The banking sector seems to have bad news attached to almost every piece of good news these days. Only a few days ago, it was revealed that the judges had ruled in favor of Bank of America (NYSE:BAC), and the settlement agreement of $8.5 billion was set to go ahead. This settlement case was the biggest threat hanging on the head of Bank of America, and its solution will certainly go a long way in solving some of the litigation issues of the company. However, it has now been revealed by the company that it is facing two more probes, which can result in substantial increase in the litigation costs of the company. Let's look at these issues and see how it will impact the business.
Two new Probes
Bank of America reported in the most recent filing with the SEC that the company was facing probes into the foreign-exchange trading and its involvement in the government mortgage program. As a result of these probes, the company has increased its estimate to $6.1 billion in total litigation costs for the year - the reserve for the last year was close to $3.1 billion. So, the company expects to spend almost double in litigation costs during the current compared to the last year. The previous estimate of litigation costs for the current year was close to $5 billion, which has been increased by about $1 billion.
Let's first talk about the involvement in the government mortgage program - BAC's compliance with the Federal Housing Administration is currently under review. Other banks have also faced similar probes. Recently, JPMorgan (NYSE:JPM) paid $614 million in settlement after it was revealed that the bank lied to the government about the quality of some of its mortgages. As the government does not review the loans before approving them for the program; it trusts the banks to present loans that are eligible for the program. In addition, JPM paid $389 million in credit care related penalties - the bank was accused of forcing the customers in availing the services that they did not sign up for. Bank of America might end up paying similar amount in penalties and fines. As I mentioned in my previous article, I have been impressed by the approach taken by JPM - the bank has been trying to settle most of the claims, which has resulted in lower litigation expenses. It has also brought less bad press for the company which has had a positive impact on the stock price.
The second probe is by the American, European and Asian authorities into the foreign-exchange trading practices of the banks. However, Bank of America is not alone in this probe; most of the banks are being quizzed by the authorities. These authorities fear that these banks may have worked together in fixing the foreign-exchange rate.
Impact on the Stock Price
The news will certainly come as a disappointment to the shareholders, who believed that the worst was almost behind the company. As a result, we might see a decline in the stock price over the short-term due to the fears of the rising litigation costs. As it is not clear how much the bank may have to pay in penalties if found guilty of fraud; there will be considerable speculation about the penalties, which might impact the stock price negatively. The uncertainty will increase the volatility in the stock price.
However, as I have stated in my previous articles, the fundamentals of the economy as well as the business of the company are getting stronger. As a result, I believe the banking sector will perform well over the next twelve months. Long-term shareholders should be patient as the long-term prospects of the business are bright, in my opinion. The company has dealt well with its litigation issues in the past and I expect it to get through these probes as well.
Furthermore, the Bank also announced that it had reached an agreement with Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) about its $5 billion stake in the bank. According to the previous agreement, the bank could call or redeem the preferred shares at any time; however, under the new agreement, the shares cannot be called back for five years. The advantage for BAC is that Berkshire Hathaway has agreed to not ask for dividends if the situation gets ugly for the bank. Furthermore, Berkshire's stake now will be treated as tier 1 capital which will help the bank meet banking regulations.
I remain positive about the prospects of the bank as the fundamentals of the business and economy are favorable for the banking sectors. As I have explained in my previous articles, the bank has increased its deposit base its total deposits-to-total-loans ratio of about 0.8 indicates it is using its deposits efficiently. I believe the growth in the business segments will continue ensuring the profitability. Furthermore, I think the bank can deal with its new litigation issues and will be able to pay fines if found guilty. In my opinion, Bank of America remains a solid long-term investment.
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.