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In our article of 12/28, we noted Bank of America (BAC) has been strongly capital-generative since Mr. Brian Moynihan became CEO in December 2009. For example, company reports show the Tier 1 capital ratio, calculated in accordance with today's regulatory regime, increased to 11.4%, presently from 7.8% at the end of 2009.

In 2012, the capital-build reduced investor concerns, prevalent in August 2011 when Mr. Warren Buffet invested $5 billion in preferred shares, that the bank did not have enough capital and would need to issue common stock at distressed prices. We believe the lower risk of "dilution" by additional share issuance at low prices accounted for the strong performance of the stock.

Expect Stock Buyback in 2013

In 2013, BAC appears to have sufficient capital and, as shown below, is better capitalized than J.P. Morgan Chase (JPM) and Citigroup (C) under the Basel 3 capital regime that is now an important focus of regulators. This means capital generated in the year will potentially and partly be available for return to stockholders, and we expect the announcement of a stock buyback possibly as early as March 2013.

(click to enlarge)

Any such return of capital to stockholders will need to be included in BAC's capital plan to regulators, and approved by them possibly as early as this March. CEO Brian Moynihan has recently commented on the importance of "earnings consistency" to these regulatory discussions so that the bank has an incentive to reduce balance sheet risk. A key source of this risk is outstanding litigation and, for technical accounting reasons, mortgage servicing.

Recent Announcements on Litigation and Mortgage Servicing

The announcement on Monday of a $10bn settlement with Fannie Mae (comprising $3.6 billion in cash and $6.4 billion in mortgage repurchases) and sale of a $300 billion mortgage-servicing portfolio are moves to reduce balance sheet risk, and the associated earnings uncertainty, to win approval of the Federal Reserve for stock buyback.

Other recent actions are also supportive. In particular, BAC has settled litigation related to its role as a payment processor for Fannie Mae and, in conjunction with other banks, to its foreclosure practices. And, finally, the bank announced on Wednesday the sale of an additional $100 billion mortgage-servicing portfolio.

Impact on Balance Sheet Risk

Settling litigation self-evidently reduces uncertainty around the balance sheet. However, the sale of $400 billion in mortgage-servicing rights, accounting for approximately one-quarter of the bank's servicing business, is also important.

When BAC, or any other firm, acts as a "servicer" of mortgages it collects payments from the borrower and remits these payments to the appropriate holders of claims related to the mortgage. In return, BAC receives a "servicing fee" which is related to the outstanding balance on the mortgage. Accounting standards require that the expected stream of servicing fees be capitalized on the balance sheet as a "mortgage servicing right" or MSR.

As of the end of last quarter, BAC's MSR balance stood at $5.1 billion. MSR balances contribute towards capital but the allowed contribution will decline to a maximum of 10% of the MSR balance, from 100% presently, under proposed Basel 3 guidelines. This does not appear to be an issue for BAC since its MSR balance is less than 5% of "Tier 1" capital of $135 billion.

Fair Value Adjustments to the MSR

However, the MSR can induce meaningful variation in earnings and, given CEO Brian Moynihan's linkage of earnings consistency to regulatory approval of the bank's capital plan, the bank has an incentive to reduce the impact.

Technically, the valuation of the MSR involves discounting expected future servicing fees and this involves assumptions regarding the average life of the mortgage (which is, in turn, affected by the rate at which borrowers choose to prepay), the default and delinquency rate, and the prevailing level of interest rates. Changes in these assumptions give rise to changes in the fair value of the MSR which flow through earnings.

Like other mortgage-servicers, BAC attempts to manage the resulting earnings variability through the use of derivatives but the process is not precise and gives rise to meaningful swings in earnings. For example, in the second quarter, there was more than a $1 billion swing (pre-tax) from the prior year as the change in the MSR valuation, net of hedges, was a positive ~$200 million versus the year-ago compare of negative ~$900 million - see below.

Fair Value Change of MSR ($mm), Net of Economic Hedge
1Q112Q113Q114Q111Q122Q123Q12
3(873)3601,166194194560

Conclusion

The "MSR" asset created by BAC's mortgage servicing business can create meaningful swings in earnings - for example of nearly $1 billion (pre-tax) on a year-on-year basis in Q2 2012. This would be a large variation even if BAC were generating normalized earnings of ~$5 billion/quarter (after-tax).

With the bank earning significantly lower returns, and with a regulatory focus on "earnings consistency" during the capital plan discussions, it is understandable management is attempting to reduce the earnings impact of MSRs. Hedging is imprecise to the extent that the $1 billion swing referred to above is net of hedging.

Outright downsizing of the mortgage-servicing business more reliably reduces the MSR risk, and we view recent announcements that BAC has sold approximately one-quarter of its mortgage-servicing portfolio in this context. We expect regulators to be reassured in the capital plan discussions, particularly those involving the possibility of stock buyback, by management's recent actions to reduce MSR as well as litigation risk.

Source: Bank Of America: Reducing Balance Sheet Risk Ahead Of Expected Stock Buyback