Bank Of America: One Last Blow Of Penalty Remaining

Jul.17.14 | About: Bank of (BAC)

Summary

Bank of America continues to get punished for wrapping shoddy home loans into residential mortgage-backed securities and selling them to investment-illiterate investors.

The second-quarter earnings of the bank clocked in at 19 cents per share. The $4 billion litigation hit crimped earnings by 22 cents per share.

One last blow expected: the Federal penalty may squeeze the bank's third-quarter profit up to 190 cents per share.

The prevailing uncertainty may pose a good opportunity for market entry at a low price, as the stock is still undervalued even after incorporating the last blow of penalty.

The Background Story

In 2008, Bank of America Corporation (NYSE:BAC) made the blunder of picking up Merrill Lynch against a hefty consideration of $50 billion. The majority of the mortgage-backed securities were issued by Merrill Lynch. Even the regulators had favored the acquisition back then, which now raises the question of whether Bank of America should be held fully accountable for shoddy home loans issued by its subsidiary.

However, the Department of Justice "DOJ" keeps stressing the fact that banks ought to admit their wrongdoings and help the community at large to recover from the impact of their behavior through consumer relief. The Justice has been dealing with a series of cases against financial institutions for wrapping shoddy home loans into residential mortgage-backed securities "RMBS" and selling them to investment-illiterate investors.

Moreover, in an attempt to retain and grow its customer base on a zero-sum market, the bank turned into a machine of producing loans, with little or in fact no emphasis on the declining quality. Low quality meant that loans were granted to people with low income levels having a very low probability to be able to pay down their installments when they fall due. Ultimately, when the housing market crashed as the borrowers were unable to pay, there was a plethora of securities available in the market for sale with no or little demand. This made the securities stand worthless in the market. The losses magnified to such a level that it nearly toppled the financial system of America. Lenders retreated from the market. Stock markets plunged and home values witnessed a nose dive.

The devastation brought about by the financial crisis compelled the Obama administration to assemble a mortgage task force comprising federal and state attorneys to scrutinize crisis-era crimes. The regulators are investigating the chain of facts and penalizing the culprits to avoid any unlawful conduct in the future.

The Current Status

Source: USA Today

Yesterday, the second-quarter earnings of the bank clocked in at 19 cents per share. Apart from the slump in mortgage origination, the $4 billion litigation hit crimped earnings by 22 cents per share. The litigation expenses also included the $650 million settlement with American International Group Inc. (NYSE:AIG) to settle all unresolved RMBS litigation issues concerning the two companies.

Excluding the impact of $4 billion in legal costs, the bank reported earnings of 41 cents per share, beating analysts' projections of 29 cents per share. In fact, the bottom line has elevated by 28% compared to the corresponding period last year.

Following the $4 billion hit, Chief Financial Officer Bruce Thompson said,

"We feel like we've gotten a large chunk of this behind us... Clearly, the DOJ is the most significant matter that's out there remaining"

Unlike JPMorgan (NYSE:JPM) and Citigroup (NYSE:C), the bank is yet to resolve a federal scrutiny for issuing faulty mortgage loans which ultimately led to the housing meltdown. Recently, the bank has been actively negotiating with the government to slice down its share of penalty to $12 billion. However, Justice had demanded a higher amount, which will be forwarded for consumer relief. In fact, the Department of Justice holds the opinion,

"If an institution is unwilling to admit its wrongful conduct in a statement of facts, or balks at paying a substantial penalty that reflects that conduct, or refuses to do right by those affected, then we will not shrink from litigating."

The statement clearly hints at the fact that the regulators are in no mood of agreeing with the $12 billion offered by the bank and has demanded more billions. In the wake of the aggressive attitude of the DOJ towards Bank of America, the fine may be as high as $20 billion. This may once again squeeze the bank's third-quarter profit up to 190 cents per share.

Final Verdict

The financial contagion has sent shockwaves through the banking industry, sending Bank of America's stock tumbling ever since the federal scrutiny began. With the last but a hefty upcoming penalty to be paid, the stock price of the scrip may plunge further as the bank bears the brunt of the one last blow. The bank is currently trading at a P/B of 0.7x, as compared to the industry average of 1.1x. The bank currently has a book value of around $22 per share. If we assume that the company will have to face a loss of 190 cents in its book value, as mentioned above, the book value will fall to $20.1 per share. Even after incorporating the litigation charges, if the share price remains the same at $15.4, the stock would still be trading at a discounted P/B of 0.76x, as compared to the industry average of 1.1x. The prevailing uncertainty may pose a good opportunity for market entry at a low price, as the stock is still undervalued even after incorporating the last blow of penalty. Therefore, I recommend buying the stock.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.