Risk, Reward Balance BofA

We are maintaining our long-term Neutral recommendation on Bank of America Corporation (BAC - Analyst Report). The affirmation is based on improving credit quality and various initiatives undertaken to stabilize its balance sheet.

However, BofA’s first quarter reported earnings were significantly lower than the Zacks Consensus Estimate. The results were significantly impacted by negative valuation adjustments related to the narrowing of its credit spreads. However, the sale of non-core assets made it possible for the company to remain profitable.

Additionally, BofA cleared the stress test in March, thereby proving that its efforts to streamline its balance sheet were fruitful. This stress test was the toughest, as BofA along with other major U.S. banks — Citigroup Inc. (C - Analyst Report), JPMorgan Chase & Co. (JPM - Analyst Report), Morgan Stanley (MS - Analyst Report), The Goldman Sachs Group Inc. (GS - Analyst Report) and Wells Fargo & Company (WFC - Analyst Report) — had an even higher stumbling block to clear, owing to their significant exposure to the stressed European countries. Hence, the stress test clearance enhanced investors’ confidence as it reflects BofA’s ability to withstand another financial crisis.

Moreover in 2011, BofA launched a company-wide expense reduction initiative – Project New BAC – with the goal of bringing down expenses by $5 billion annually by 2014. Other than reducing expenses, this initiative focuses on increasing revenue, strengthening risk control and making changes to allow better execution and customer service, while returning more value to shareholders.

However, we remain concerned regarding BofA’s elevated cost structure. Though operating expenses started declining in the recent quarters due to the implementation of Project New BAC, we believe that as the company is in the process of addressing legacy issues and continues to invest in its franchise, operating expenses will remain elevated in the near term.

Also, a low interest rate environment and lower hedge income, due to the new financial reform law, will continue to drag down BofA’s net interest yield, at least through the remainder of 2012.

Further, the financial reform law is expected to have a lingering impact on BofA’s profitability by resulting in higher costs, fee reductions and restrictions. Also, the new capital proposals unveiled by the Fed suggest that banks would be required to maintain a total tier 1 ratio of 7% of risk weighted assets, which is well above the current requirement of around 2%. In the mid term, stricter capital requirement is expected to reduce the company’s flexibility with respect to its business investments to some extent.

Overall, we believe BofA is making sincere efforts to keep itself afloat. Measures like realigning the balance sheet in accordance with regulatory changes, launching expense reduction initiatives and continuously improving asset quality assure better prospects.

BofA currently retains a Zacks #3 Rank, which translates into a short-term Hold rating.