Like other banks, Bank of America (BAC - Free Bank of America Stock Report) faces a raft of problems in the tough operating environment:  weak loan demand (at mid-2011, its average loans were down 3% year to year); margin pressure in the low interest-rate climate (25 basis points of  margin compression from the 2010 June period); the negative effect of new regulations on noninterest revenue (service charge income in the June quarter declined 22% year to year, and the company will give up $475 million a quarter of debit card fees after October 1st); and still relatively high levels of problem assets (accounting for over 3% of loans and foreclosed properties on June 30, 2011). 

Resolving these problems will take time, but they are probably manageable. To be sure, improvement in loan demand and the margin will depend on economic activity and the Federal Reserve’s interest-rate policies. But the company is making progress in lowering its problem assets (down about 15% from mid-2010). And over time, it may be able to offset much of the noninterest revenue lost (due to new regulations) with new or higher fees, and new services. 

On the other hand, Bank of America’s mortgage problems and related legal costs continue to mount, with no clear end in sight. The company isn’t the only big bank faced with complaints regarding sloppy mortgage underwriting and foreclosure practices, as well as investor claims that it misrepresented now-soured mortgage-backed securities and demands that it buy those securities back from investors. But Bank of America is more exposed to the mortgage mess than other banks owing to its 2008 acquisition of troubled Countrywide Financial, which catapulted the company from the fifth largest U.S. mortgage originator and sixth largest mortgage servicer to the number one position in both areas at the time of the transaction.

The company has been desperately trying to put its mortgage woes behind it. Results in the last six quarters included $22 billion of expenses to address Bank of America’s mortgage representation and warranties exposure, including  proposed settlements of claims by government-sponsored enterprises Fannie Mae and Freddie Mac, by monoline insurer Assured Guaranty (AGO), and by a group of Countrywide private-label mortgage securities trusts. It’s hard to get a handle on Countrywide’s ultimate mortgage costs, but at mid-2011, the company said it had $11.6 billion of unresolved repurchase claims from all sources. New claims no doubt are still being submitted, however. There has been considerable opposition to the settlements, which has delayed their completion, and Bank of America continues to be the target of new lawsuits, including one filed by the Federal Housing Finance Agency recently, that claims the company failed to disclose the risks associated with $57.4 billion of mortgage bonds that it sold to Freddie and Fannie.       

The costs of resolving its mortgage problems have caused Bank of America to report losses in three of the past four quarters. These losses are taking a bite out of shareholders’ equity at a time when the bank industry is preparing to adopt stricter international equity capital requirements. Investors are questioning whether Bank of America will be able to meet those higher capital standards, in spite of Berkshire Hathaway’s (BRKB) purchase in August of $5 billion of Bank of America preferred stock, and despite Bank of America’s efforts to sell noncore assets, like its international credit card business, which should help raise its equity-to-assets ratios. The company also recently replaced a number of key personnel, in an effort to strengthen its management team, and is reducing its workforce.

So what can Bank of America do to contain its legal costs and strengthen its equity capital? If there were easy answers, the company no doubt would have acted on them by now, but industry observers have some suggestions.

In an article in the American Banker, Robert Smith, the former Chairman and Chief Executive Officer of Security Pacific Corp., a California bank that Bank of America acquired back in 1992, suggests that the company “dump Countrywide into bankruptcy and take a writeoff”. Legal matters are not our expertise, but we wonder whether bankruptcy would shield Bank of America from Countrywide’s mortgage-related legal liabilities or whether the courts would frown on this strategy and somehow still hold Bank of America responsible. Since Bank of America’s ballooning legal costs are its main problem, such a move would greatly aid the big bank if it worked. We’re not sure it would.

Mr. Smith also suggests that Bank of America “Raise enough new capital to remove any doubt of (its) survival”. In actuality, the company has been resisting issuing additional common stock, and instead has been selling nonessential assets and businesses to beef up capital. Selling additional stock would dilute current stockholders’ holdings, and would be very unpopular, since many investors have already taken quite a hit on their Bank of America stock. The idea also raises the question of how much stock would need to be sold, given that Bank of America’s ultimate mortgage/legal costs are hard to pin down and may not be known for some time. 

Others suggest that Bank of America sell core businesses, including Countrywide and Merrill Lynch, in addition to noncore operations, as a way of boosting capital and lightening its legal cost burden. But Countrywide’s legal liabilities probably would deter potential buyers. As for Merrill, its acquisition significantly expanded Bank of America’s investment banking capabilities. Bank of America is trying to increase the cross selling of products between Merrill and the bank, and probably would be reluctant to part with Merrill. Note that divestitures, large and small, deprive the company of the revenues generated by the assets sold.

In the end, rebooting the big bank probably will include some combination of the above ideas: more asset sales; more stock; and perhaps some move by all parties involved to cap Bank of America’s mortgage-related legal liabilities, in order to avoid having the government bail out the company a second time.


At the time of this article’s writing, the author did not have positions in any of the companies mentioned.