vote to separate from the European Union last week, known as Brexit, it's tempting to get scared and flee. Let me explain why doing so is a mistake -- starting with the reasons Brexit is bad for Bank of America, and then moving to the reasons long-term investors shouldn't be concerned.
There's no question the turmoil ignited by the vote will be bad for Bank of America, as it will be for most banks -- and particularly for universal banks. In the first case, the heightened volatility in debt and equity markets will impact the North Carolina-based bank's trading and investment banking units.
It hits trading because Bank of America's institutional investor clients will be more inclined to stay on the sidelines as opposed to buy and sell securities when prices are in such flux. This will reduce the commissions the $2.2 trillion bank earns from coordinating trades between clients.
On top of this, companies that may have previously been inclined to go public or issue debt will be less likely to do so until things settle down. This will hit Bank of America's investment banking fees. Along the same lines, it's reasonable to assume business investment will drop, as future plans are put on hold until things settle back down. This will lower demand for loans, which is the primary product banks sell.
Interest rates are also now likely to stay lower for longer, which will continue to weigh on Bank of America's net interest income. For much of the past year, the Federal Reserve has intimated that it was in favor of raising interest rates. It made good on this in in December, raising the Fed funds rate by 0.25% -- this is the rate banks charge to lend their excess reserves held by the Fed to other banks.
In the period since, it was assumed the Fed would soon raise rates further, as the unemployment rate has dipped below the Fed's 5% target -- the official unemployment rate last month was 4.7%. However, all of this changed last week. Following a disappointing jobs report in May -- job creation was at its lowest level last month in more than five years -- the Fed backed away from insinuations that it was on the verge of raising rates again.
This is bad for Bank of America because higher rates would boost its interest income since a large proportion of its loan portfolio is indexed to prevailing interest rates. To put this in perspective, Bank of America would earn $6 billion more a year in net interest income if short- and long-term rates increased simultaneously by 100 basis points (i.e., one percentage point).
This is one of the main reasons Bank of America has failed to earn at least 12% on its equity in each of the past eight years, which matters because it marks the threshold between value creation and destruction. The other main reason -- unconscionably high legal fees -- have now been put to rest. Consequently, the one thing standing between Bank of America and respectable profitability will now remain in place for longer than previously anticipated.
If you were wondering why Bank of America's shares have consistently traded for a double-digit discount to book value even after most of its legal liability has been absorbed, this is it. It's also why the bank's shares are down more than twice the amount of the S&P 500 since the Brexit vote was announced last week.
To those of you who are still with me, this seems like a pretty dire scenario. And, to be clear, it's not good news. However, there are three important points to keep in mind.
The first is that Bank of America passed this year's stress test with flying colors -- the results of which, coincidentally, were announced on the same day of the U.K.'s vote to exit the E.U. This shows the bank has more than enough capital to survive an economic scenario that's even worse than the financial crisis. Rest assured, in other words, that Bank of America isn't going anywhere anytime soon.
Additionally, the results from the second part of the stress test will be announced this week -- on Wednesday. It's at this point investors are likely to learn that Bank of America has been given approval to raise its dividend and increase its share repurchase program. The latter will be particularly beneficial, given how cheap Bank of America's shares currently are.
It's also important to appreciate that Bank of America has more highly liquid assets on its balance sheet than ever before -- along the lines of $678 billion in cash and equivalents, according to Yahoo! Finance. This enables the bank to survive very severe disruptions in the funding markets, as the biggest threat to a bank isn't insolvency, but rather illiquidity.
Finally, Bank of America's competitive position among universal banks could improve as a result of the U.K. vote. Dick Bove, one of the leading analysts in the United States, made this point to me in a conversation last week. This follows from the fact that European universal banks are likely to lose market share as they fight to stay alive at the center of the proverbial storm.
When all is said and done, then, it's reasonable to think the future will include lower profits in the short and medium terms, but then higher earnings per share over a longer period of time. Thus, for long-term investors, the drop in Bank of America's stock price seems to present an opportunity to capitalize off of others' fears.
If you decide to go in this direction, you'll want to average into the position: Buy, say, a third of your allotment today, a third next week or month, and the final third a week or month after that. This will allow you to average down in the not-unlikely event Bank of America's stock continues to fall in the weeks and months ahead.
