Bank of America: Recovery in Mortgage Profit Margins Adds to Stock Upside
Bank of America’s (NYSE:BAC) significant exposure to the US housing market created a mess during the housing melt down in 2008-09, whereupon the bank accepted $45 billion from Troubled Asset Relief Program (TARP). Most other Wall Street banks experienced similar turbulence during this period due to mortgage related exposure including competitors Goldman Sachs (NYSE:GS), JP Morgan (NYSE: JPM), Citigroup (NYSE:C), UBS (NYSE:UBS) and Bank of America (NYSE:BAC).
In 2009, Bank of America’s outlook improved as its revenue from its mortgage business nearly doubled to $15 billion due in large part to the acquisition of Countrywide, which the government supported.
We estimate that the mortgage business accounts for around 2% of the $16.12 Trefis price estimate for Bank of America’s stock, which is 27% ahead of the current market price.
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Rise in Mortgage Loans Outstanding
The mortgage business of Bank of America generates revenues from selling various types of mortgages and loans to customers. It earns revenues in form of interest on mortgage loans, production fee in writing new loans and service fee for servicing loans that it has sold to other parties.
Bank of America’s interest earning mortgage amount has been rising gradually due to lower rates and touched $193 billion in 2009. We estimate that a recovery in the US housing market will help it to reach $207 billion by the year 2013. The decline in home prices in the US because of high rate of foreclosures and excess inventory of housing has weighed on the mortgage market in recent years but government programs and incentives to new home buyers should help to clear excess inventory and bring back life to the US housing market over time.
Decline in Provision for Credit Loss
A provision for credit loss is an expense that a bank sets aside as an allowance for bad loans. Bank of America had $1 billion in provision for credit loss in 2007, $6 billion in 2008 and $11 billion in 2009 due to the collapse of the US housing market. So far in 2010, trends indicate that provisions for credit loss would decline to nearly $9 billion.
Provisions for these credit losses have a direct impact on the bank’s operating margin for its mortgage business. The margins declined from about 40% in 2006 to -58% in 2009 when the credit loss soared to $11 billion. We estimate that a decline in provisions for credit loss will push operating margins to 20% moving forward.
However, if the revenues from mortgage business grow as projected and the credit loss decline more sharply, operating margins for Bank of America could increase back to its historical level of 40% which would result in 5% increase in our price estimate for Bank of America.