Bank Of America: Handicapping Capital Returns

| About: Bank of (BAC)
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Endless litigation has ruined Bank of America's capital return plans for 2014.

We'll take a look at recent settlements in light of the resubmitted plan.

2015 promises much more robust capital returns.

Bank of America's (NYSE:BAC) never ending legal issues have reared their ugly head once more in recent weeks, with the landmark settlement with the Department of Justice apparently coming to an impasse. This doesn't include other judgments against the Charlotte bank that, while comparatively minor, are still destroying shareholder value in favor of nameless litigants and the Treasury's coffers. In this article, I'll take a look at BAC's legal issues in light of the company's stress test snafu that halted any meaningful capital returns in 2014.

At the end of May, BAC resubmitted its capital plan to the Federal Reserve following the unpleasantness that the well-publicized accounting miscalculation caused earlier this year. We all remember it, but in short, the bank has unknowingly excluded certain losses related to complex securities it inherited from Merrill Lynch from its capital calculations, inadvertently inflating reported capital levels. This set the stage for the suspension of the dividend increase to a nickel per quarter and the $4 billion in buybacks that were scheduled for this year.

On top of this, the DoJ settlement is going to be huge. BAC apparently offered $12+ billion to the government but was rebuffed as that number was somehow too low. The ridiculous nature of these suits aside, BAC shareholders need some resolution to this and other legal issues. BAC has already settled with the FHFA for a whopping $9.5 billion and is now on the hook for another unfathomable figure to the DoJ for virtually the same thing; it turns out you can be sued for the same thing twice.

At any rate, these suits aren't even the entirety of what BAC is dealing with. It seems every week there is something else cropping up where someone is suing BAC over mortgage practices of its subsidiary that was independent at the time of the offenses. There's the mutual fund-related fine that, while for "only" $24 million, is still real money. And then there's the mortgage suit related to Merrill that I'm sure will cost the bank large sums of money when it's all said and done. This list is by no means exhaustive and while I'm hoping BAC has its worst problems behind it, we won't know until we get there.

So what does all of this mean for BAC's capital return plans? We won't know what was in the resubmitted plan until the Fed makes a ruling on said plan, a move it has up to 75 days from May 27th to make. At some point Federal judges will disallow Bank of America and its TBTF competitors to be used as Treasury piggy banks but for the time being, that is reality. As such, we must make estimates based on the fact that the nation's chief bank robber isn't done extracting revenue from BAC, as evidenced by the repeated suits and the outright rejection of a very generous settlement amount in the case of the DoJ litigation. Greed and outright arrogance permeates the air with these suits as the government agencies looting Bank of America and others have become emboldened by victories and are out to extract ever larger settlement amounts.

In terms of these events' effects on capital returns, we know BAC is going to have a hard time in 2014. The FHFA settlement removed $6.3 billion in capital outright and another $3.2 billion in repurchased securities. The DoJ settlement is going to take at least $12 billion but likely more as that amount was rejected by the DoJ. Apparently the government wants something like $17 billion so if we assume that number is the right one, we are talking $26+ billion in settlements this year for BAC. For a bank that was probably going to earn less than $15 billion this year without all of this nonsense, that is a crippling blow to capital levels.

That doesn't mean BAC can't return anything; it just means we need to alter our expectations. BAC is reserved for some of this legal rubbish but since the bank doesn't release what it is reserved for, and for good reason, we have almost nothing to go on. Analyst Mike Mayo seems to think BAC's reserves are just $2.4 billion, although where he got that number from isn't clear. I happen to think it's much more than that due to the enormity of earlier litigation reserve amounts in prior quarters buried in the financials and the fact that BAC actually reduced its reserves earlier this year. Of course, we won't know until it's too late to do anything about it, but I still think Mayo is overly pessimistic.

Assuming BAC has something like $6 to $8 billion in reserves, the DoJ settlement will still remove another ~$10 billion from capital this year, almost eliminating earnings for 2014 over and above what it is already reserved for. If Mayo is right about the reserve number, it will definitely eliminate 2014 earnings. Thus, for capital returns on the resubmitted plan, we need to be cautious. I think the resubmitted plan is probably for the dividend increase to five cents from a penny but I think the buybacks are probably off the table. I hope I'm wrong, but given the sheer size and uncertainty of the DoJ settlement, I can't see the Fed approving more than the dividend increase. Said increase would cost BAC about $2.1 billion over the course of a year, and given the uncertainty surrounding shares, I'd be very surprised if the Fed was lenient enough to allow buybacks as well. As such, keep expectations low when the Fed rules on BAC's resubmission but also remember that 2015's plan isn't that far off and should be much more favorable to shareholders.

Disclosure: The author is long BAC. 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.