Will Legal Problems Bury Bank Of America?

| About: Bank of (BAC)

The sequels of the mortgage implosion and the subsequent financial meltdown continue to plague Bank of America (NYSE:BAC). Bank of America is being sued by federal prosecutors in New York for having made abusive and fraudulent mortgage loans and then having sold them off to Fannie Mae and Freddie Mac, government backed mortgage housing institutions, causing taxpayers massive losses when these went bad during the 2008-09 recession. BAC is being sued for at least $1 billion, with the risk that the penalty may treble.

BAC's problems in this regard, of course, started when it bought Countrywide Financial in June of 2008. Countrywide's dubious lending practices, continued under BAC, apparently were brazen in name as well as in deed, being referred to infamously but rather appropriately at the bank as the "High-Speed-Swim -Lane", HSSL, or "hustle" for short.

In the third quarter, the BAC was hit by litigation charges having to do with its acquisition of Merrill Lynch, tax issues in the U.K. and accounting revisions, amounting to some $4 billion. Nevertheless, at the time the share price did not suffer as much as the latest news seems to have done.

Apart from the latest lawsuit brought by federal prosecutors over fraudulent and abusive mortgage loan practices, BAC faces $22.7 billion in outstanding legal claims as of June 30th derived from its mortgage business, and an overall estimated $53 billion loss on that score.

BAC's stock is currently trading at around $9. Its net income has been on a downward trend since the third quarter of last year when it reached $6.2 billion -with the exception of the second quarter of this year when it reached $2.5 billion- reaching $340 million in this year's third quarter. As a result earnings per share have dropped precipitously from $0.63 in the third quarter of 2011 to $0.09 in the third quarter of this year. As of September 2012, its net operating margin was 5.4% and its net profit margin was 1.66%.

BAC was, of course, both a perpetrator and a victim of the housing market meltdown, and of the larger financial and economic debacle that engulfed the country beginning in 2008. The result was a precipitous drop in its share price from more than $40 before the crisis began in 2008 to a low of around $5 towards the end of 2011, to a current price hovering a little above $9. It must be said though that BAC was hardly alone in the banking industry in having its share price drop like a rock in this period, with some peers, like Citigroup, doing much worse.

Even though housing in general seems to be on the mend and third quarter GDP growth exceeded expectations with 2% growth, substantially better than the anemic 1.3% growth of the first quarter, it still is not a good enough pace if sustained to make a substantial dent in unemployment going forward.

Headwinds BAC may be facing from the overall economic and regulatory climate though may be significant. The Volcker rule of the Dodd-Frank act, which limits proprietary trading by banks, will cost by some estimates up to $10 billion in profits for the biggest banks, including BAC, if applied strictly. Uncertainty over the fiscal cliff facing the federal government at the beginning of next year that threatens to cut spending and increase taxes to the tune of 5% of GDP, continuing uncertainty over whether the Euro Zone will hold together or fall apart with potentially disastrous consequences, and slowing growth in emerging markets, especially in China which reduced its growth to 7.4% in the last quarter, the slowest growth since the depths of the recession in 2009, all paint a fairly uncertain economic picture for the future.

Meanwhile BAC's competition of Citigroup (NYSE:C) and J P Morgan Chase (NYSE:JPM) isn't doing much better with percentage drops in their share prices greater than BAC's., while Morgan Stanley's share drop price hasn't been as bad as BAC's since the start of the recession in 2008.

Given the uncertainty over the course of the new litigation by federal prosecutors and the uncertainty in the general economic outlook, and considering BAC's average performance since the end of the recession, it pays to look at BAC's fundamentals.

A good methodology to assess stocks that combines value, growth and momentum characteristics, developed by Valuentum Securities, is used to look at BAC. The system ranks companies according to how well they do on such measures as return on equity, DCF analysis and capital adequacy in the case of banks.

Valuentum's assessment, according to its DCF residual income model, is that BAC's fair market price is $9 a share. The model opens up a range of 20% up or down such that if the current share price is above the range the share is overvalued and if it is under that range it is undervalued. Since BAC is currently priced slightly over $9 it is deemed to be fairly valued.

Next this method compares BAC with its peers by looking at its share price to book value ratio and comparing it to other banks'. With a ratio of 0.76 BAC scores high on this metric.

One analyst concurs with this analysis going so far as to say that on this measure BAC is undervalued given that it is over $9 at present. With book value of $13.5 and an average market to book value among comparable banks at 1.4, his analysis concludes that the range to which BAC could reasonably expect to reach would be between $13.5 and $18.87.

But on a return to equity basis, where earnings are divided by book value, BAC doesn't do well at all. Valuentum uses 10% as a threshold for the cost of capital for banks below which banks' performance is considered poor. BAC barely breaks into positive territory with a score of 0.1%.

On a capital adequacy basis, which measures BAC's capital versus its risk weighted assets, it scores fairly well, according to Valuentum. A score above 10% is considered good and BAC scores 12.4% for 2011.

The Valuentum method adds up all these metrics and gives the company a score on a scale of 1 to 10, with 10 being the best and 1 the worst stock to buy. Overall, it considers BAC fairly valued, giving it an overall score of 7, which is not good enough to merit a buy recommendation.

If we combine BAC's particulars with the overall economic situation it doesn't makes for a compelling case to own BAC shares. The banking sector to begin with is still dealing with the aftermath of the 2008-09 financial meltdown as a whole, with an economy that is recovering at a snail's pace and facing an uncertain future, especially as it relates to the fiscal cliff and the Eurozone ongoing debt crisis.

As we've seen, BAC carries an especially heavy burden when it comes to dealing with potential losses resulting from its mortgage business arising from its purchase of Countrywide. Going forward BAC's legal contingencies will weigh heavily on its stock price. Even though its operating margin will not be affected its legal exposure to lawsuits will still affect BAC's bottom line significantly because it increasingly appears they won't be a one-off phenomenon, especially considering BAC may not have seen the last of potential lawsuits arising from its mortgage loan dealings. If we add to that BAC's anemic earnings potential it would be just as well to try and look for a more promising stock.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: This article was prepared for Freedonia Freelance by one of our analysts.