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Summary

  • Bank of America reported a quarterly loss of $514 million, after $6 billion in legal costs.
  • The mortgage crisis-related legal costs might become a recurring problem in the upcoming quarters.
  • The developments in core banking units also do not present a bright future for the stock.
  • I do not expect the stock to outperform the market over the next 12 months.

Bank of America (NYSE:BAC) reported an unexpected first-quarter loss last month, after taking a $6 billion charge to cover litigation expenses, a figure that far exceeded the legal settlements the bank had announced. Revenue remarkably improved in two of the bank's major businesses, including GWIM (Global Wealth & Investment Management) and Global Markets. However, the results were overshadowed by higher-than-expected legal costs. The extra litigation expenses came from setting aside money to cover future legal settlements tied to previously disclosed mortgage-related matters.

In March, the bank agreed to a $9.3 billion settlement to resolve claims that Countrywide and other Bank of America entities overstated the quality of the mortgages they sold to Freddie Mac (OTCQB:FMCC) and Fannie Mae (OTCQB:FNMA). The disastrous acquisition of Countrywide Financial Corp. has been the key factor in the more than $50 billion of legal expenses the bank has logged since the financial crisis. Also, the funds that the bank had set aside for covering all of the settlement were severely criticized by some analysts and followed by substantial downgrades in earnings estimates. What is worse, the bank has still some home loan issues to resolve in the future.

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In order to gain some insight about the financial performance of the bank during the first quarter, I think the table above is worth checking in the first place. Firstly, some emphasis should be put on net interest income, which is the most disappointing part of the first-quarter results recorded by the bank. The bank saw a remarkable decline in its net interest income by 6.5% on a quarterly basis (5.4% on a yearly basis). On the other hand, a 16.6% quarterly rise was observed in non-interest income, mainly due to "trading account profits" and "equity investment income" that were up by 185.9% and 65.4% respectively (see detailed table below). It looks like that the bank had benefited from the developments in the bond market by raising its trading account profits. As the end of the golden age of the investment banking gets closer, we may expect that these earnings would be sorely hit. However, I should note that those developments had also badly influenced the net interest income, thanks to lower interest rates, through their impact on margins.

On the balance sheet side, I do not find the loan growth satisfying in consideration of the progress in the economy. Like many, I expected loan growth to be higher. Even if household lending is growing slowly, business loan growth is picking up the slack in the United States. In my opinion, the bank should have been better positioned for the progress in the business lending area, which has huge potential. Additionally, the earning assets growing by 0.3% compared to a year earlier do not give me the resources that I need to draw a rosy picture for the next quarters. Revenue generated from the core operations is likely to fail to meet expectations.

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Recently, some analysts cut earnings estimates for 2014, due to the low level of legal reserves. It is true that the US prosecutors are seeking more than $8 billion from the bank to resolve federal and state investigations of the lender's sale of bonds backed by home loans in the run-up to the 2008 financial crisis, and the bank only has $2.4 billion on reserve. This means that the company still would have to face unexpected legal costs the same way it did in the last quarter. The Sword of Damocles will be hanging over the head of the bank, and not surprisingly, this will lead the stock to perform poorly.

In my last article on Bank of America, I remained largely bullish, along with touching upon some points of concern, such as legal woes. Unfortunately, my fears came true in the first quarter, and the bank reported an unexpected loss. I believe that with a price-to-book ratio of 0.7, the stock mostly priced in above-mentioned unfavorable trends, but I cannot say that things will quickly pick up and then everything will be great either. Therefore, my advice to investors is to employ a wait-and-see strategy, as I remain strictly neutral on Bank of America.

Source: Bank Of America: Grey Days Ahead