Fed's Easy Money Buoys Bank of America

What do bank stocks have to do with the Parable of the Talents, the Gospel account of what happens to three servants who invest free capital given them by their master?

Second-quarter earnings from Bank of America (BAC - Cramer's Take - Stockpickr), released Monday, give us some clues. Like the master in Jesus' parable, Fed Chairman Alan Greenspan has given banks an enormous gift in the form of much lower interest rates. The challenge now, particularly for subpar institutions like Charlotte, N.C.-based Bank of America, is to use this "free cash" to repair and remake themselves. If they fail to take advantage of the Fed's generosity, they'll suffer when the central bank has to tighten monetary policy.

Bank of America reported earnings of $1.24 a share in the second quarter, way above the $1.18 expected by analysts surveyed by Thomson Financial/First Call. Surely, this is evidence that the Bank of America revamp, started last year, is progressing well. The market seems to agree: The stock was up 3.2% to $62.20 Monday. The quarter's numbers showed laudable gains in Bank of America's fee businesses, exactly the area that the bank wants to improve and expand in. However, question marks remain.

Thanks, Al

Before getting too carried away with the numbers, look at how much lower borrowing costs helped. Interest income from loans fell by 3% from the first quarter, but Bank of America's own interest expense fell by a colossal $700 million, or 13%, producing net interest income of $5.03 billion, which was 8% above the first-quarter number. Thank you very much, Mr. Greenspan.

The problem is that Bank of America aims to de-emphasize its lending businesses in favor of noninterest income, which actually fell 1% sequentially. However, this drop was mainly due to a nasty dip in trading income -- and it masked considerable success in fee businesses. Revenue from service charges, brokerage fees, mortgage banking, credit cards and investment banking all showed increases from first-quarter levels. Bank of America bears, like this column, will be eating huge helpings of crow, cooked Southern style, if the bank can sustain these sorts of increases in the next couple of quarters. Moreover, these gains have little to do with the beneficent Greenspan and more with Bank of America's new-ish CEO, Ken Lewis. Well done.

However, the fee businesses have now become all the more important because the really easy gains from net interest income that come from lower interest rates are petering out. Bank of America finance chief Jim Hance said on a conference call Monday that the bank's net interest profit margin would remain around, or slightly improve on, the second quarter's 3.61%. In other words, the big sequential quarterly jumps in this margin in the first half of 2001 are unlikely to be repeated.

In fact, the drop in trading income from first-quarter levels starkly illustrates the limits of the Fed easing on banks' businesses. Trading businesses did extremely well in the first quarter at banks positioned to capitalize on rate reductions -- and there were many of them. In the second quarter, however, Bank of America suffered big declines in interest rate derivatives and bond revenue, which dragged trading income down to $376 million from $699 million in the first quarter.

Call Up the Reserves

And Lewis needs to be working faster on cost cutting if he wants to keep Wall Street on his side. The expense ratio, which compares costs to revenue, is still stuck around the 54% mark, around the same as in previous and year-ago quarters; the bank's goal is to bring operating costs down to about 50% of revenue.

Finally, the one area where Bank of America still looks iffy is credit quality. To be sure, past-due loans went up less than in the past few quarters, but increase they did -- to $6.2 billion, compared with $5.9 billion in the previous quarter and $3.9 billion in the year-ago period. What's more, as credit quality has deteriorated, the bank's bad-loan reserve has dropped as a percentage of past-due loans. It now stands at 118% of past-dues, compared with 185% a year earlier.

Since additions to the reserve have to be subtracted from profits, the drop smacks of earnings management. In fact, if the second-quarter loan loss reserve had stayed at the first quarter's 123% of nonperformers, Bank of America would have to have added an extra $283 million to its reserve, which would have brought per-share earnings down to about $1.13.

Hance said on the call that the reserve was appropriate for the amount of credits it sees becoming past due over the coming months. He added that the regulators' annual examination of banks' large corporate loans, recently completed at Bank of America, "went very smoothly." However, Hance also said that credit quality could continue to worsen for another couple of quarters. The deterioration, he said, was particularly bad among overleveraged companies.

Bank of America probably has two more quarters left in which to prove itself. By then, the Fed's largesse will have run out -- and the talents will be counted...