Bank of America's Q2 Earnings: One of Its Best Performances Since the Financial Crisis

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Bank of America (BAC 1.67%) put more distance between itself and the financial crisis on Monday, reporting what amounts to its third-highest quarterly profit in the past five years. The performance was especially impressive given the inhospitable environment confronting banks.

The North Carolina-based bank earned $4.2 billion, or $0.36 per share, in the three months ended June 30. That was below the $5.1 billion it earned in the year-ago period, but nevertheless above analyst expectations. The average estimate of analysts polled by Yahoo! Finance called for earnings per share of $0.33.

"We had another solid quarter in a challenging environment," said chairman and CEO Brian Moynihan in prepared remarks. "Our responsible growth strategy led to improved customer and client activity, and each of our four business segments reported higher earnings than the year-ago quarter. We also moved closer to our longer-term performance targets."

Based on its bottom line, Bank of America's performance last quarter was one of its best since the financial crisis. The only exceptions are the second and third quarters of last year -- it also earned more money in the third quarter of 2011, but that was due to accounting adjustments and one-time gains on sales that boosted its profits by a net $7.6 billion.

Data source: Bank of America. Chart by author.

The results buttress claims that Bank of America has finally turned the corner, after absorbing more than $200 billion in excess legal, credit, and operating costs related to the 2008 crisis. There are two tangible reasons to believe this is the case. First, a court order last year reduced Bank of America's outstanding legal liabilities by $7.4 billion and stymied the inflow of new claims by a factor of 10.

And in the most recent quarter, Bank of America shuttered its legacy assets and servicing segment, its "bad bank," which was responsible for disposing of toxic and non-core assets. The unit had recorded $44 billion in net losses in the years from 2011 to 2015. At its peak, it employed the equivalent of 54,000 full-time employees, including contractors.

Despite these developments, Bank of America is still far from where its executives and shareholders want it to be in terms of profitability. Its return on assets in the second quarter was 0.78%. This is meaningfully below Bank of America's 1% target, a commonly cited benchmark used to distinguish between banks that create value for shareholders and those that destroy shareholder value.

Low interest rates have now become the $2.2 trillion bank's principal problem. Despite a slight uptick in short-term rates last December, after the Federal Reserve increased the Fed Funds rate by a quarter of a percent, Bank of America's net interest margin fell to 2.03% in the quarter, down from 2.05% in the first quarter and 2.37% in the second quarter of 2015. This measures how much Bank of America earns from its portfolio of loans and fixed-income securities.

Data source: Bank of America. Chart by author.

Whether the bank can reach its profitability targets without higher rates is debatable, but there's no question that it would benefit more than many of its peers from an eventual rise. In Bank of America's latest quarterly filing with the SEC, it estimated that it will earn $6 billion in added net interest income if short- and long-term rates increase by 100 basis points, or 1%. That's roughly twice the boost that JPMorgan Chase (JPM 1.18%) would see in the same scenario.

This isn't to say, however, that Bank of America's earnings won't continue to improve. "The question is, can we grow earnings without rates improving?" Moynihan said on its earnings call. "We believe we surely can."

To do so, the bank will focus on three areas: increasing noninterest income, reducing costs, and carefully managing risk. To this end, Moynihan revealed a new cost-cutting initiative, designed to reduce costs from $57 billion last year to $53 billion a year by 2018. This is on top of the $15 billion in annual cost savings that Bank of America has already achieved since Moynihan took over as CEO.

One of the highlights of the bank's performance last quarter was its trading revenue, which increased by 14% compared to the same period last year. There were concerns that the Brexit vote on June 23 might weigh on trading operations, as was the case in the first quarter, but just the opposite occurred. The day following the vote was Bank of America's busiest equities trading day since the crisis. The same trends fueled trading profits at JPMorgan Chase and Citigroup, which reported year-over-year increases of 23% and 15% in their respective trading units.

It's also worth noting that Bank of America made it through the annual stress test in the second quarter. It was the first time in three years that it passed the test without having to resubmit its capital plan. Bank of America thus got the go-ahead from the Federal Reserve to boost its dividend by 50% and repurchase $5 billion worth of common stock over the next 12 months. It was only the second time since the crisis that it has increased its quarterly payout.

For investors, there's no question that Bank of America is headed in the right direction. Last year was the first time since 2008 that the bank has reported respectable earnings in four consecutive calendar quarters. And while its first-quarter results this year were hit by lower trading profits, the rebound in the second quarter should put investors at ease.

The big question going forward is whether Bank of America will be able to earn its cost of capital (a return on equity of around 12%, or roughly double its current profitability) in an environment that's especially hostile to bank profits. There's no telling how long interest rates will stay low -- they've been near zero in Japan for two decades. Additionally, the nation's biggest banks are subject to increasingly onerous capital and liquidity requirements passed since the crisis that weigh directly on their bottom lines.

These struggles aside, I nevertheless remain bullish on Bank of America's stock, thanks largely to the fact that its shares trade for a 40% discount to book value. That's too large of a haircut given the bank's progress since the crisis, the fruits from which are now starting to be reflected more consistently on the bottom line.