The coronavirus pandemic has been particularly scary for bank stocks. Banks are heavily influenced by the state of the economy, so when the economy struggles, hard times and loan losses can follow. And investors haven't forgotten the role banks played in the Great Recession.
As the second-largest bank in the country, with exposure to broad swaths of the economy, Bank of America (BAC 1.70%) is inevitably at the crux of investors' concerns. Let's take a look at how risky Bank of America's stock is roughly eight months into the pandemic.
Image source: Bank of America,
Prepared for loan losses
Let's start with credit quality, because bad loans are one of the main issues that can sink a bank and its stock price.
As the coronavirus has upended lots of industries, borrowers in those industries have become more likely to default. Bank of America has had to set aside capital to prepare for large amounts of loan losses. Through the third quarter of 2020, the bank had reserved roughly $19.6 billion for future potential losses across the entirety of its loan book, including credit card loans made to consumers, loans to small businesses, and loans for commercial real estate. This $19.6 billion represents 2.07% of Bank of America's total loan book.
These losses have not come to fruition. Net charge-offs (debt unlikely to be collected and a good indicator of actual loan losses) through the third quarter of 2020 only represented 0.40% of total loans, which is a solid charge-off rate in normal economic times. Thanks to government intervention, net charge-offs have stayed low. Regardless, if the losses that Bank of America is currently projecting end up materializing, the bank has the money ready to cover them. And because of the way loan-loss provisions are recorded on the income statement, the bank has already absorbed the negative impact on earnings.
What if things get worse?
But what if Bank of America's team ends up with more loan losses than they're currently reserving for? After all, the economic situation is still pretty murky, so who's to say things won't get worse?
The Federal Reserve actually asks this question, too. It puts the largest U.S. banks through a series of hypothetical and typically adverse economic scenarios to see how their balance sheets would hold up in these situations. Earlier this year, the Fed put banks through a "severely adverse scenario" where unemployment reaches 10% and real gross domestic product (GDP) contracts by 8.5% by the third quarter of 2021. As it turned out, unemployment in October was 6.9% and real GDP contracted 3.5% between the end of 2019 and the end of the third quarter of this year.
In the Fed's "severely adverse scenario," Bank of America would sustain loan losses of $47 billion, which is equivalent to 4.7% of its total loan book and more than double what the bank has currently reserved for. Remember, the bank has about $19.6 billion already set aside for losses, so if that severely adverse scenario plays out, it would need to set aside another $28 billion.
On the bank's third-quarter earnings call, CFO Paul Donofrio said the bank has a $35 billion capital cushion above its regulatory capital requirement. That capital can specifically be used for unexpected loan losses if the bank needs it. Also, the bank can dip below its regulatory capital requirement and still operate from a position of strength. But at that point, regulators would be watching the bank closely, and the bank might need to consider trimming its dividend or suspending share repurchases if its capital ratios got low enough.
Still, all of this makes me feel very good about Bank of America's capital position. Additionally, although the bank still has some loans on deferral because of the pandemic, CEO Brian Moynihan said the majority of these are residential mortgage loans where the borrowers have already put in a good amount of equity.
Is the stock price risky?
I think Bank of America has already experienced the brunt of the pain from the pandemic. If a second stimulus bill isn't passed, the bank may need to build reserves again. If a vaccine for the virus doesn't prove effective, that could obviously cause more pain at the bank. But Bank of America is prepared to cover double the amount of loan losses it's currently projecting.
Additionally, I don't think the economic outlook will get as uncertain as it was in the first or second quarter of the year. Trading slightly above book value as of this writing, Bank of America's stock likely has way more upside than downside in the long term.
