What's Behind Bank of America's Big Settlement

This article is part of our Rising Star Portfolios series. You can read about the Dada Portfolio here.

Bank of America (NYSE: BAC  ) has reached an agreement to settle with Bank of New York Mellon (NYSE: BK  ) over residential mortgage backed security trusts for $8.5 billion (and concurrently set aside an additional $5.5 billion of provisioning). New York Mellon was the trustee representing a group of investors including Pimco, The New York Fed, and Blackrock (NYSE: BLK  ) , who claimed that Countrywide (now a Bank of America subsidiary) misrepresented the quality of the mortgages it sold them during the housing run-up. The claim was part of, but not the primary focus of the Dada Portfolio's short thesis for Bank of America.

The securities in question had with an original principal value of $424 billion, about half of which has been repaid so far.

It's a bit unusual that Bank of America would settle so quickly. These kinds of putback claims are tough cases to win, since investors have less access to the loan files than the bank, and they have to show that the losses were due to the misrepresentations, not, say, a bad economy. MBIA (NYSE: MBI  ) is three years into a similar lawsuit with Bank of America.

There are at least three possible explanations for the quick settlement. Management could be getting tired of the incessant bad PR and uncertainty surrounding their mortgage liabilities. The stock is near its 52-week low and trades for about 0.5 times book value. Never be surprised by the degree to which management, particularly on Wall Street, can be affected by headlines and short-term stock prices.

Secondly, a court case could have led to all those files being opened, which could uncover all sorts of potentially embarrassing mortgage irregularities should they exist. It's not exactly a secret that Wall Street's underwriting standards and practices may not have been flawless and completely above-board during the housing boom.

It's also possible Bank of America just got a great deal. As Yves Smith puts it: "BofA can judge what its risks are VASTLY better than the investors. There are a lot of reasons why it would make sense for BofA not to settle now. Yet it was all over this like a cheap suit. That says it must regard this settlement as a real bargain."

Keep in mind that even after this major settlement, we haven't seen the last of Wall Street's liabilities over allegedly shoddy underwriting and foreclosure practices.

The settlement could embolden investors to take on other originators like JPMorgan Chase (NYSE: JPM  ) and Wells Fargo (NYSE: WFC  ) (though their exposure may not be as extensive as that of Countrywide).

And Bank of America itself still has some outstanding Countrywide liabilities, class action lawsuits from homeowners, attorneys general suits over their foreclosure practices, and possibly trouble from county recorders who believe banks have been cutting corners on chain of title issues for years.

It'll be interesting to see how all of this gets worked out.

You can follow the Dada Portfolio on Twitter @TMFDada, or visit our discussion board here.

Ilan Moscovitz doesn't have an interest in any companies mentioned in this article. The Motley Fool owns shares of JPMorgan Chase. The Fool owns shares of and has opened a short position on Bank of America. The Fool owns shares of and has created a ratio put spread position on Wells Fargo. 

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  • Report this Comment On July 06, 2011, at 8:31 PM, polenium wrote:

    Hells, bells, the rating agencies misstated the value of the mortgage backed securities.

    Check out "inside Job". Paulson, Geithner and Larry Summers were all peddling the stuff.

    They were all in on it except the people that lost a lifes work so they could have a little fun at the 'Wall Street Casino' and those that will pay with imposed 'austerity'.

    This law suit is just a bunch folks fighting over the spoils of their heist.

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