A Thorough and Timely Analysis of Bank of America

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The past week-and-a-half rank among the most eventful stretches that I can remember for bank stocks, and Bank of America , in particular. Things won't die down anytime soon, either, as the nation's second-biggest bank by assets is scheduled to report second-quarter earnings two weeks from now, on July 18.

Given this, I thought investors would appreciate a thorough summary of everything that's happened over the past 10 days, insofar as Bank of America is concerned. While there's a lot to absorb, the important thing for long-term investors to keep in mind is that, despite the ups and downs in the market, the North Carolina-based bank has evolved into one of the most-secure investments in the bank industry today, thanks to record amounts of capital and liquidity.

Bank of America passes the stress test

The starting point in all of this is June 23 -- the day the Federal Reserve released the results from the first round of this year's stress tests. The purpose of the stress tests is to gauge the impact on large banks' solvency if, among other things, the unemployment rate doubles to 10%, stock prices are cut in half, home values drop by 25%, interest rates veer into negative territory, and for the eight systematically important banks, their largest counterparty defaults. It's akin to a 100-year financial cataclysm that combines the worst aspects of the 2008 financial crisis and the 2011 European sovereign-debt crisis.

In this way, the stress test is analogous to a flight simulator that's used to test how pilots would respond in an emergency scenario. But instead of assuming that the airplane loses power in one of its two engines five miles away from an airport, it tests how a pilot would perform if the plane lost power in both engines somewhere over the Atlantic Ocean. A crash landing is inevitable; in other words, the only question is whether there will be any survivors.

This helps explain why Bank of America has struggled so much on past tests. It ran into problems on the 2014 test after belatedly discovering that it had mismarked the value of debt securities inherited in its 2008 acquisition of Merrill Lynch. And in 2015, the Fed required it to resubmit its capital plan to "address certain weaknesses in its capital planning processes." It was the only U.S.-based bank that was singled out to do so -- though Goldman Sachs, JPMorgan Chase , and Morgan Stanley had to temper their requests to return capital to shareholders in order to meet minimum capital requirements.

The good news is that Bank of America not only passed this year's test, but it did so with flying colors. The thing to watch in this regard is its common equity tier 1 capital ratio, or CET1 ratio. This measures how much high-quality capital Bank of America has on its balance sheet to absorb losses from its trading and lending operations. Going into this year's test, its CET1 ratio was 11.6%, which equates to $163 billion worth of tier 1 common capital. After running the Fed's hypothetical gauntlet, this fell to 8.1%, or $123 billion in high-quality capital.

That's a big drop; but even afterward, it still had more-than-enough capital to satisfy its regulatory minimum. The instructions to this year's stress test say that banks must maintain a CET1 ratio of 4.5% to pass.

By this measure, Bank of America emerged with $54 billion in capital above and beyond the amount it's legally obligated to hold. And even if you use the 5.875% CET1 ratio that Bank of America must have in order to be considered well-capitalized in normal times, it still exceeded its regulatory minimum by $34 billion. Thus, either way you look at it, Bank of America has succeeded at constructing a fortress balance sheet under chairman and CEO Brian Moynihan's watch.

Data source: Federal Reserve. Chart by author.

Thanks to its performance on the first round of the stress test, as well as improvements to its capital-planning process, the $2.2 trillion bank received approval this past Wednesday to increase its dividend by 50%, and repurchase $5 billion worth of stock during the next 12 months. This was only the second time since the crisis that it's raised its quarterly payout, which explains why its stock rallied in the latter half of this week.

The fallout from Brexit

But this is skipping ahead in the story, as something else happened on June 23 that carries significant implications for Bank of America, as well. That was the day a majority of voters in the United Kingdom cast ballots in favor of leaving the European Union, incited by spurious rationales that have since been disproven. The magnitude of the consequences from this mistake remain to be seen, but it's bad for banks almost any way you look at it.

The most-pressing problem is that the British pound has fallen by roughly 10% relative to the dollar. It's at its lowest level against the dollar in three decades, and it could very well fall further from here.

The vote caused virtually every other major currency (including the euro and the Chinese yuan) to drop against the dollar, as well -- the sole exception being the Japanese yen. This will reduce U.S. exports, decrease the revenue from profits earned abroad by U.S.-based multinational corporations, and thereby throttle U.S. gross domestic product. The heightened uncertainty caused by the vote is also likely to reduce business investment, which will weigh on loan demand.

The main implications for banks are twofold. In the first case, the market volatility ignited by the vote will reduce trading and investment banking revenues at universal banks, such as Bank of America, JPMorgan Chase, and Citigroup . In addition to their traditional banking operations, these banks generate revenue from making markets -- that is, from facilitating the purchase and sale of securities and financial products among corporate clients and institutional investors. When volatility increases like this, however, these customers stay on the proverbial sidelines, which reduces trading commissions, as well as fees from underwriting bonds and helping companies go public.

This happened in the first quarter, when bad news sent Bank of America's trading income down 16%, and investment-banking fees lower by 22% compared to the year-ago period. The same figures were off at JPMorgan Chase by 11% and 24%, respectively.And at Citigroup, by 13% and 27%. Brexit was one of the issues at the time, as the scheduled referendum was announced during the quarter. Investors were also disturbed by evidence 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.

For a while, it appeared as if these trends had reversed course in the second quarter. Jefferies Group, a U.S.-based investment bank owned by Leucadia National, said that its sales and trading revenue increased on a year-over-year basis by 21% in the three months ended May 31. The performance of its fixed-income division, which tends to account for the lion's share of trading revenue at large universal banks, was particularly good, growing by 55%.

These trends were confirmed by statements from big-bank executives. Bank of America's Brian Moynihan said earlier in the quarter that he feels good about trading revenue, predicting a mid-single-digit year-over-year revenue gain. And executives at JPMorgan Chase and Citigroup echoed this. The head of JPMorgan Chase's investment bank, Daniel Pinto, said its trading revenue should climb by the mid-teens, while Citigroup's CEO Michael Corbat forecasted a slight uptick. While it remains to be seen whether this held up through the end of the second quarter, it's prudent to assume that their third-quarter results will suffer.

The second implication concerns interest rates, which have been at an historic trough since the financial crisis. Low rates are bad for banks because they reduce the revenue from their loan portfolios, much of which are indexed to prevailing rates. As a result, higher rates will necessarily translate into higher net revenue, which, in turn, will translate into bigger profits.

Bank of America estimates that a 100-basis-point simultaneous increase in short- and long-term rates will translate into $6 billion more in annual net interest income. This makes it the most asset-sensitive big bank -- meaning that it will benefit from higher rates more than other banks -- but it's certainly not alone. For example, JPMorgan Chase predicts that a similar increase in rates would boost its net interest income by $3 billion.

Lest there be any doubt, higher rates are desperately needed by banks right now, and none more so than Bank of America. One of the reasons that its shares trade for a 16% discount to its tangible book value is because its return on equity is well below the level that's necessary for it to create value for shareholders -- that is, after factoring in an investors' opportunity cost of not investing that money elsewhere.

For Bank of America to satisfy this threshold, known as its cost of capital, it needs to earn at least 12.2% on its equity, according to an analysis by Rafferty Capital Markets' Dick Bove. That's nearly twice the 6.6% that it earned on its average common shareholders' equity last year. And even if you use a more restricted measure of equity -- its 9.11% return on average tangible common shareholders' equity -- Bank of America still comes up short. If rates were to climb, meanwhile, this gap would largely close.

But the problem now is that interest rates aren't likely to go higher anytime soon. We already had an inclination that this was the case before the United Kingdom's vote on June 23, as Fed chairwoman Janet Yellen said earlier in the week that the central bank was backing off its earlier insinuations that rate rises were just around the corner.

The Fed changed course after the latest employment report showed that jobs growth in May increased at the slowest pace in over five years. The Fed's decision to back away from rate increases will now only be bolstered by the expected fallout from the events in Europe. Rates are now likely to stay lower for longer, which, despite contrary claims from certain analysts, is categorically bad for Bank of America.

Effective Federal Funds Rate data by YCharts.

It's nevertheless impossible to say how long rates will stay low. In Japan, they've been hovering near zero since stock and real estate bubbles burst there in 1995. If that's the case in the United States, which could become a self-fulfilling prophecy if immigration is stymied and trade barriers are erected as promised by a certain political candidate, then Bank of America is in for a world of hurt. Given its size, it has thus far been able to escape the sights of activist investors, who would be inclined to force it to fundamentally change its business model if, as already noted, it can't earn its cost of capital. And if it's not able to do so without higher rates, then it may lay prostrate too long to avoid the short-sighted designs of activist investors.

Watching second-quarter earnings

Higher rates aside, investors will get an updated look at how Bank of America is navigating the current environment when it reports second-quarter earnings on July 18. What you'll want to watch for is whether or not it has another quarter of respectable profitability -- say, net income of $4 billion or higher. Last year was the first time since the crisis that it was able to turn in decent earnings in four consecutive calendar quarters. That translated into its best annual performance in nearly a decade.

The good news in this regard is that many of the negative headwinds specific to Bank of America are beginning to abate. The most important of these was a legal decision in the second quarter of last year that eviscerated the lion's share of its outstanding legal liabilities. It allowed Bank of America to reduce its then-current outstanding legal claims by $7.6 billion, and it slowed the inflow of new claims from a flood to a trickle.

Prior to the decision, it was getting $2 billion or more in new claims a quarter. After the decision, it dropped to somewhere around $200 million -- though, as best as I can tell, it no longer reports this figure, which suggests that the bank believes it to be immaterial.

Bank of America has also made considerable headway at reducing operating expenses. The headcount in its legacy assets and servicing unit, which services mortgages and houses toxic and noncore assets dating back to the financial crisis, is down to the equivalent of 10,000 full-time employees from a peak of 41,800 in the second quarter of 2012. On top of this, Bank of America has closed more than 20% of its branches over the past seven years. The net result is that annual noninterest expenses, excluding litigation, have declined by $15 billion, or 21%, since 2011.

The bad news, however, is that this now shifts the emphasis at Bank of America to boosting its revenue, which is meaningfully lower on a size-adjusted basis than competitors like Wells Fargo. And this will only get worse now given the likely decline in trading and investment-banking revenues coupled with a prolonged period of ultra-low interest rates.

The question for investors is whether the large discount on Bank of America's stock adequately compensates for what looks like a challenging revenue environment for longer than expected. I think that it does; but, as they say, the proof is in the pudding.

The article A Thorough and Timely Analysis of Bank of America originally appeared on Fool.com.

John Maxfield owns shares of Bank of America and Goldman Sachs. The Motley Fool owns shares of and recommends Leucadia National. 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.