Bank of America’s Breakout Quarter

Since the recession, the banking industry has pressed on to find its footing. With Bank of America (BAC 1.53%) at the center of the legal universe the outlook was bleak for righting the ship.

As quarterly earnings reports continue to trickle in, it appears that America's second largest bank by assets had an outstanding past quarter. Has B of A finally turned a new leaf?

A full transcript follows the video.

Kristine Harjes: A breakout quarter for Bank of America? This is Industry Focus.

Hello! Happy Monday, everyone! This is Kristine Harjes for The Motley Fool and I am pleased to welcome back John Maxfield to the show. Today we're going to dive into the most interesting story to come out of this quarter's bank earnings season, which is Bank of America. The quarter was dramatically different than previous ones have been for this bank that has really struggled since the recession.

Let's talk about what numbers stood out, which ones matter the most, and whether this is just the beginning of a new era for Bank of America -- which is, by the way, the United States second biggest bank by assets. Let's kick it off by talking about the earnings' numbers itself. Quarterly pre-tax earnings were $7.5 billion, which was the bank's best performance since the financial crisis. Anyone that follows the bank news, this was outstanding performance.

The bank has really been struggling since the recession and reporting downright disappointing earnings in at least half of the quarter since 2009. John, does this recent quarter mark the end of a trend?

John Maxfield: That's the question. If you go back to 2008 when the entire financial crisis started and the credit markets froze, much to its chagrin, Bank of America purchased Countrywide Financial. That was also the same year they purchased Merrill Lynch. Ever since then, Bank of America has really struggled to compete against their better competitors like Wells Fargo and J.P. Morgan Chase. Just to turn a profit they've had upwards of $100 billion in various types of settlements and legal judgements.

Their efficiency ratio -- which shows how much money they spend to operate the business relative to the amount of revenue that they generate -- has been much higher than Wells Fargo or J.P. Morgan Chase. All of these things have contributed to much lower profitability than you would expect from the second biggest bank in the biggest economy in the world. This most recent quarter seems to mark a dramatic departure from Bank of America's post-crisis performance.

Harjes: Let's talk more about the efficiency ratio that you just mentioned. In this quarter they just reported earnings on, the efficiency ratio was 62.5%, which is getting pretty close to that sub-60% that bank investors want to see. We talk about this metric all the time. John, can you remind our listeners what the big deal is about efficiency?

Maxfield: One way to interpret the efficiency ratio is that it's a measure of how much it costs a bank to generate each dollar of revenue. If a bank's efficiency ratio is 62.5% as was Bank of Americas in the most recent quarter that means it cost Bank of America 62.5 cents to generate every dollar of revenue. Another way to look at that is there's roughly 38 cents leftover to set aside for future loan losses via provisions, to pay taxes, then to either distribute to shareholders via dividends or share buy backs, or to allow to fall to the bottom line on the balance sheet to accrue to the bank's book value; to increase the bank's book value.

It's a critically important metric because in an industry as competitive as Bank of America -- and this is something that Warren Buffett has spoken of in the past -- you have to either have a niche assortment of products like a New York Community Bancorp does, or you have to be a low-cost producer. Then when you dig in a bit further and you look at the important of the efficiency ratio it's not just that a bank is spending less money than its competitors to generate each dollar of revenue; but we've also seen there's an appearance of a direct correlation between a bank's efficiency and their underwriting disciplines.

Banks that are more efficient tend to have the discipline to write better loans. That's really important because right now not many loans are going bad, but once the economy goes into another recession -- which will happen at some point in the future -- when that happens you have loan losses go way up. That's particularly bad for banks that have bad underwriting disciplines. You're having the operating cost savings, but you're also saving yourself money by having a low efficiency ratio; presumably on the loan side.

Harjes: Do you think Bank of America is ever going to catch up to some of these banks that are able to achieve a really low efficiency ratio? You've got New York Community Bancorp which is around 43%. Then you've got US Bancorp, Wells Fargo who is in the mid-50s; does Bank of America stand a chance of catching up to them?

Maxfield: You talk about New York Community Bancorp, and I think their efficiency is around 43%, or 44% which means the majority of the money they bring in the front door actually then falls to the bottom line, or finds its way to shareholders. It's pretty remarkable. It's in a very niche market though. It serves principally large owners of multi-family buildings in the New York City metropolitan area. What that means is it can have fewer branches, and each loan that it makes is much larger, but it still only takes the same amount of people.

They're able to be operated much more efficiently than a Bank of America that has 1000s of branches spread from coast to coast. Again, to your point, a much better analogy is a J.P Morgan Chase, or Wells Fargo because these are very similar on a global level. They have your investment banking sites, but you also have these large consumer banking sides and it's the large, branch franchise that requires so much expenses. We know that it's able to run a network like that more efficiently than Bank of America has in the past because Wells Fargo has. The question then is: can Bank of America match Wells Fargo?

At least for the near future I don't think it will ever match Wells Fargo's efficiency, because Wells Fargo has been more efficient than Bank of America for many, many decades. I think Bank of America can get down very close to Wells Fargo because Wells Fargo has proven it can be done. Despite all the problems over the past few years Bank of America is run by brilliant people. It's staffed by brilliant people.

There's no reason to think that given the opportunity, once revenue increases relative to expenses, they could drop that efficiency ratio down to a 'Wells Fargo' level. Not necessarily down to it, but close to it.

Harjes: They seem like they are on the right track. If you want to pivot to another metric where the bank shined this past quarter, let's talk about return on assets. That came in at 0.99% which is just shy of the 1% threshold. What is the big deal about this over-under 1%?

Maxfield: If you're a bank investor this is a really important threshold to keep in mind. The 1% return on assets means on an annual basis, if you take your annual income, divided by the assets on a bank's balance sheets it will equate to 1%. This is important because most banks are leveraged by a factor of 10:1. When you put that in the math engine and it spits out a number; that means the return on equity. On a return on assets of 1%, your return on equity is generally going to be around 10%.

It's not going to be perfect, but it's going to be round 10%. It's that 10% threshold that matters because that equates to a bank's implied cost of capital. If a bank can earn more than 10% on its equity -- more than 1% on its assets -- that means it's creating value for its shareholders. Whereas if it earns less than 1% on its assets and less than 10% on its equity that means it's destroying value for its shareholders. That is a critical threshold. The other thing to keep in mind with that threshold is; because it differentiates between creating and destroying value, it also has a tendency to dictate the valuation of a bank's stocks.

If you look at Wells Fargo, or US Bancorp, or J.P. Morgan Chase; all these banks generate more than 10% on their equity, and thus more than 1% on their assets. All of their shares trade for a premium to book value. Whereas you look at Bank of America or Citigroup where both of the banks have struggled to return 1% on their assets since the financial crisis; both of their stocks are trading for a discount to book value. In large part, that's a direct result of those profitability figures.

Harjes: Really interesting. One more thing I want to touch on was the awesome article you wrote last week. I wanted to bring it up on the show for anyone who didn't see it. It was called Two Reason to Believe Bank of America Has Finally Turned the Corner. In it you pointed out two more ways which we haven't touched on yet, where Bank of America really shined this quarter. Let's first look at the bank's legal troubles. Why does that particular trend have you excited?

Maxfield: Let me just say it was an excellent article. Normally I wouldn't toot my own horn, but it was really good.

Harjes: If you do say so yourself.

Maxfield: I know it's horrible for me to say that. I'm talking to the current perspective of Bank of America shareholders. If you have a position as the bank I do strongly recommend that you read the article.

Harjes: I can vouch for him. It was well done.

Maxfield: Thank you very much. The first thing I talk about in there is this dramatic decline in their litigation expense. During the second quarter Bank of America had a good quarter on its own, but there's also a development in the legal world. If you go back to the financial crisis, Bank of America has been plagued by representation and warranty claims. These are legal claims that are associated with Bank of America's mortgage business and the whole mess they acquired with the Countrywide Financial acquisition.

If you go to a Best Buy and you buy a refrigerator and you bring that refrigerator home and you have a problem with it -- some sort of manufacturer defect -- what do you do? You take that refrigerator back to Best Buy, you return it, and you get your money back. The same concept applies in the financial industry. What banks do nowadays is, as opposed to originating a mortgage -- I'm going to buy a house so I go to a bank and get a mortgage -- that bank originates that mortgage, but then it doesn't keep it on its books. It then sells it to institutional investors like Fannie Mae, Freddie Mac, or insurance companies, university endowments, hedge funds and so on.

If that mortgage then goes bad and the investor that bought that mortgage can trace it back and say "The origination standards under which this mortgage was underwritten were faulty." They will take that back to the bank that underwrote that mortgage and return it. That's a representational warranty lawsuit. This is what has caused Bank of America tens of billions of dollars since the financial crisis. In the second quarter there was a court case from New York's highest court that said "Any representation and warranty lawsuit must be brought within six years after the sale of the mortgage, or the sale of that asset was made."

What that has allowed Bank of America to do is lop off $7.5 billion worth of outstanding legal representation and warranty claims that were existing, but had been brought after that six year time frame. What this now allows Bank of America to do is put a ring fence around its liability at this point for those types of claims, and because those have been the biggest drag on its earnings; that's now freed up going forward. That's a huge thing for Bank of America.

Harjes: That is great news for them. The other thing you mentioned in this "Two Reasons" article was the tone of CEO Brian Moynihan. What was it you picked up on in the conference call?

Maxfield: I listen to Bank of America's conference calls, or read their transcripts every quarter and I have for the past four years. For the most part, Brian Moynihan has done what he needs to do. He's a really smart guy and knows way better than I do what to with a bank, but he's focused a lot on Bank of America's expenses because that has really been the bank's problem. When you look at his comments you'll have two or three paragraphs of prepared remarks talking about expenses on past conference calls. In his most recent one he only talked about expenses for three sentences in his prepared remarks.

He took all that other conversation that he would have been talking about it and shifted that over to talking about ways that it's going to generate revenue. Hiring new advisors for its branches, investing in technology; all of these other things. What was so striking about this was, the magnitude of the switch. He didn't gradually move over into a paragraph of expenses, a paragraph of revenue generation, it was basically a wholesale [...] of conversation about expenses and then replaced that with all this revenue talk.

To me, on top of that litigation news, it could be evidence that Bank of America has finally passed that threshold and put the financial crisis in the rearview mirror, for the most part.

Harjes: Awesome. We are almost out of time, but I want to bring up one more thing because it's so interesting to hear you singing Bank of America's praises this quarter. Anyone that's been following your coverage of the bank -- myself included -- has heard nothing but the bear case.

How ridiculously high legal expense is, a culture that's shown through multiple past crisis of poor discipline when it comes to credit risk, a blue it expense base -- which you can see in the awfully high efficiency ratio -- and all in this competitive industry with really well run banks like the ones we already mentioned. Like J.P. Morgan, Wells Fargo, US Bancorp. After all this Bank of America has always seemed like you'd paint it as a second, or even third tier bank. Has your outlook truly changed, or is your excitement just about this single quarter?

Maxfield: I hate to say it, but I think my outlook has changed. I know that people say "John's a flip-flopper." In my opinion, not only have the facts lightly changed for all the reasons we just talked about, but I've also spent some time digging into Bank of America's performance in the 1980s. In the 1980s they had three successive years of losing money. After that it was able to turn its operations around.

To put that into perspective, even in the financial crisis the bank didn't have three successive years of losing money. If you look back in the '80s you have these three successive years of losing money, and then after that it not only recovered, it went on to earn more money than it had ever earned before. What that made me realize was, in a bank recovery from a significant event like this, once the legal issues are cleaned up, once the bad loans are cleaned up the bank's profitability can literally skyrocket almost overnight.

It just gave me an entirely new context through which to think about what it looks like for a bank like Bank of America to recover from a crisis like the financial crisis. It just made me realize that maybe I'd been overly pessimistic about its future in terms of profitability.

Harjes: I'm going to go ahead and give you another endorsement and say: that is the sign of a disciplined mind. Taking this new information and revising your opinion on a stock. Don't let it go to your head. Let's face it; companies are dynamic, things change, and let's hope things continue to change in a positive direction for Bank of America.

John, thank you so much for distilling this past quarter's earnings and pulling out so many great points and having the flexibility to take it all in and maybe revise what you had previously thought about the bank. Folks, be sure to check back in to Fool.com for more coverage on Bank of America and many other bank stocks.

As always people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against. So, don't buy or sell stocks based solely on what you hear.