After 10 months of negotiations, 49 state attorneys general and the federal government agreed to terms on penalties to be imposed on five major loan servicers. The settlement amount totals $25 billion, and provides relief for struggling homeowners, gives conditions for refinancing of underwater homes, gives guidelines for mortgage servicing reforms, alongside direct payments to foreclosure victims and states in the amounts of $1.5 billion and $2.5 billion, respectively. In this article, I focus on three major banks, and assess the effects on their balance sheets. Based on current market conditions, I also give investment recommendations.
Bank of America (NYSE:BAC) has to obey the $11.8 billion in commitments made under the mortgage settlement agreement. This includes $2.4 billion in direct cash payments. Because this bank is too big to fail, it seems that the federal government would give it leeway to make these payments over time (i.e. three years).
On February 16, 2012, Bank of America tendered $3.41 billion in subordinated notes. The company will probably reissue bonds at lower interest rates to capitalize on the low interest rate environment. This should enhance the fixed charge ratio, and improve the likelihood of the continuation of dividend distributions and interest payments for many years to come. Additionally, in fiscal year 2011, the loss before taxes fell to $230 million from $1,323 million, instilling more confidence in the notion that dividends and interest payments are secure for several more years. The debt to equity ratio has also fallen to 1.89, which is another metric that should give investors a bit more comfort. Additionally, the firm's share price has also been above $5 since December 19, 2011, portraying the market's confidence that Bank of America has turned a corner. The bank can ultimately manage to work through the consequences of this settlement.
In addition, despite preferred dividend payments coming out to $1.4 billion, I have confidence that preferred dividends and bond interest distributions will continue for the medium term. As for an investment pick, I like Bank of America's 5.50% Subordinated InterNotes, and it trades under ticker symbol "IKL." Since February 16, it has journeyed from $23 to almost $25, exhibiting confidence from investors that the company will honor its payments. Based on its trading history, I believe that this will hover near the $25 level for a while. To maximize yield, consider getting in at or below $23.50 in the next few weeks. The next dividend payment is on April 16 with a record date of March 30. This security has an A- rating. The current yield is 5.5%, but the distributions do not qualify for the 15% tax rate.
In re agreement with state attorneys general, Wells Fargo's (NYSE:WFC) commitment is $5.3 billion, including a $1.0 billion direct payment to the feds. To put this in perspective, the company made $23.656 billion in EBIT and preferred dividend payments amounted only to $844 million. Also, the ratio of earnings to fixed charges is 4.32, using 2011 numbers. So, this ratio surely will decline in the midst of the mortgage settlement, but the company will lobby hard to maintain its good credit rating. Moreover, the debt to equity ratio is 1.06, which is the lowest among its peers in this article. In 2008, it was 3.94, and in 2009, that figure was 1.97. So, I would say that Wells Fargo has made a lot of progress since October 2008, and can absorb the penalties placed by the settlement.
Income investors should take a look at the 7.50% non-cumulative Perpetual Convertible Class A Preferred Stock. The current yield is a hefty 6.8%, but it recently closed at $1,101 per share. Because it debuted in April 2008, shares are nearing all-time highs, as we move forward from the post-Lehman catastrophe. I am a bear on the general stock market trends, so expect a pull back here. Go in, when this is sub-$1,050. This is rated A- by S&P. The next dividend payment is on June 15, and the record date is in the final week of May. The Google Finance ticker symbol is WFC-L.
Citigroup's (NYSE:C) portion of the settlement is $2.2 billion. The company has already set aside after-tax charges of $84 million and $125 million in its 2011 results. Consider that in 2011, EBIT rose by 13% to $14.899 billion, and preferred dividends totaled to $26 million. The fixed charge ratio is also a healthy 1.91.
The common stock has not shown much response since the announcement of the settlement. In fact, it is up by 6.59% since February 3, while the S&P 500 is 3.33%. Taking this a step further, I say that preferred dividends are relatively safe for the next several years. The latest debt to equity ratio is 1.89, which is down from 5.07 in 2008. Thus, you can rest assured that Citigroup is moving onto a new era of more conservative banking practices, and the firm can handle the new pressures imposed by the mortgage settlement.
For those looking for a fixed-income investment, I suggest the 6.50% Depository Shares Series T Non-Cumulative Convertible Preferred Stock. Shares trade right below $51 with a current yield of 6.3%. I believe that the markets are overheated, despite the recent 200-plus point plunge in the Dow. This has also shot straight up from $40 in January, so this should come down pretty violently. Consider buying in at $45. However, S&P rates it at a BB+, so you must be aware of how much downside risk that you can handle. The next dividend payment is on May 15. The record date is in the first week of May. The Google Finance ticker symbol is C-I.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.