We have lowered our recommendation on Bank of America Corporation (BAC”>BAC) to Underperform from Neutral. The downgrade is based on BofA’s recent decline in credit ratings, weak capital position and various legal battles into which the company is embroiled.
Though BofA is poised to benefit from its large-scale operations, improving credit quality as well as the efficiency initiative program, the recent payments to settle mortgage-related claims will likely hamper its results. Also, revenue headwinds and issues related to the regulatory changes will continue to limit the company’s earnings.
BofA is one of those US and European banks whose ratings has been downgraded by Standard & Poor's (S&P) recently. This ratings downgrade will increase the company’s already high funding costs and create a negative impact on its financials, leading to more drastic cost cutting measures.
BofA has been trying to soar up its capital levels and pass the fourth round of stress test, which is to be conducted by the Federal Reserve. The company along with five other U.S. banks – JPMorgan Chase & Co. (JPM”>JPM), Citigroup Inc. (C), Morgan Stanley (MS), The Goldman Sachs Group Inc. (GS”>GS) and Wells Fargo & Company (WFC”>WFC) – will have an even higher stumbling block to clear as they have significant exposure to the stressed European countries. However, we believe that BofA’s chances of passing the test and gaining eligibility to enhance shareholders value are rather dim.
The purchase of Countrywide Financial in 2008 resulted in several problems for BofA. The company had bought the mortgage lender for $2.5 billion and since recorded more than $30 billion in losses from bad loans, mortgage-backed securities claims and lawsuits. The company is still facing numerous litigations and this will likely have a material impact on its financial stability.
Additionally, low interest rate environment and lower hedge income due to the new financial reform law, will continue to drag down BofA’s net interest yield, at least through the first half of 2012.
On the flip side, BofA has launched a company-wide expense reduction initiative. The key aim of this efficiency initiative is to bring down expenses, increase revenue, strengthen risk control and make changes to allow better execution and customer service, while returning more value to shareholders.
Furthermore, BofA has been trying to regain its foothold in the market through various measures including realignment of balance sheet in accordance with regulatory changes, shedding non-core assets to strengthen its capital position and reshuffling its top management to line up its operating units to key customer groups, thereby promising a good business intention.
Additionally, we are quite impressed with the faster-than-expected improvement in BofA’s credit quality. With improving economic conditions, credit metrics are expected to improve. Also, underwriting changes made by BofA across all its products will continue to help improve delinquencies.
Currently, BofA retains a Zacks #3 Rank, which translates into a short-term Hold rating.
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