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Bank of America (BAC)
Will Bank of America Exit the Investment Banking Business Because of One Bad Quarter?
Chuck Prince has to be breathing easier today. After days of constantly hearing about how he was mismanaging the world's largest bank and how he was on the verge of being shown the exit door at Citigroup (C: Charts, News, Offers), Sandy Weill's handpicked successor can now point to the fact that another banking titan - Bank of America, the second largest bank in the world, couldn't navigate the credit markets much more effectively either last quarter. Granted, Citigroup's third quarter was worse than BOA's but not by that much. The former reported a 57% drop in net income earlier in the week while the latter this morning disclosed that its bottom line dived 32% and revenue fell 12%. While most analysts on Wall Street had expected Citigroup to turn in a lousy quarter, Bank of America's Q3 was expected to be relatively strong given the fact that it has lesser exposure to fixed income instruments including the much maligned subprime mortgages. Plus it doesn't rely on M&A activity as much, which has almost slowed to a crawl industry wide. However, BOA wasn't even within a mile of the earnings estimate of $1.06 a share as it came in at $0.82. What parts of BOA's business were the most to blame for this debacle and how is this quarter going to change the medium to long term strategy of the company?
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There was a $2 billion provision for credit losses which dragged down earnings. But these provisions are almost commonplace these days among the big banks. What hurt more was the fact that BOA's investment banking division reported about $1.4 billion in trading losses. This combined with a $247 million write-down in leveraged loans resulted in the division's profits plummeting 93%. Hence, BOA's investment bank which is still considered an also-ran on Wall Street and not thought of in the same breath as investment banking heavyweights such as Lehman Brothers (LEH: Charts, News, Offers) and Goldman Sachs (GS: Charts, News, Offers), earned only $100 million this last quarter. The other parts of the business performed relatively well, especially given the challenging capital markets environment. The US Trust purchase from Charles Schwab (SCHW: Charts, News, Offers) which was completed earlier this year boosted revenue in the lucrative high-end wealth management business to $2.2 billion and the core bread and butter retail banking business (i.e. the consumer unit) turned in a fairly decent quarter as revenue at the division rose 6.2% but earnings slipped 16%.
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The next couple of quarters are going to be challenging for BOA. The consumer unit is bracing for more write-offs as delinquencies and late payments increase. Plus no matter how robust consumer spending has been over the last few years, it has to slow down sometime soon especially if the economy slips into a recession. That is obviously not good news if you are Bank of America and run the country's largest retail banking and credit card operation. However, Bank of America definitely has the size, expertise and experience to weather a storm in consumer spending and probably come out stronger than most of its rivals. Its big name reputation, which has reportedly been attracting consumers to its mortgage division even when other mortgage businesses are dropping left and right, should help.
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However, the area that has to concern CEO Ken Lewis and Bank of America shareholders more is the investment banking business. $1.4 billion in trading losses means a lot of bets (both with firm and client capital) went awry. Obviously, this also calls into question the risk management procedures at BOA. So where does this division go from here? For years, Bank of America has wanted to gain a solid foothold in the lucrative IB arena and billions of dollars have been spent with the aim of making it a major player in the field. Further testament to how much BOA fancies itself as a Wall Street powerhouse and not a Charlotte consumer bank, is the new skyscraper that BOA is currently building in midtown Manhattan. You don't spend that much on real estate to house a retail banking operation, you do it show that you want to be a major player in the investment banking field. But after these third quarter results and Ken Lewis' despondent tone during today's conference call, you have to wonder just how committed BOA is to the IB business. His exact quote was "I never say never, but I've had all the fun I can stand in investment banking at the moment." That sounds like a defeated man who is all but ready to pull the plug on the IB division. Even if such a drastic step doesn't happen, major restructuring in the division is guaranteed. That would be a mistake. After spending all this time and money to build it up, throwing in the towel after one bad quarter (especially after the Q1&Q2 of '07 were pretty good) would be the wrong move and would send the wrong signal. It's not like the IB environment has been permanently dislocated. Things have gotten off-track obviously but once a couple more interest rate cuts are made, liquidity will reappear and deals will start happening again. There is a lot of money to be made here, just ask Goldman Sachs. Sure, $1.4 billion in trading losses is going to sting no matter who you are but Bank of America has the stomach to digest it - that is if it wants to. So instead of shying away, it should step up and make a big acquisition (e.g. Bear Stearns (BSC: Charts, News, Offers)) in this field, right now is the time to do it since valuations are depressed.
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