Bank Of America: Government Settlements Cost Less Than They Appear

| About: Bank of (BAC)


Government headline settlements with banks often substantially exceed the actual costs to shareholders. For example, BAC's $9.3 billion headline settlement with FHFA in Q1 cost shareholders $3.3 billion.

We can use JPM's $13 billion settlement with DOJ and other agencies as a template for how BAC's settlement with the DOJ may play out.

BAC's remaining shareholder costs are likely lower than the headline costs , due to existing settlements, non-cash penalties, and existing reserves.

I estimate a $12-$17 billion headline settlement, but only $500 million - $4.5 billion in pre-tax costs to shareholders.

Earlier this year, the FHFA announced a huge, $9.3 billion settlement with Bank of America (NYSE:BAC). However, BAC's first-quarter earnings only included a $3.3 billion pre-tax loss for that settlement, around a third of the headline amount. Today I'm going to discuss why there's such a big difference in the headline numbers versus what is reported to shareholders. Then I will make some educated guesses as to shareholder losses relating to the DOJ's reported $12-$17 billion settlement.

Of the $9.3 billion FHFA settlement, $3.2 billion of cash was exchanged for $3.2 billion of mortgage bonds at market value. At the time of closing, they were exactly even on the trade. After closing, those mortgage bonds have risen in value: Fortune claims that BAC will realize a $138 million gain on those bonds in the second quarter, and may ultimately record a $1.4 billion profit on those bonds through maturity.

BAC likely had additional reserves they took in prior quarters. So, the total loss they reported in Q1 was:

Headline settlement $9.3B
Cash exchange for securities -$3.2B
Existing Reserves -$2.8B
Q1 cost to shareholders $3.3B

JPM's settlement is a template for BAC's settlement

In Q4 2013, JPM made a large, $13 billion settlement with a series of federal and state agencies. The DOJ has said that settlement would serve as a "template" for other settlements. So I'm using the existing JPM/DOJ settlement and categories to make an educated guess about the structure of a future BAC/DOJ settlement.

Below I've made a chart of the JPM settlement, ordered from the largest dollars to the smallest. The height of the squares are proportional to the dollar amount and the color (green/red) indicate my view on BAC's current position. For example, if they already settled with an agency, I colored it green. If that item is unresolved, I colored it red.

JPM Settlement ($B) % of total BAC Notes
Homeowner aid, non-cash $4 31% These numbers add to the headlines, but are non-cash and "cost" the bank a fraction of the headline number.
FHFA $4 31% BAC has already settled FHFA claims, as described above, for $6-$9 billion depending on accounting.
FIRREA $2 15% Complicated cases with several legal issues that will probably be appealed to the Supreme Court.
NCUA $1.5 12% Settled for less than $200M
Various states $1 8% Little visibility
FDIC $.5 4% Fairly small component
Total: $13 100%

The "non-cash" charges are green, because this comes in the form of homeowner assistance and debt reduction. These items typically do not cost the bank much money; for example "debt reduction" on a loan that has already been written down, does not create much/any additional charge against earnings.

What you can see is that about 75% of the total dollars from JPM's settlement is either non-cash or already settled.

Estimating headline settlement vs. shareholder costs

Settlement Type Headline ($B) Shareholder Cost ($B)

Add: Homeowner aid (non-cash);

FHFA (settled); NCUA (settled)

$8.5-$10 $0

Add: FIRREA; FDIC; state claims (range is 1x-2x JPM's settlement)

$3.5-$7 $3-$7

Subtract: existing reserves

N/A $2.5
TOTAL: $12-$17 $.5-$4.5

I have calibrated my headline numbers to span the distance between what BAC has reportedly offered ($12Bn) and what DOJ has asked ($17Bn).

For the portions of the settlement that are still unknown, I've written a range which is 1x to 2x what JPM paid. BAC's FHFA settlement at $6.3Bn was about 150% of what JPM paid so this 1x-2x range seems reasonable.

I've estimated a $2.5Bn reserve (they took this in Q1 2014), but there is the possibility BAC took additional reserves at an earlier time.

This leads to an estimate of a charge of between $500M and $4.5Bn. The high end of that range is still a big number, but, substantially less than the $12-$17Bn headlines you may be fearing.

Disclosure: The author is long BAC. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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