Why B of A’s Higher Legal Reserves Could Be a Good Thing



Just when it appeared that Bank of America might be turning the corner, it dropped another bombshell Wednesday, racking up $6 billion in expenses for mortgage litigation that resulted in an unexpected quarterly loss—its first since 2011.

B of A has spent the past four years resolving massive mortgage-repurchase claims and settling regulatory disputes tied to crisis-era woes. But the bank now appears to be waging an even larger battle to convince analysts and investors that there is some end in sight to its litigation risk.

It seemed to be working, at least initially.

“It looks like they now have dealt with most of the litigation issues from a reserve perspective, and we think that’s healthy,” says Guy Moszkowski, a managing partner and CEO of Autonomous Research.

Analysts grilled Bruce Thompson, B of A’s chief financial officer, about an additional reserve of $2.4 billion for what he would describe only as “previously disclosed legacy mortgage-related matters.” Several complained about volatile quarterly swings in B of A’s reserves and asked whether more surprises are ahead.

B of A has consistently under-reserved, preferring to take charges after big settlements, analysts say. It had total reserves of more than $16 billion heading into the first quarter. Moreover, banks typically seek to avoid disclosing too much about their legal reserves especially when they are in the middle of multiple negotiations.

“Higher litigation costs clearly blurred the progress we made,” Thomson said. “We obviously don’t like to report a loss to shareholders.”

B of A took a $3.6 billion charge for a previously announced settlement of mortgage securities sold to Fannie Mae and Freddie Mac. It also reached a crucial settlement of up to $950 million with monoline insurer Financial Guaranty Insurance, for which it had previously reserved.

As a result, B of A reported a net loss of $514 million in the first quarter, or five cents a share, though it would have posted a profit of 35 cents per share without the extra litigation costs.

“The loss reflects the cost of legacy mortgage issues,” B of A’s CEO Brian Moynihan said, adding that he was “disappointed” with the results.

Part of the additional reserve may go toward the so-called “Hustle,” or “High Speed Swim Lane,” case in which the government prevailed in court contending that the former Countrywide Financial—which B of A bought in 2008—rewarded employees based on the volume of loans produced regardless of their quality. The bank also has additional private-label claims still outstanding on loans originated by B of A, the First Franklin unit of its Merrill Lynch arm and third parties, analysts say.

The additional reserve was “not out of line” with B of A’s pending litigation and settlements, Moszkowski says. Since 2010, B of A has paid an estimated $22 billion in legal settlements. “It’s a good thing to have those reserves built in,” Moszkowski says.

But the bigger challenges for B of A going forward are the same ones that plague other large banks including JPMorgan Chase and Citigroup: sluggish revenues, mortgage declines and a slow U.S. economic recovery.

Net interest margins are stalling at a time when many analysts had hoped they would be widening in a higher interest rate environment. B of A said there is a probability that net interest income would take another hit in the second quarter and rise gradually from there through yearend.

Mortgage originations have been a weak link for all of the top banks in the first quarter. B of A’s home loan originations fell 65% to roughly $9 billion, and the litigation expenses caused its consumer real estate division to post a loss in the quarter of roughly $5 billion.

Still, Moynihan said B of A has no intention of loosening credit to borrowers or chasing market share, as it has in the past. Instead, it will focus on making home loans to core “mass affluent” customers and will keep many of those loans on its balance sheet.

“The days of being 20% market share are far behind us,” Moynihan said. “We’ve gotten down to a $10 billion in originations—we’re comfortable where we are. [Mortgages] will be a smaller business.”

On a call with reporters early Wednesday, Thompson said: “We are not going down-market. On the contrary, we are focusing more and more on those people we have relationships with and a large number of those loans will come on our balance sheet.”

B of A’s shares were down 2%, to $16.03 a share, in late afternoon trading. However, there were some bright spots in its first-quarter results.

B of A reported record asset management fees and strong organic deposit growth.

Average loans and leases rose 11%, to $271.5 billion; there is “good loan demand” for commercial and industrial loans, as well as real estate loans, though fierce competition can cut into margins, Thompson said.

Chargeoffs, delinquencies and allowances for loan losses declined in the first quarter.

Operating units reported revenue and earnings “that were either flat or higher” from a year earlier, Thompson said with little celebration.

“We feel that we’re better positioned than we were coming into 2014,” he said.

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