Bank Of America (BAC): Fed Stress Tests Were Disaster For Shareholders

Bank of America (NYSE:BAC) is about to suffer from a major lost opportunity thanks to the recent Federal Reserve stress tests. It shouldn’t have come as a surprise. The handwriting should have been on the wall for anybody who noticed the CET1 (Common Equity Tier Number) in its Q4 2021 end-of-the-year report. The fifth line of the first slide reported a standardized CET1 ratio of 10.6. It struck me at the time that this was pretty close to the 10.5 the Fed was going to require on the stress tests. I checked other banks and BAC compared unfavorably with its peers.

Everybody loved BAC and saw that it was going to book big time with rising interest rates. Bank of America was well aware of this advantage and its earnings call slides included a line saying how much their income would benefit per 100 basis point lateral increase in interest rates. Under CEO Brian Moynihan, Bank of America had turned itself around after the 2008-2009 disaster and gone from strength to strength. It had taken care of both customers and employees during the pandemic and lockdown and still made good money. Now that they were getting that rise in interest rates they should race ahead of all other diversified banks.

The only thing to worry about with BAC was that it had the most exposure to consumer banking among its peers and as a consequence held more of the kind of loans that would be heavily discounted by the Fed in the upcoming stress test. I wrote about the difference between investment banks and diversified banks with large consumer exposure in this article on Goldman Sachs (GS). The short version is that investment banks are structured so as to do better on stress tests.

My assumption at the beginning of the year was that CEO Brian Moynihan had this all worked out. Surely he had a strategy in place to take advantage of rising rates while managing loans so as to improve its CET1 ratio enough to get out of the danger zone. That isn’t what happened. Here’s the way the Fed described the worst case scenario used in the stress tests taken into account for the stress tests:

2022’s hypothetical scenario included a severe global recession with substantial stress in commercial real estate and corporate debt markets. The unemployment rate rises by 5-3/4 percentage points to a peak of 10% and GDP declines commensurately. Asset prices decline sharply, with a nearly 40% decline in commercial real estate prices and a 55% decline in stock prices.”

And here are the stress test results for the four major banks which have already led JPMorgan (JPM) and Citi (C) to halt buybacks:

Bank	Q4 21 Actual	Test Result	Minimum
Bank of America	10.6	7.8	7.6
JPMorgan	13.1	10.6	9.8
Citi	12.2	9.5	8.6
Wells Fargo (WFC)	11.4	8.7	8.6

JPMorgan CEO Jamie Dimon was apoplectic and didn’t hold back when asked a question about the tests at JPM’s July 14 earnings call. “We don’t agree with the stress test,” Dimon said. “It’s inconsistent. It’s not transparent. It’s too volatile. It’s basically capricious, arbitrary.” It was one of those “you want to know what I really think” remarks. Having earlier said he saw a “hurricane” coming, he went on to say that JPM would still make money in a worst case scenario but would suspend share buybacks. He added that JPMorgan was pulling back on “risk weighted assets,” citing mortgages, which require capital set aside.

“It’s not good for the United States economy and in particular, it’s bad for lower-income mortgages,” Dimon continued. “You haven’t fixed the mortgage business and then we’re making it worse. It’s not good for the United States economy and in particular, it’s bad for lower-income mortgages,” Dimon said. He then explained that JPM would continue originating mortgages but immediately offload them although other banks might recede from home loans entirely. “It’s a terrible way to run a financial system,” Dimon said. “It just causes huge confusion about what you should be doing with your capital.”

Bank of America, of course, commits a far larger percentage of its capital to mortgages than JPMorgan. At the Bank of America Q2 earnings call Brian Moynihan and his CFO seemed determined to talk around the subject of the stress tests and their consequences for BAC, including buybacks. Here’s Moynihan talking about capital after mentioning customers and the 22% increase in dividend:

Third, we’re going to be building capital given the new higher amounts received during the stress test. It will make our balance sheet even stronger. Along the way, we believe our expected earnings generation over the next 18 months will provide an ample amount of capital, which allows us to support customer growth, pay dividends and use the rest to allocate between buying back shares and growing into our new capital requirement.”

What struck me about this paragraph was how carefully it was worded. It had many words but little content. The balance sheet would be “even stronger.” The quiet center of it was that earnings generation “over the next 18 months” would be allocated after customer growth and dividends to buying back shares and “growing into” the new capital requirement. The timing is vague. The policy seems to be that Bank of America would grow itself into better shape that would enable it to do better in00 future stress tests. Only then would it talk about things like buybacks. Erika Najarian of UBS was unwilling to leave it at that and asked the question again of CFO Alastair Borthwick:

Erika Najarian

Got it. And my second question is a follow-up on capital. I guess the first is are you working to actively reduce the stress capital buffer? And maybe remind us where you think the pain points were for this year’s test that you think you could address for next year? And second, should we — what is the pacing of buybacks like from here as you potentially — as you — or not potentially, as you build towards that January 1, 2024, new hire minimum?”

Alastair Borthwick

On the second question, that’s going to be dictated by our LOBs use of the balance sheet. Our 1 goal is to keep them in the market winning every day and let the capital support that. That’s what we do because what they’re doing is providing good returns and stuff. So that requires us to — well, it will be driven by, frankly, loan growth more than anything else in the near term because the markets business will bounce around but won’t move much.”

That’s a stumbling evasion of specificity followed by a quick change of subject. The subtext hovers over both conversations. Buybacks have been one of the major attractions for BAC shareholders for the past half dozen years. Organic growth has been hard to come by and in its absence Bank of America has manufactured growth in all per share numbers by aggressive buybacks. Now that buybacks have been pulled away, how should shareholders look at BAC. That’s clearly not a question that Bank of America wanted to engage.

Let’s Look At The Numbers

The following table contains the numbers that matter. They are not the usual operating numbers. Those look fine through mid-year 2022. There’s a good positive case to make about every part of the Bank of America business, and, trust me, the CEO and CFO went over it in mind-numbing detail line by line. If you don’t trust me read it for yourselves. I wrote this recent article comparing BAC to JPM and detailing BAC’s operating success.

The problem is that the Q2 2022 results amounted to a detailed picture of a frozen moment in time with the assumption that subsequent numbers will be similar. Unfortunately, quite a lot of uncertainty and dread hangs over the future. Let’s leave that to unfold on its own and instead take a look at buybacks in some detail:

Date	2017	2018	2019	2020	2021	6 MO,22
Shares Outstanding (M)	10287	9669	8836	8651	8077	8036
Shares Retired	(234M)	618M	833M	185M	574M	40M
Net Income	$18B	$28B	$27B	$18B	$32B	$13.3B
Book Value Per Share	$23.8	$25.1	$27.3	$28.7	$30.4	$29.9
Spent on Buybacks	$12.8B	$20.1B	$28.1B	$7.8B	$25.1B	$3.6B

I would love to do a piece of nifty arithmetic to get the average price paid per share, but there is a catch to doing that. The number of shares retired does not equal the number of shares bought because BAC uses a significant portion of shares repurchased to offset shares paid out as compensation. There is thus no very good way of getting the exact average price of shares repurchased accurately. As a result you cannot calculate the price paid per share by simply dividing the amount spent on buybacks by the number of shares retired.

What seems clear is that even after adding a substantial number of shares for stock compensation to the 2021 number for shares retired, BAC paid over $40 per share repurchased in 2021. The stock price during 2021 confirms that this is roughly correct. What also is clear is that the same dollar amount of share repurchases would have bought back 20-25% more shares if done in 2022. The shares bought back in 2021 were also bought at a price above the price at which Bank of America is currently trading.

This is certainly unfortunate for BAC shareholders. There are two periods in which BAC shares could have been bought cheaply, 2020 and the first six month of 2022. In 2020 all banks were constrained from doing buybacks for much of the year, and the result is clear in the small dollar number of $7.8 billion in the bottom row above. You can’t very well blame either the Bank of America CEO or the Fed for that. The dollar amount for 2022 seems almost certain to be much smaller than the number for 2020 despite the fact that no crisis is currently unfolding as far as we can see. Worse yet, the responses of both CEO and CFO in the above quotes indicate that reduced buybacks may continue for as much as another 18 months.

Which Leader Should Shareholders Hold Responsible?

The real question is which leader to hold accountable. Jamie Dimon’s candidate is Jay Powell. He sees Powell as having panicked about a deep recession and taken excessive preemptive action harming the banks and their shareholders as well as having counterproductive impact on the US economy. He was clearly stunned by the failure of the Fed to take into account what he often calls JPMorgan’s “fortress” balance sheet.

In the case of Bank of America, however, the question is how they got caught off guard despite the fact that their CET1 ratio was the closest to the newly required 10.5. Who dropped the ball? It certainly feels as though the top leadership at Bank of America failed to take the Fed seriously or else expected that their good operating results would place them above the requirement. If they did so assume, they were clearly wrong. Their meager 5% increase in dividend was far from making up for the loss of buybacks. As for the apparent decision to go full out for growth, that may just work out if everything goes right, but it comes with risks. To be proven right in the long run requires the assumption that a recession does not happen in the meantime.

What Bank of America fails to acknowledge is the importance of buybacks to a core premise of its shareholders. In an industry for which organic growth in revenue and earnings has been hard to come by, the manufactured growth provided by share repurchases is very important from the shareholder point of view. BAC seemed to be well aware of this when the Fed initially permitted buybacks. Consider the fact that 2021 buybacks of roughly 7% of BAC shares produced a 7% jump in shareholder value. The 2019 buybacks added 8 1/2%.

Those buybacks further made it possible to increase the dividend 7% and 8 1/2% respectively with the same amount of cash going out the door. From the shareholder perspective the solid operating performance is fine and the higher NII (Net Interest Income) from higher rates is also a good thing, but there is a fair chance that higher rates will recede within a couple of years and banks may find themselves back in a miserable low rate regime which requires them to find a bunch of alternative ways to earn money. I’m sure customers won’t be delighted by a return to nitpicking fees and service charges.

The Fed is unlikely to acknowledge going off the deep end with the stress tests, and, who knows, they may know something the rest of us don’t. If nothing else, Jay Powell knows what he is going to do. The CEO at Bank of America, however, needs to acknowledge that the loss of buybacks is a very big deal for BAC investors and provide an account of how the bank got into a position which caused an interruption of buybacks. As a shareholder I would personally like to hear something less evasive about both past and future at the next quarterly earnings call. What were they thinking?

BAC Is Also In The Doghouse With Both Quant Rankings And Factor Grades

Here are the Seeking Alpha Factor Grades for Bank of America:

These letter grades tell the story. Valuation has improved a little as the stock crashed while Momentum and Revisions as a pair went from bad to worse. Growth tanked. Profitability stayed poor at D-.

Quant Ratings, if anything, are worse. The most telling was BAC’s ranking in its own industry group. It was ranked number 35 out of 56 in the Diversified Bank industry. All three of its peers – JPMorgan, Citigroup, and Wells Fargo – were ranked higher. Ranking below Citi and WFC is quite a comedown for a bank recently seen as number one in the industry.

Both Seeking Alpha writers and Wall Street analysts rate Bank of America a Buy. The Quant Ranking rates it a Hold. Meanwhile I am more or less locked into my position because it was bought at a great price when Bank of America was still putting the last crisis behind it. Selling would mean paying a large chunk of my capital to the IRS. I’m disappointed but still willing to give CEO Brian Moynihan the benefit of the doubt and wait to see if he comes clean about CET1, the stress tests, and BAC’s future. My ranking matches my own situation. I rate it a Hold.