Brexit

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Brexit Batters Bank of America and Rivals

By Markets Fool.com

Investors in Bank of America (BAC) are in for a wild ride over the next few days and weeks as the market absorbs the news from the United Kingdom that it will separate from the European Union, prompting Prime Minister David Cameron to resign this morning. Shares of the nation's second-biggest bank by assets are currently down more than 5%.

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Before we get into the three reasons that the Brexit vote is weighing on Bank of America's shares, let me first say that I intend to use this as an opportunity to add to my position in the North Carolina-based bank. I don't intend to buy (and definitely not to sell) anything today, but if bank stocks get cheaper over the next few weeks, bank valuations will become incredibly attractive.

Bank of America's shares were already cheap before last night's Brexit vote. Even after gaining more than 3% yesterday after B of A'slaudable performance on this year's stress test, they still traded for a 15% discount to tangible book value. That's low, particularly when you consider that Bank of America lords over the most valuable deposit franchise in the United States.

This isn't to say that Bank of America won't be hurt by the Brexit vote, because it will be in at least three ways.

 

How Brexit will affect Bank of America

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First, elevated volatility in the debt and equity markets will cause Bank of America's trading clients to stay out of the market. Its Global Markets segment caters to institutional investors -- hedge funds, sovereign wealth funds, insurance companies, university endowments, etc. It does so by making markets, which consists of buying securities from one and selling them to another, earning a commission each time it does. But when the market is especially volatile, these clients tend to clam up, reducing trading volumes and thus Bank of America's commissions.

We saw this during the first quarter of the year, when a wave of bad news sent the bank's trading income down 16% on a year-over-year basis. Brexit was one of the issues at the time, as the scheduled referendum was announced at the beginning of the year. Investors were also spooked by news that China's economic growth is moderating and by concerns over loan losses at banks that had lent to the energy sector, which is buckling under low oil and gas prices.

Bank of America also has an investment bank that takes companies public, issues bonds and other types of fixed-income securities for clients, and advises companies on mergers and acquisitions. Its clients in this corner of its business will also be more inclined to sit on the sidelines until the markets settle down, which will weigh on the fees that Bank of America earns from lining up these deals.

It's for these reasons that KBW believes universal banks will be hit especially hard by the Brexit vote. As it explained in a report issued before today's news:

 

 

A vote for Brexit would lead to macro uncertainty and this would likely result in higher volatility (sometimes unhealthy), but also lower capital markets activity as companies stop transacting due to uncertainty in law and markets. We would also expect the British Pound and Euro to depreciate versus the dollar and this would cause FX headwinds for select companies. Overall, we would classify U.S. Universal Banks and Exchanges & Order Execution Firms as having the greatest risk to earnings should Brexit occur.

 

 

The second way Brexit will impact Bank of America is by encouraging the Federal Reserve to keep interest rates lower for longer. Over the past year it has seemed as if the central bank was on the verge of raising interest rates. To this end, the Fed noted at its April meeting that "it likely would be appropriate" to raise rates in June if the economy continued to rebound.

These plans were abandoned, however, after the May jobs report revealed the slowest pace of hiring in more than five years. Fed chairwoman Janet Yellen took note of this in congressional testimony earlier this week, saying that "the pace of improvement in the labor market appears to have slowed more recently." She then went on to list a number of additional concerns, including uneven economic growth, vulnerabilities in the global economy, slowing growth in China, "surprisingly weak" business investment, and an inflation rate that's still only half of the Fed's 2% target. The net result, said Yellen, is that "the federal funds rate is likely to remain, for some time, below the levels that are expected to prevail in the longer run."

While this is bad for all banks, which earn more money from their loan portfolios when interest rates are higher, it's particularly bad for Bank of America, which has much more to gain from higher rates than the other national banks. In its latest 10-Q, it estimates that a 100-basis-point (1%) increase in short- and long-term rates will generate $6 billion in additional net interest income. That compares to only $3.1 billion at JPMorgan Chase (JPMand presumably even less at Wells Fargo (WFC), which began to reposition its balance sheet last year in anticipation of rates staying lower for longer.

The Brexit vote will play into the Fed's calculus by way of the currency market. In times like these, the U.S. dollar gains in value relative to other currencies. This pushes down corporate profits in the United States because it makes our exports more expensive to buy abroad. It also has a negative impact on U.S. companies that earn money from operations in other countries, as they must then convert currency earned elsewhere into a dearer dollar.

The final reason that the pending Brexit will hit Bank of America is that the bank will likely have to move some of its London-based investment banking units to the continent -- most likely to France or Germany. As KBW explains in its report:

 

 

The UK subsidiaries for the U.S. Universal Banks are generally the gateway into the EU due to the passporting privileges that these subsidiaries enjoy. The passport authorizes a bank located in one European Economic Area (EEA) state to conduct business in the other EEA states (the 28 members of the EU, as well as Norway, Iceland, and Liechtenstein). Therefore, all of the banks may eventually need to bolster or even establish operations in the EU should the UK leave the EU.

 

 

KBW believes that Bank of America will have to relocate 1,386 of its 5,545 U.K.-based employees as a result. This will increase expenses, though the impact will be temporary.

 

Keep calm and carry on

 

It's hard to say what the net effect of these three things will be on Bank of America's bottom line, other than to say that it won't be positive. KBW predicts that they'll reduce the bank's earnings per share by 3.1% this year and 6.1% next year. I have a lot of respect for KBW's analyses, and particularly for its global director of research, Fred Cannon, but at this point all we can do is sit back and wait to see the true impact of Brexit.

Let me reiterate, though, that savvy investors perceive times like these as opportunities to buy, not to flee. It was at Bank of America's low point in 2011, after all, when Warren Buffett bet $5 billion of Berkshire Hathaway's (BRK.B) money on the bank's stock. I recommend keeping this in mind over the next few weeks.

The article Why Brexit Is Battering Bank of America (and Other Bank Stocks) originally appeared on Fool.com.

John Maxfield owns shares of Bank of America and Wells Fargo. The Motley Fool owns shares of and recommends Wells Fargo. The Motley Fool recommends Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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