A small mistake by the people at Bank of America (NYSE:BAC) has caused some concern among the shareholders of the bank. BAC recently received approval from the Federal Reserve to increase per share dividend to $0.05 and a $4 billion buyback of shares. However, an error while calculating the capital and capital adequacy ratios has caused the bank to halt the capital disbursement process. The news about the error in calculation and the rumored payment to the federal authorities have caused the stock to lose value over the last few days. Both these events have different implications for the bank in the short term as well as the long term.
First of all, let's talk about the error. The Federal Reserve has developed a stress test that evaluates financial institutions under different scenarios of recession. Banks conduct the internal calculations to meet the stress test requirements, and then the Federal Reserve also tests the banks under similar conditions. There are benchmarks for the banks regarding capital ratios that banks have to meet. Failure to meet these benchmarks results in a financial institution failing the stress test. Bank of America was cleared after passing the stress test, and the bank was allowed to go ahead with the above-mentioned capital plan. However, recently, it has been determined that BAC made some mistakes while calculating the necessary capital.
The error mainly comes from the complex securities that came with the acquisition of Merrill Lynch - structured notes are bonds that also have a derivative instrument attached to them. As a result, the evaluation of these products becomes extremely complicated. The evaluation involves a number of assumptions and scenarios. Furthermore, the treatment under U.S. GAAP and IFRS increases the complexity. The bank was able to report earnings correctly, and the previous financial results will not be affected by the adjustment. However, for Bank of America, it means the bank has less than reported quality "capital," and it will submit the revised calculation in a month's time.
It is very likely that the buyback plan will be cancelled, and the increase in per-share dividend will be considerably less than the previously-announced numbers. The decrease in per-share dividend is mostly a psychological factor, as the cash retained does not go anywhere, and it increases the value of the business. However, some investors like to receive regular cash payments, which affect their investment decisions. The majority of the existing shareholders of the bank is betting on the recovery in the stock price, and shareholders are mainly concerned with the price appreciation.
The reversal of the buyback plan will have a larger impact, in my opinion. The future EPS will not be boosted by a lower number of shares post-buyback. The news caused the single largest drop in the stock price in a day since 2012, when the stock fell more than 6%. An important factor to consider here is that the error can dent investor confidence in the financial system, as accounting errors are always a cause for concern.
The second issue is the news about BAC having to pay in excess of $13 billion to the federal authorities due to the sale of low-quality mortgage bonds. This article very nicely explains the breakdown of the proposed settlements to the authorities. According to the calculations done in the article linked above, the settlement comprises three components: payment to FHFA, payment for consumer relief and payment to other federal regulators and state attorneys general. BAC made payment of over $6 billion to the FHFA during the last quarter; $5.7 billion will be the payment for consumer relief and $5 billion should be paid to other regulators. The combined amount comes to $16.9 billion, less than the $22.5 billion reported by Bloomberg. However, it should be kept in mind that these numbers are mere speculation, and the real settlement can be larger or smaller than the above-mentioned numbers. Nonetheless, the above-mentioned calculation gives a good insight into the process of settlement and its components.
It is clear that BAC will have to make further payments in litigation expenses, which will likely result in further losses for the second quarter. However, these settlements will take away a constant issue of mortgage securities and related litigation expenses.
These two issues have caused a substantial decline in the stock price- so, what should the shareholders do? In my opinion, BAC shareholders should hold on to their shares. The announcement of the settlement and proposed payment may cause the stock to go down further slightly, and investors might be tempted to sell now to buy later at lower levels. However, it will be a risky strategy, in my opinion. The long-term growth prospects of the business are good, the growth in its business segments is strong and the overall economic environment is favorable for banks. The settlement regarding the mortgage securities will finally free the bank from the massive litigation issues, and we will see a smoother upward movement in the stock price as the market starts to realize the growth in the business.
Disclaimer: This article is for educational purposes only and it should not be taken as an investment recommendation. Investors are urged to do their own due diligence before making any investment decision.
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.