One reason that Bank of America's (NYSE:BAC) profitability lags its two principal peers is because it has to hold more capital relative to its assets than JPMorgan Chase (NYSE:JPM) and Wells Fargo (NYSE:WFC). But there's more to it than just the quantity of capital, because the quality of capital matters as well.
Bank of America's problem is that it has too much goodwill on its balance sheet, which came from its long history of overpaying for acquisitions. Let's say, for example, that Bank XYZ has a book value of $100 million, but is bought by Bank ABC for two times its book value, or $200 million. To account for the $100 million premium, Bank ABC must record it as goodwill on its balance sheet.
Goodwill is an intangible asset. It just sits on a bank's balance sheet taking up space. It's like the ghost of Christmas past that forever haunts firms that overpay for acquisitions. And no bank had been guiltier of this than Bank of America. Its two biggest acquisitions serve as cases in point. It purchased FleetBoston Financial in 2003 for 2.8 times book value. And it paid 1.4 times book to buy Merrill Lynch at the absolute trough of the financial crisis.
Meanwhile, one week after Bank of America paid a 40% premium to book value for Merrill Lynch, JPMorgan Chase picked up Washington Mutual for a 73% discount to book. Fast-forward another week and Wells Fargo paid 70% less than book value for Wachovia, which more than doubled Wells Fargo's size.
You can see the impact of these deals on the percentage of common equity that's accounted for by goodwill. The figure at Wells Fargo is 14.9%. It's 21.4% at JPMorgan Chase. And at Bank of America, it's 29.8%.
This may not have been as big of an issue before the crisis, but regulations passed in its wake make this additional goodwill incredibly significant. One of the things that lawmakers and regulators have done is to reduce the total amount of leverage that banks can use. This hits the nation's biggest banks the hardest, because they have to hold more capital relative to their assets than their smaller counterparts do. Right now, for instance, JPMorgan Chase must reserve 3.5% more of its equity as a buffer against future losses. Bank of America and Wells Fargo have to hold 3% and 2% more, respectively.
But even more significant for present purposes, regulators have constrained the type of equity that can be leveraged in the first place -- and goodwill doesn't qualify. As a result, even though it's counted against a bank when calculating return on equity, it can't be used to produce profits. This acts as a double whammy against Bank of America and helps explain why it generated a 6.2% return on equity last year compared to 10.5% and 12.8% at JPMorgan Chase and Wells Fargo, respectively.
There's little that Bank of America can do to overcome this other than to figure out some way to squeeze more profits out of its operations -- something that's virtually impossible to do given the commoditized nature of banking products. This doesn't mean that Bank of America's stock isn't a buy right now. But it does mean, at least in my opinion, that it's a shorter-term value play rather than a long-term bet on outperformance.
John Maxfield owns shares of Bank of America. The Motley Fool owns shares of and recommends Wells Fargo. The Motley Fool has the following options: short March 2016 $52 puts on Wells Fargo. The Motley Fool recommends Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.