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Trouble remains for BofA despite mortgage pact

by contributor Aaron Timms  |  Published January 8, 2013 at 8:48 AM
The junk is out of the trunk, but is this really the beginning of a fitter, better Bank of America Corp.?

Late last year, Meredith Whitney, the celebrated Wall Street banking analyst who rose to prominence in 2007 with her out-of-consensus -- and ultimately accurate -- sell call on Citigroup Inc., told CNBC that once it got the "junk out of the trunk" Bank of America would be a big buying opportunity. "I have not seen an opportunity like this in four or five years," said Whitney, the head of Meredith Whitney Advisory Group LLC.

Now, with Monday's announcement of a $10 billion settlement with Fannie Mae over its soured home loan portfolio, a large portion of Bank of America's trunk has been definitively de-junked. But whether that spells the end of the gloom for the troubled Wall Street giant is another matter entirely.

The deal will see Bank of America pay Fannie Mae $3 billion directly to settle outstanding disputes relating to the quality of home loans its subsidiary, Countrywide Financial, sold to the government-owned housing finance corporation in the years leading up to the financial crisis, as well as an additional $6.75 billion to repurchase a basket of disputed loans at a discount to their original value. The Fannie settlement overshadowed two other big announcements on Monday, with Bank of America also offloading servicing rights to $306 billion in delinquent home loans to a number of other firms including Walter Investment Management Corp. and Nationstar Mortgage Holdings Inc., and the bank taking its place alongside nine of its Wall Street peers, including Citigroup, JPMorgan Chase & Co. and Wells Fargo & Co., in an $8.5 billion settlement with the Federal Reserve and the Office of the Comptroller of the Currency over foreclosure abuse claims.

Taken together, Monday's settlements remove a fundamental drag on growth for Bank of America as it has attempted to chart a post-crisis path back to sustained profitability. The major albatross for the bank has always been the legacy of its disastrous $4 billion acquisition of Countrywide in 2008, which left the company saddled with potentially huge legal liabilities that were necessarily unknown and imprecise in dimension. The settlement with Fannie Mae removes a lot of that uncertainty, and will reduce the ongoing burden associated with servicing troubled loan. But the bank is by no means out of the woods.

For a start, the Fannie settlement does not, of itself, dispose of all the outstanding mortgage-related problems bedeviling the bank. Fitch Ratings last year estimated BofA's potential future liabilities arising out of the legacy mortgage business at $20 billion; Monday's settlement naturally leaves considerable headroom before that ceiling is reached. The bank's exposure to private-label claims and warranties, according to its third-quarter earnings presentation, is around $10 billion, virtually identical in size to the claims that had been put by government-owned enterprises such as Fannie Mae. According to JPMorgan analyst David Trone, this suggests that Bank of America will continue to suffer under a steady drip of mortgage claims in the years ahead; and given the atomized nature of the claims, it's less likely they will ever coalesce into a one-stop settlement as has happened with Fannie Mae.

"These types of kitchen-sinks suggest that the problem is over, but as we've seen, the mortgage mess lingers on and on," Trone wrote in a note. "Financial penance for legacy issues will continue, in our view. ... [W]e expect to see cases throughout the next couple of years." Other disputes over the mortgage mess remain unresolved, including a civil suit filed by federal prosecutors in October last year that could require more than $1 billion to settle. Analysts describe all of these claims as being less straightforward and less simple to litigate than those that were the subject of Monday's settlement with Fannie.

And despite the generally upbeat reception that Monday's announcement received, one minor clanger among all the good news struck some analysts as the kind of public relations misstep typical of Bank of America in recent years: The bank last year reserved $16 billion for costs associated with the settlement of the mortgage morass, but on Monday said it would be adding a further $2.5 billion to that reserve. "One thing [JPMorgan] has done well is under-promise and over-deliver," said Morningstar Inc. analyst Jim Sinegal. "BofA has sort of done the opposite. They'll say, 'We're fully reserved,' then they'll say, 'Actually, we need another $2.5 billion.' They'll say, 'We're going to pay a dividend,' then, 'Actually, we're not.' That's a problem."

The likely persistence of legal headwinds into this year and beyond led ratings agencies, while welcoming the Fannie Mae settlement as a step in the right direction, to remain unmoved in their fundamental assessment of the bank yesterday. "Although significant amounts of legacy issues are resolved, sizeable amounts remain," Standard and Poor's wrote in a note. "We see BofA as remaining opportunistic in continuing to reduce legacy mortgage exposures in 2013. This should result in reduced exposures and earnings volatility in the future, but the costs may be reflected in continued charges and, therefore, earnings volatility over the next several years or so." The bank expects fourth-quarter earnings to be "modestly positive," an assessment with which most industry watchers agree; but beyond that the outlook is murkier.

This uncertainty arises because, looking beyond the weight of this legacy legal exposure, there is much to do if Bank of America is to make a success of the universal banking model with which it -- for better or worse -- finds itself saddled. CEO Brian T. Moynihan took over at the helm in 2010 and has spent much of his time since attempting to pick a path through the numerous land mines laid for him by his predecessors, including the Countrywide acquisition and the 2008 purchase of Merrill Lynch.

In 2011, Moynihan outlined a growth strategy under the cheerily revisionist banner "Project New BAC," with a focus on reducing risk-weighted assets, deep cost cutting, an expansion in wealth management, and the settlement of mortgage claims. The last of those appears to be on track, but there has been limited movement on the other three. Costs cuts have offered themselves as the fastest way back to operational efficiency, but even though multiple nonessential assets have been sold off, including several international credit-card units, an insurance unit and stakes in foreign banks, job cuts -- despite the stated ambition under Project New BAC to eliminate $5 billion in annual expenses and 30,000 jobs by the end of 2013, and to save a further $3 billion by mid-2015 through cuts to the capital markets business -- have been slower to materialize.

"Bank of America is still a long way from producing acceptable returns on capital," Sinegal said. "Right now they probably need to integrate more than they need to grow. There are some [lines of business] that could be cut, but if you think about how Bank of America has developed historically, it makes sense for them to try and get the different units to speak to each other rather than cutting altogether. Still, the more they can reduce their size in the individual units, the better. That's what people are looking for."

Citigroup, which has worked aggressively under new CEO Mike Corbat over the past two months to shed jobs and reduce its international footprint, is described by many analysts as the Wall Street peer whose cost-cutting example Bank of America would be best advised to follow. The fact that Citi, long the sick man of U.S. banking, can be held up as a model gives a strong sense of how much work Bank of America has left to do.

There is, in short, still a lot of junk to be removed from this trunk.

Tags: Bank of America Corp. | Brian T. Moynihan | Citigroup Inc. | Countrywide Financial | David Trone | Fannie Mae | Federal Reserve | Fitch Ratings | JPMorgan Chase & Co. | Meredith Whitney | Mike Corbat | Nationstar Mortgage Holdings Inc. | Office of the Comptroller of the Currency | Standard and Poor's | Walter Investment Management Corp. | Wells Fargo & Co.

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