Bank Of America Improves Its Prospects By Eliminating Regulatory Headwinds

| About: Bank of (BAC)


Bank of America has underperformed its peer big banks in 2014 because of a problematic stress test submission that the Federal Reserve required it to resubmit and the related fallout from it.

The bank's resubmission was approved, allowing the bank to increase its dividend from $0.01 to $0.05. A forthcoming repurchase plan is also reasonably likely.

The bank is expected to soon settle its mortgage-backed liability with the Department of Justice, which will remove yet another anchor to share valuation.

In the past week, Bank of America Corp (NYSE:BAC), the second-largest U.S. bank based upon assets, has turned its near-term prospects around. The resolution of regulatory issues shall allow the bank to both return capital to shareholders and provide greater focus on actual operations, both of which should bode well for its valuation.

In April, the bank suspended plans to increase its dividend and share repurchase plan after an error in its stress-test submission to the Federal Reserve was identified. The error inflated BAC's capital levels by $4 billion, due to its inclusion of certain structured notes that it acquired through the 2009 acquisition of Merrill Lynch that subsequently matured or were redeemed, and required it to resubmit its submission and requested capital actions. As a result of the need to resubmit, the bank suspended its plan to raise the common stock dividend to $0.05 a share from $0.01, as well as a $4 billion stock repurchase plan. On May 27, the bank resubmitted its requested capital actions, which the Federal Reserve approved this week. Upon doing so, the bank increased its quarterly dividend to $0.05.

The other headwind is that Bank of America must settle its mortgage-backed liability with the Department of Justice. Now that the Federal Reserve has approved the bank's capital plans, it is expected that BAC will soon reach a settlement with the DOJ. This settlement will be substantial, with many expecting the value to end up being around $17 billion. As significant as this number is, the expected settlement is now already priced into the equity, and the market will look favorably at the resolution of this expected event.

Last month, BAC reported a 43 percent decline to second-quarter profit, largely due to declining mortgage revenue and increasing litigation costs. Earnings attributable to shareholders came in at $2.04 billion, or $0.19 per share, compared to $3.58 billion, or $0.32 cents per share, a year earlier, but those results included about $4 billion, or $0.22 cents per share, in litigation expenses.

The bank's real estate services business continued to be a drag on earnings, though primarily due to litigation costs associated with its pre-existing liabilities. The bank made $13.7 billion in home loans in the quarter, which was nearly a 50 percent decline from the same quarter last year, with first mortgage originations falling by nearly 60 percent. Recently, declining interest rates may result in a strong turnaround for home loans at BAC and its peers, to the extent that there may be pent-up demand for financing and refinancing at current rates.

The bank's bond trading revenue increased by five percent to $2.4 billion, excluding an accounting adjustment, which was a considerably better performance than JPMorgan Chase (NYSE:JPM), whose fixed income trading revenue fell by about 15 percent, or Citigroup (NYSE:C), whose fixed income trading revenue declined by about 12 percent. The company's Merrill Lynch investment management division reported record revenue in the quarter, which also helped offset some of the declines to the bank's lending numbers.

Getting past the DOJ litigation should remove a significant headwind for Bank of America. Similarly, the market should react positively to the bank's increased dividend and the strong possibility of further dividend increases over time, as well as a potential share repurchase plan on the other side of the expected DOJ settlement. As a result, it appears likely that Bank of America will outperform the other big U.S. banks in the near term.

Disclosure: The author is long C. 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. Family members own BAC.