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There were many comments on my recent Bank of America Corporation (NYSE:BAC) article concerned about the litigation costs faced by the BAC. Therefore, in this article I will analyze the impact of litigation on BAC, the price implied loss expected at BAC and whether such loss expectation is realistic or not.

BAC, being the second largest bank of America in terms of its assets, is going through a rough time since it came in to the limelight of the US regulators. The bank has been facing litigation cases and charges for quite some time now.

Quantitative incentives at Countrywide bring trouble for BAC

The bank acquired Countrywide in the year 2008. It must be regretting this decision by now as apart from the consideration paid by the bank, it has had to pay much more in litigation costs. The problem started with how the reward system was designed by the management of Countrywide for its employees which eventually led to the low quality sales. In an attempt to retain and grow their customer base on a zero-sum market, the bank turned into a machine of producing loans with little or in fact no emphasis on the declining quality. When I say quality here, I mean that loans were granted to people with low income levels having a very low probability to be able to pay down their installments when they fall due.

Wondering why did it even happen in the first place? Well, the corporation was promoting the wrong compensation plan which had a high in-built incentive to turn unethical and deliver results let it be by any means. The inside story was that the employees were being rewarded for the number of loans being disbursed regardless of the loan quality while on the face of it, Countrywide was claiming to have updated its underwriting criteria to be more strict and stringent now.

Who were they fooling?

Going through the news, it was quite astonishing for me to realize that the bank had been selling these impaired quality loans majorly to the two government-sponsored entities, Fannie Mae and Freddie Mac. The bank failed to realize that government is the ultimate authority and will in a good position to penalize the bank for the poor prank it was trying to play. And that is exactly what happened. In fact, the government is doing it to send a clear signal to all the mortgagers out there that no mortgage fraud would be tolerated and go unpunished. The bank will be liable to pay $864 million in damages if proven guilty. Also, Freddie Mac has demanded a buyback of loans amounting to greater than 1.4 billion.

Apart from the government agencies, many others, like American International Group (NYSE: AIG), were seriously affected. The insurance company was on the brink of failure and was forced to sell its mortgages at a significant loss to meet the credit default swaps (CDS) claims. The loss was incurred due to the low quality of these mortgages and around 40% of the loans were found to be in non-compliance with the underwriting guidelines published by the bank.

The response of BAC

The bank has been repeatedly defending the imposition of these penalties by reiterating the point that these loans were disbursed before the acquisition was made by the bank and thus, it shall not be held accountable for that period.

Financial impact

The bank is currently trading at a market capitalization of $153.6 billion and a price to tangible book value of 1.01. With an industry average price to tangible book value multiple of 2.91, the market is expecting the bank's book value to fall to $52.78 billion. This would mean a loss of almost $100 billion.

Staying conservative and assuming that the bank is proven guilty, it would have to pay $864 million which would be a clear cut expense in the bank's income statement. Also, in this scenario I am assuming that the bank would be held liable to pay $23 million to the owner of Rhode Island on the claim that it had breached the lease agreement.

The impact of buying back loans highly depends on the proportion of loans that will turn delinquent and may have to be written off as non-performing loans which will effectively determine that pressure on the bank's bottom line. Assuming a delinquency rate of 40% (the percentage of mortgages found to be written below the bank's underwriting standards), a buyback of $1.4 billion loans could result into a loss of $0.56 billion.

A major lawsuit filed by AIG has been recently won by the Bank of America. The claim made by the insurance giant amounted to over $10 billion and could have been a major hit to the bank.

Altogether, the currently running cases along with the delinquencies expected are anticipated to amount to a maximum loss of $1.65 billion in the worst case scenario. However, the market is expecting that the bank will experience either an additional $98.35 billion loans to go bad which translate in to a exuberantly high non-performing loan ratio of approximately 10% while historically the highest ratio was hit in 2009 at 3.75% during the financial crisis or the litigation costs could jump to $98.35 billion which again is quite unrealistic. For this very reason, the bank is trading at quite a discounted level as things may not go bad to that extreme for the Bank of America in the near future.

What may be clear by now is that despite the good financial performance of the bank as exhibited by its improving efficiency ratio from 84.93% in the third quarter of 2012 to 75.38% in the third quarter of 2013 and net interest yield of 2.44% which has increased from 2.32%, respectively, the litigation costs may continue to stifle the company's margins and financial position in the coming quarter as well. However, once the bank is over with paying this one-off litigation expense, if proven guilty, it will be free to move ahead and benefit from its increasing efficiency level that may remain hidden and ignored by the analysts due to the immediate damages to be paid. Following the clearance of these cases, the stock price would rebound to its intrinsic level.

Conclusion

In the short term, the bank is likely to have tough time dealing with the regulatory action. However, this may prove to be a blessing in disguise for investors in the sense that the share price of Bank of America is extraordinarily depressed as explained above.

If the bank experiences a loss of around $50 billion, a highly pessimistic assumption. Its tangible book value will fall to around $100 billion. Still the bank should trade at a market cap of $291 billion at current industry P/TBV. That means a return of around 100% from current price. Therefore, reiterate my buy recommendation on the stock.

Source: Bank Of America: Litigation A Blessing In Disguise