Merrill Lynch And Countrywide Financial: Huge Thorns In The Side Of Bank Of America

| About: Bank of (BAC)

Summary

BAC's Merrill Lynch and Countrywide Financial acquisitions continue to cause major problems with regards to unresolved mortgage-backed securities.

From 2004 to 2008, Countrywide, Merrill Lynch and BAC together issued nearly $1 trillion of mortgage-backed securities to private investors; to-date nearly 25% of all these have defaulted.

US Judge Rakoff has called these lending programs "brazen fraud" driven by "hunger for profits and oblivious to the harms thereby visited" - certainly not the press BAC needs today.

With litigation costs up and profits down, BAC still appears to have a great deal of cleaning up to do before it's an attractive investment.

Bank of America (NYSE:BAC) is in the midst of negotiations with the Department of Justice (DOJ) over at least a $14 billion settlement related to DOJ's mortgage securities probes.

Recently, however, BAC was fined $1.3 billion with regards to the dealings of Countrywide Financial in particular, which BAC acquired at the cusp of the financial crisis.

Cost of Settlement

BAC is offering the DOJ a roughly $14 billion settlement that includes a combination of cash and consumer assistance. The consumer assistance would take the form of mortgage principal write-downs for struggling homeowners. The DOJ, on the other hand, is insisting on at least $17 billion, with a larger percentage allocated to cash fines as opposed to consumer assistance.

In BAC's second-quarter earnings release, the bank stated that it had already recorded $60 billion in mortgage-related costs, including a $6.3 billion payout to the Federal Housing Finance Agency from a lawsuit made on behalf of the Fannie Mae and Freddie Mac.

BAC acknowledges that it needs to pay for previous wrongdoings, but believes the fines that DOJ are demanding in the settlement are overly punitive, and wants most of the fine to be allocated to consumer assistance instead of hard-money fines, allowing for less impact on the bank's financials.

Negotiations

The impasse is significant enough that the US Attorney General, Eric Holder turned down a request for a meeting with BAC's chief executive, Brian Moynihan earlier in the year. The DOJ's reasoning was that the two parties are still too far apart to make a meeting worthwhile.

It is believed that Mr. Moynihan was looking to plead his case to the Attorney General that both the Countrywide and Merrill Lynch acquisitions were made under Federal government pressure and during a time of overall financial industry distress. Hoping that the DOJ will show leniency because of this supposed pressure is a long shot.

Two months after BAC announced the purchase of Countrywide, Bear Stearns collapsed, and less than 6 months after that, Lehman Brothers fell. BAC definitely may have had buyer's remorse on the bad timing of the purchase, but the top executives of the bank did not visit the Fed to ask for assistance in the way of asset protection until after Bear Stearns' collapse.

This implies they thought it was a good deal initially, but the market changed and they were not prepared for the severity of the downturn, forcing them to go hat in hand to the Fed. The Fed refused to help, and BAC did the deal anyway.

In regards to the Merrill Lynch acquisition, there may be some truth to the argument that the government pressured the bank into completing the deal. At the time, BAC had believed that the acquisition of Merrill's "thundering herd" would add significant value to BAC's financial position. During due diligence, it was determined that the losses were greater than thought. This prompted BAC to try to scuttle the deal, but BAC was ultimately pressured into going forward only after threats from then Treasury Secretary, Henry Paulson, and receiving $20 billion in bailout loans.

Structure Of The Fine

From 2004 to 2008, the combined entities of Countrywide, Merrill Lynch and BAC issued nearly $1 trillion of mortgage-backed securities that were sold to private investors. Countrywide issued nearly 75% of the securities; BAC issued only about 4%. To-date, nearly 25% of all the securities issued by the trio have defaulted. Amazing!

BAC's argument that its fine should resemble the structure the DOJ accepted from one of its chief competitors, JPMorgan (NYSE:JPM), is weak. JPMorgan's recent $13 billion DOJ settlement included a $2 billion penalty to atone for its own misconduct, and $11 billion in payments to other agencies related to securities issued for its acquisition of Washington Mutual and Bear Stearns. Both of these acquisitions were clearly done utilizing government programs. In addition to the fines, JPMorgan had to agree to a statement that described its culture at the time of the misconduct as one in which people were allowed to mislead investors about the quality of mortgage loans it was selling.

Impact Of Fine On BAC

With the magnitude of the fine still to be determined, the effect of the settlement on BAC's financials is not yet fully clear; however, in the second quarter of this year, BAC recorded an additional $4 billion in litigation-related expenses, along with a 43% decline (larger than expected) in profit.

The shares are down YTD.

(Nasdaq.com)

As stated previously, the bank has already reserved a significant amount to account for the potential loss, and continues to record more.

"[The lending program] was from start to finish the vehicle for a brazen fraud by the defendants," US Judge Rakoff describes, "driven by a hunger for profits and oblivious to the harms thereby visited, not just on the immediate victims but also on the financial system as a whole." This is certainly not the kind of publicity BAC wants to garner moving forward in 2014.

With additional, worrying patterns of mismanagement in 2014, including violations of sanctions, we believe BAC has a great deal of cleaning up to do in its operations before it is an attractive investment.

We continue to reiterate our recommendation that shareholders should sell this stock that continues to pay its shareholders only one penny each quarter.

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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.