The fact that Bank of America (NYSE:BAC) isn't likely to outperform Wells Fargo (NYSE:WFC) over the foreseeable future shouldn't come as a shock to anyone. What may be more surprising, however, is the possibility that Bank of America may never be able to match Wells Fargo's profitability.
This boils down to a single line item on the two banks' balance sheets: goodwill. "Goodwill is the purchase premium after adjusting for the fair value of net assets acquired," Bank of America explains in its latest 10-K. It materializes when one bank acquires another bank for more than the latter's book value, with the goodwill recorded by the purchaser reflecting the premium paid.
While goodwill is typically a nonissue in most industries, the same cannot be said of banking. This is because banks are nothing more than leveraged funds. They take a small sliver of capital, leverage it up with borrowed money, and then use the combined proceeds to buy interest-earning assets. Holding all else equal, the larger the leverage, the bigger the return on equity.
Furthermore, because federal regulations cap the amount of leverage an individual bank can use, it's critical to get as much out of each dollar in assets as possible. For example, let's assume that two banks of equal size can each hold a maximum of $100 million in assets. If one of the banks has $10 million of goodwill, only $90 million worth of its assets will be available to earn income, putting it at considerable disadvantage from a profitability standpoint to the bank with less or zero goodwill.
And herein lies the issue for Bank of America compared to Wells Fargo. According to their most recent balance sheets, Bank of America's goodwill accounts for 3.25% of its total assets while Wells Fargo's equates to only 1.66%. This is in large part the reason that 87% of Wells Fargo's assets earn interest while only 84.3% of Bank of America's do. Reverse these percentages, and Bank of America would have earned roughly $1.7 billion more on a pre-tax basis in 2013, equating to a 10% boost in annual pre-tax income.
Now, just to be clear, goodwill in and of itself is not necessarily a bad thing. One of the best-run banks in the country, New York Community Bancorp (NYSE:NYCB), serves as an apt example. As of Dec. 31, its goodwill accounted for 5.2% of its assets. It's important to note, however, that New York Community Bancorp has two massive advantages that more than offset the impact of inert assets; both its expense base and history of credit losses are among the lowest in the industry. Meanwhile, Bank of America's are in contention for the worst.
The point here is simple. While I'm bullish on Bank of America's shares over the long term, it's clear that the Charlotte, N.C.-based bank is laden with more than legal liability stemming from the financial crisis; it must also atone for the imprudent acquisitive ways of its former leaders. By overpaying for acquisitions relative to competitors like Wells Fargo, they may have doomed it to a future of relative underperformance.