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With Bank of America (NYSE:BAC) hovering around $5 a share, the billion dollar question is about its potential liabilities related to a barrage of lawsuits, and its strategy to navigate these liabilities.

In a Bloomberg Businessweek cover story (September 12-September 18, 2011) on Bank of America, one analyst stated "litigation aside, there is nothing wrong with this company."

However, it is hard to put the litigation "aside" for now. And it is difficult to accurately value what the ultimate payouts will be. In fact, this is precisely the role of litigation: To determine the value of the liabilities Bank of America owes to plaintiffs.

The Paul M. Barrett and Dawn Kopecki Businessweek piece touches on Moynihan's quest to bring clarity to the uncertain liabilities facing Bank of America. And even if investors can't yet derive an exact dollar figure for the liabilities, they can still look at the big picture and, more importantly, the broader strategy BofA employs in facing these liabilities.

The big picture reveals two strong counterforces in these cases. As a defendant, Bank America is still formidable. Headed (aptly) by a career lawyer--Brian Moynihan-- Bank of America generates over one hundred billion dollars a year in revenue and has the ability to pay legal claims or tap markets for additional capital (and even call on a very shrewd investor like Warren Buffet, for $5 billion). Its field general in the legal battles is a former top SEC lawyer Gary Lynch.

On the plaintiff's side, it is a challenge to track all of the cases (and they continue to emerge). Nathan Vardi of Forbes even did regular Bank of America "lawsuit of the day" coverage, following the endless stream of cases. The plaintiff's situation is also unique in the sheer financial power of the plaintiffs. Bank of America faces all state attorney generals, multiple federal agencies, large pension funds, and major financial and insurance firms (and potentially all local governments as well). The parade of plaintiffs represents some of the most sophisticated and best-funded plaintiffs imaginable.

Are there any ballpark figures for what the litigation will cost? The Barrett and Kopecki piece drops the litigation into three tidy buckets, along with their estimates value of liability:

  1. Loan originations (e.g., from Countrywide's lax origination) $8.5 billion;

  2. Mortgage Backed Securities $10 billion (from understating risks);

  3. Servicing/Robo-signing $ 20 billion.

However, much will depend on the exact facts and posture of a given case and even the judge involved (with some judges reluctant to approve settlement proposals they do not see in the public interest).

In addition, these figures may just be the start of the overall liabilities. For example, there is the Bank of America shareholder lawsuit based on the Merrill Lynch acquisition (estimated at $50 billion by some sources); recent cases from across the U.S. contend the electronic filing system (MERS) used by mortgage firms may have shorted counties by billions of dollars; and in some of the cases against Bank of America, major players are opting out of class actions--such as T-Rowe Price (NASDAQ:TROW) and Black Rock (NYSE:BLK)--causing Bank of America to fight on even more fronts.

Many investors have seen this movie before: A major U.S. company facing massive lawsuits. Consider Exxon (NYSE:XOM) (i.e., Valdez oil spill); BP (NYSE:BP) (ongoing Gulf oil spill litigation); Phillip Morris (MO, PM) (tobacco litigation); and Johns Manville (NYSE:BRK.A) and W.R. Grace (asbestos litigation).

Investors also know there are several possible endings. Well-funded Exxon battled litigants for decades (with punitive damages rules even changing in the interim); BP looks like it will be damaged but survive largely intact; and Phillip Morris used a combination of settlements, restructuring, and case by case litigation to survive and continue to profit. Firms with massive asbestos litigation, however, were largely overwhelmed.

Bank of America may have another ace to play as it is closely linked to the American economy (think "too big to fail"). Moreover, almost all the litigants stand more to gain from Bank of America as a going concern, able to pay out structured settlements or buy back bad mortgages, than as a bankrupt basket case. In some ways, Bank of America's current weakness could be a bargaining strength. The firm really can't pay everything plaintiffs are asking for at present, and since there can be no blood from a stone, the plaintiffs will have to take a fraction of their claims now or take their chances in the very long and costly trial and appeal process.

How will Bank of America fair? Three possible scenarios emerge:

  1. Buy Scenario: Bank of America could potentially prevail in significant court motions and/or begin to reach favorable consolidated settlements in many cases, clearing the way for the firm to be more highly valued. A tandem bonus could come from improved underlying economic conditions (i.e., recovering housing market). While promising housing starts data has emerged, there has been less favorable litigation news.

  2. Sell Scenario: Litigation costs and settlements could begin to overwhelm the firm, with legal costs dragging on and distracting the firm, liabilities ballooning, further depressing the stock price. Additional liabilities could (and do) continue to emerge, and the company may be forced to consider major structural changes or reorganizing to pay claims and find a way forward.

  3. Hold Scenario: Bank of America could continue to manage its massive litigation, incrementally paying claims, fighting others for the long term, and using its "too big to fail" leverage to stay afloat in a weakened state for the foreseeable future. Eventually, the firm could shed enough liability to begin using retained earnings for shareholders boosting the stock price.

Perhaps an equal threat to Bank of America going forward is strategic. Trying to juggle innumerable lawsuits and multi-billion dollar liabilities, the company runs the risk of becoming a litigation management company that also happens to do some banking. Every dollar or hour spent on litigation costs is one less on consumer and commercial banking or financial services. The lawsuits also create public relations headwinds. There will be little chance of using cash for anything but settlement reserves (sorry dividend seekers) and employees likely face near term downsizing, cost cutting, and the sell of divisions and assets.

Bank of America's now has to mesh its litigation and banking strategy. Its litigation costs and the timing of settlements may drive strategic actions rather than a coordinated banking strategy. Already, Bank of America has sold international assets, leads in the number of laid off workers for 2011 (Project New BAC) and embarked on a disastrous debit card fee (ironically for $5 dollars, about the price of its stock).

So the stock is likely stuck as a "hold" for the foreseeable future, with upticks on favorable news related to liabilities and the underlying economy, a process that could take many months or even years as Bank of America executes its litigation and banking strategies.

Disclosure: I am long BAC.

Source: Will BofA Succeed? Depends On Its Litigation Strategy

Additional disclosure: I own all stocks mentioned through index and mutual funds.