Bank Of America: More Settlement Payments?

Dec.11.13 | About: Bank of (BAC)

Bank of America Corporation (NYSE:BAC) has performed very well this year. BAC has a YTD increase of 34.19% based on its December closing price of $15.58. The stock is still trading very near its 52-week high of $15.98 but investors are sitting on fences, playing a wait-and-see game. The stock price is not making any substantial movements at all.

I was expecting a small rally for BAC after the December 2 announcement that Bank of America has reached a settlement with Freddie Mac (OTCQB:FMCC). The $404 million negotiated payment by Bank of America is reputed to be the last payout penalty for the defaulted mortgages fiasco. This settlement deal was supposed to shield Bank of America from further paying more money to Freddie Mac or Fannie Mae (FNMA.

However, the market has not made any substantial support for Bank America up to this day. Are investors still fearful that BAC is still vulnerable to more future payments over the bad mortgage loans it made? The bank has already paid over $14.8 billion in settlement deals from claims by mortgage-finance companies since 2010.

The Worst is Not Yet Over

Bank of America, after settling with Freddie Mac, also got approval from a federal judge for the $500 million settlement over the Countrywide Financial Inc. Residential Mortgage-Back Securities it sold from 2004 to 2007 to the plaintiffs Iowa Public Employees System, Western Conference of Teamsters Pension Trust Fund, Maine State Retirement System and the Federal Deposit Insurance Corp (FDIC).

Unfortunately, Bank of America still has more RMBS-related litigation problems. It is still negotiating an $8.5 billion settlement with other plaintiffs who filed RMBS courts cases against it. The stock market is perhaps nervous that this negotiated amount is likely to be rejected by the plaintiffs. Bank of America might pay more to finally settle all its pending RMBS litigation.

BAC is vulnerable to a big drop if Bank of America gets hit with another huge settlement pay. The $404 million settlement with Freddie Mac is not related to lawsuits that the Federal Housing Authority has filed against Bank of America. The Federal Housing Finance Agency is seeking to recover more than $57 billion that Freddie Mac and Fannie made. How much of those mortgage securities are from Bank of America is unclear but this fact is a huge threat to BAC.

Bank of America's Reserves Allocation

The billions of settlement payments that it had paid and will probably still continue to pay has been a big drag on Bank of America's income. I also wonder if Bank of America has set aside enough reserves to cover all future settlements.

Yes, Bank of America has one of the best balance sheets today but I am still uncertain as to how much money will the bank really have to pay to get rid of its obligations over the mortgage securities problem. The glowing third quarter Report for 2013 results shows Bank of America is doing great. As of Sept. 30, it has earned a net income of $8.72 billion. The banking industry is subject to economic cycles and I'm afraid that BAC's reserves for settlement payments may soon gravely affect the profitability of Bank of America.

Cost-Cutting Savings

On the other hand, BAC is increasingly more cost-efficient. The profit margin is notably increasing over the past two years. Bank of America management is doing a great job reducing its business overhead. The bank has continued to seek out better returns from its lending operations.

The savings that the bank derives from lower operating costs may be used to increase its reserves for future settlement deals. Unfortunately, the exact amount that Bank of America must pay is still undetermined.

Conclusion:
I'm not going to recommend a Buy rating for Bank of America right now. I agree with the current market perception. Despite the great economy and low interest rates right now, BAC is still susceptible to future mortgage-securities "put-back" payments. As long as this threat exists, Bank of America shares will have a hard time attracting solid bullish support.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.