Bank of New York Mellon Stock Has Plunged But Is Not A Buy Yet

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The Bank of New York Mellon (NYSE:BK) has plunged about 33% since mid-February and needs to drop some more before it becomes a buy. Higher interest rates have significant impact – both positive and negative on their results. BONY is not a traditional bank and unless they change their primary business model, their future operations will most likely be stagnant. Basically the stock needs to decrease more so it trades on a dividend yield basis relative to the forecasted 10-year U.S. Treasury note yield.

Huge Loss In First Quarter or Profit? – Confusion

Did they have net income applicable to common shareholders of The Bank of New York Mellon of $699 million or was it actually a loss of $895 million? It all depends upon how you want to consider paper losses on securities available-for-sale.

Income Statement From April Press Release

Income Statement From Press Release (sec.gov)

The reported results in their April news release followed an accounting standard of not recording paper gains/losses of securities available-for-sale on the income statement and just showing those on the balance sheet. They reported both methods in their more extensive financial results in their May 10-Q.

Consolidated Income Statement From May 10-Q

Income Statement From 10-Q (sec.gov)

BONY showed a loss of $1.531 billion on assets available-for-sale on the income statement above. This was caused by sharply higher interest rates. In their 10-Q, they also showed that their cost basis for securities available-for-sale was $95.213 billion and that the fair value at the end of the quarter was $92.419 billion – $2.419 billion paper loss. The quarterly decline is even worse when compared to December 31, 2021. At the end of 2021 their securities available-for-sale cost basis was $100.774 billion and fair value was $101.839 billion – $1.055 paper gain. So the quarterly change was actually a total paper loss of $3.474 billion. Management stated in their conference call that during the first quarter they moved some of these securities over to their securities held to maturity portfolio.

Those securities being held to maturity do not show unrealized gains/losses on either the income or balance sheet – they are only shown in parentheses on the balance sheet. The results in this portfolio were also bad. Their total cost basis is $60.602 billion and fair value was $57.659 billion – $2.943 billion paper loss. The ending 2021 total had a very modest loss of $91 million. Collectively, the total quarterly market value changes for both portfolios was $6.326 billion or a $7.83 loss per share.

Data by YCharts

Rising Interest Rate Curve Impact

Rising short-term interest rates are having a positive impact on BONY because they will again start charging fees, instead of waiving fees, associated with money market accounts. If they did charge fees when short-term interest rates were almost 0%, the returns on those accounts for investors would have been negative. This is not some minor issue – it involved a significant amount of lost revenue: 1Q’22 ($222 million); 4Q’21 ($278 million); 3Q’21 ($262 million); 2Q’21 ($276 million); 1Q’21 ($211 million). The total waived fee revenue in 2021 was $1.027 billion or $1.27 per share using the latest number of shares outstanding.

Since I am expecting that short-term rates will continue to increase for the next few quarters and will remain over 3% going forward, BONY will most likely be able to return to earning their normal fees on money market accounts.

On March 31, they had a total of $9.706 billion in securities maturing within one year. Since the average yield was 1.20%, I assume some of this is maturing paper that was purchased when interest rates were higher. Without knowing the details of maturing securities it is difficult to estimate the potential increase in yields for rolled-over paper accurately, but with current 6-month yields of 1.44% and 1-year yields of 2.01%, I would expect higher interest income on the re-invested securities, especially since I am expecting interest rates to continue to rise for the rest of this year.

When their $45.236 billion securities that mature within 1-5 years are rolled-over into new paper, the yields should be much higher than the March 31 average on this paper of 0.98%, since I expect 90-day bills to yield over 3.0% by mid-2023 and longer paper to yield over 4.0%.

The 1-5 years is a wide range so it really is impossible to estimate the increase in interest income. Just for the sake of discussion, assume that the total of these two portfolios of $54.942 billion has an average yield increase of 200 basis points, which I consider conservative, the annual interest income would increase by almost $1.1 billion or $1.36 per share.

The estimated changes in interest rates contained in their 1Q 10-Q were not as optimistic as my projections or even the estimates from last year. Their estimates are for only net interest revenue and do not include the increase in fee revenue from money markets.

Estimated changes in interest revenue (sec.gov)

While higher interest rates have a positive impact on interest revenue, higher rates have a very negative impact on note/bond prices. The lower the coupon and the longer the maturity the more the price will drop as interest rates increase.

BONY must have been chasing higher rates by buying longer dated securities because they have $21.503 billion of 5-10 year maturity with an average yield of 1.15% and $3.257 billion over 10 years maturity with an average yield of 2.73%. When the market prices drop, those losses will not be recorded on the type of income statement shown in the press release unless the losses were actually taken by selling the security. The paper losses will, however, be reflected in the second type of income statement shown above.

These paper losses might be very substantial. For example, the current 10-year note (2.875% 2/15/32) was auctioned in February with a median yield of 1.853% and price of 99.737071, but the price, as of the time I am writing this, is 90.2175 with a 2.98% yield. That is over a 9.5% price drop. If there is an average price drop of 15%, which I consider very likely over the next year, the combined paper loss would be about $3.7 billion or $4.60 per share. (I am actually expecting more than a 15% average price drop over the next year because of higher interest rates.)

Business Model

The Bank of New York Mellon is not a traditional bank. They don’t issue credit cards or make car loans. They don’t even deal directly with most of the population. Even before they swapped their retail banking operations for JPMorgan’s (JPM) trust services operations in 2006, most of their Manhattan branches required a very high dollar amount to even open a checking account.

They are really just the largest “back office” in finance with an additional large wealth management operation. Both areas have been stagnant to slightly lower lately. With costs increasing, margins have been hurt. Their major problem, in my opinion, is poor management-from the top down. Their board of directors are composed of mediocre individuals and that flows all the way down to lower level managers. There is a joke on Wall Street that if you are not smart enough to get a job with a good firm you can always have BONY as your fallback place to work. There is a new CEO, Robin Vince, taking over this year who worked at Goldman Sachs (GS) for a long time, so there is hope that management will improve. (These opinions are based on being a client for many decades.)

For a while they had fairly strong growth as ETFs became extremely popular and they expanded internationally, but that growth has leveled off. They are always spending money on new technology just to stay even because their services are really just “commodities”. It is almost impossible to brand name their services.

Their wealth management is the basis for much of their lending activity. Wealthy clients might need a $10 million mortgage on their new East Hampton house or financing for a business they own. At least BONY does not make high risk loans or even moderate risk loans and they have a very small level of non-performing loans (less than 1%). Almost ⅓ of their total $67 billion loans are your standard margin loans for financing securities.

The demand deposits ($90 billion) are key to their lending and investments. These are a cheap source of cash/capital because they do not pay interest and the key reason why higher interest rates will increase their profits.

I don’t expect much growth in their wealth management for individuals. First, their service level has dropped sharply from many years ago. You now just get services that were typical for banking 40-50 years ago-nothing really special, but it is better than “press 2” to get a “menu” after you enter your account number and pin number. Second, I think wealthy younger people do not feel the need to have a “babysitter” help them with managing their money – they do not need an actual person-they just need their phone.

Stock Repurchase Program

Management considers stock repurchases to be part of their payment to shareholders. I strongly disagree. Cash used to repurchase shares should instead be used for paying down debt, CAPEX/growth expenses, or as cash dividends paid directly to shareholders, in my opinion. I am totally against a company repurchasing their stock. BONY has used $24.518 billion of their cash to repurchase 587,164,539 shares at an average price of $41.76. This has been a total waste of cash because the current BK stock price is barely above the $41.76 average repurchase price. During 1Q 2022, they repurchased 1.911 million shares at an average price of $61.64. Why? They should have increased the cash dividend instead.

I fully understand the income tax reasons for repurchasing instead of paying additional cash dividends, but many investors hold high dividend paying stocks in IRAs or in pension accounts. I often fight with management of companies over this issue.

Valuation

I owned BK stock since I was a kid, but sold it in 2007 when Bank of New York and Mellon Bank merged because I was strongly against that deal. While the stock price has dropped sharply this year, I am waiting to buy at a lower price.

Some use comparing the stock price to book value of $45.76, but I think this is an incorrect valuation metric because the value includes intangibles, such as goodwill. I would rather compare stock price to tangible book value of $22.76. The current price is getting “close” to being a buy compared to historic data.

Data by YCharts

A major reason why I would buy BK stock is because of their yield compared to the 10-year yield. Since I am expecting the 10-year yield to be about 4% by mid-2023 and I am also expecting BK to raise their quarterly dividend to $0.38 by the 3Q 2023 based on my expectation of higher revenue/profits from increased interest rates, I would consider buying BK stock at $38. Using the future $0.38 quarterly dividend, the yield would be 4% at $38.

Conclusion

While I was not a Bank of New York client when Alexander Hamilton managed the bank, I have been a client for many decades. I have been disappointed by the decline in the quality of their services. Management for many of the last years has been just “functional” at best. Hopefully the new CEO can raise standards for the employees.

Rising interest rates both help and hurt Bank of New York Mellon. With higher short-term rates they can charge fees again instead of waiving them and they will be able to roll-over maturing paper into higher yielding securities. These higher interest rates, however, have a strong negative impact on the market prices of debt securities they own or trade.

I may consider buying BK stock if it trades at $38 because I am comparing my forecasted 10-year interest rate to my 2023 dividend yield. Currently I have a neutral/hold recommendation.