Quick Thoughts: BAC/COF – Rising Net Interest Margins and Payout Ratios
Bank stocks have rallied sharply as the market interpreted comments on Wednesday by Fed Chairman Yellen that short rates would increase earlier than previously discounted. We continue to see BAC (up 4% over last two days) as the best play on a normalizing rate environment because the ability to buy-back stock is levered to rising net interest margins; we are more cautious on names such as CMA (up 5% over last two days) which score well on traditional measures of asset-sensitivity (such as a tilt to C&I loans or the “gap ratio”) because our analysis suggests these measures are not well correlated with outcome net interest margins.
The release of the Fed’s 2014 CCAR results yesterday support a substantially increased return of capital to shareholders at BAC, and we expect the payout ratio to increase from the current 35% to 60% (so that share repurchases in 2014 double to $7bn from $3.2bn in 2013); as shown in the table below, the minimum (Tier 1 common) capital ratio in the “severe” stress at BAC fell to 6.0% which is only slightly below the 6.3% result for JPM; regulators do not allow a return of capital if the ratio falls below 5%. Our model has the ROE at BAC increasing to 7% and the balance sheet increasing 3% which generates a 60% payout ratio assuming the current capital buffer is enough.
The Fed results also indicate that, despite its tilt to credit cards (which, in the stress tests, generate losses almost equal to those from trading businesses), COF has a substantial excess of stress-test capital (with a stress ratio of 7.6% near the 8.2% of USB and WFC). Even if COF does not return any of its excess stress-test capital, the payout ratio can rise to 70-80% (from 25% in 2013) given an ROE of 10% and balance-sheet growth not likely to exceed 2-3% in 2014; in practice, this means the stock buyback can increase 4-5 times from under $500mm in 2013 to over $2bn in 2014.
Table: Fed CCAR Results for “Severe” Adverse Scenario
(includes GDP down 6%, unemployment over 11%, a one-quarter and one-half decline in house and equity prices respectively, and a 10-year Treasury yield of 1%)
The Net Rev Cum/Act column compares the CCAR “severe-stress” forecast for net revenue over the 9 quarters from 2013Q4 through 2015Q4 to the actual 2013 run-rate