Bank of America's Albatross

I would venture a guess that many investors perceive Bank of America (NYSE: BAC  ) as an enormous, though highly risky, buying opportunity. I would also venture a guess that this perception is generally grounded in moral hazard -- essentially, the belief that a future without the lending giant is impracticable and, thereby, unfathomable. With $1.2 trillion in deposits, representing nearly 12% of the entire nation's liquid wealth, B of A truly is too big to fail.

At the same time, it simply cannot be denied that the bank faces serious challenges -- so serious, that I believe it would have been seized already by regulators if not for its size. This reality is illustrated by the fact that B of A, the nation's second largest lender behind JPMorgan Chase (NYSE: JPM  ) , trades for a shocking 36% discount to tangible book value, less than any other major money center bank, with the exception of Citigroup (NYSE: C  ) . To translate this into dollars and cents, the market is effectively assuming that B of A will lose $48 billion over the near- to mid-term.

 The question of whether or not to invest in B of A accordingly hinges on this. If you believe that the market has overestimated the bank's prospective losses, then its stock is a buy. But if you believe the market has underestimated the extent of B of A's exposure to toxic assets, then it's probably time to sell the lender's stock if you own it, and avoid it if you don't.

What follows, in turn, are various estimates of B of A's exposure to so-called repurchase claims – arguably, its biggest residual liability dating to the financial crisis.

Repurchase claims: The albatross around B of A's neck
Over the last two decades, nothing less than a revolution has occurred in finance. Under the old way of doing things, banks solicited credit-worthy borrowers, lent them money to purchase something, generally a home or a vehicle, and then sat back, while interest and principal payments accrued. Under the new way of doing things, known as securitization, banks took this process a step further, by transferring their loans into a separate corporate entity, and then selling stakes in the entity to institutional investors, like pension funds and insurance companies. In the parlance of Wall Street, banks migrated from the storage business to the moving business.

While this revolution was heralded as a lucrative godsend on Wall Street, it also created an additional and seemingly unforeseen consequence. By selling their wares to customers, not unlike an electronics store or any other type of retailer, banks unwittingly exposed themselves to the dreaded return of defective products -- in this case, securitized loans. These returns are known as "repurchase claims," and are generally associated with securities populated by defective mortgages -- that is, mortgages that lacked proper documentation, or were obtained via fraud.

To get back to B of A, in turn, aside from the souring mortgages on its balance sheet, these repurchase claims signify a veritable albatross around its neck. At the end of the second quarter, the bank reported that a full $22.7 billion of them are both outstanding and unresolved, exceeding related provisions by $7 billion.

 

Source: Bank of America's quarterly filings.

While this $7 billion excess is unquestionably a large number, anyone who follows B of A knows that a loss of this size is entirely digestible. Just last year, B of A provisioned twice that amount in anticipation of repurchase claims from a group of private investors represented by Bank of New York Mellon (NYSE: BNY  ) . Aside from the billions of dollars that B of A holds in surplus capital and liquidity, the lender recorded earnings of over $3 billion in the first and second quarters alone.

Yet, the concern is that these liabilities could grow considerably over the next few quarters. Between 2004 and 2008, B of A, and its much-maligned subsidiary Countrywide, sold $1.1 trillion in mortgages and/or mortgage-backed securities to various governmental agencies, like Fannie Mae and Freddie Mac. (I'm presently ignoring claims by private investors and so-called monoline insurers, as their relevance pales in comparison.) At present, a full $132 billion of these are either in default or severely delinquent, i.e., more than 180 days past due. And, like an electronics customer who bought a faulty television set, the government now wants its money back.

Estimating how much of this $132 billion will translate into a loss on B of A's income statement is a function of two factors. The first is the aggregate value of the loans that it actually ends up repurchasing. To stick with our electronics analogy, a store like Best Buy will typically accept returns only for manufacturers' defects. Well, the same is true of repurchase claims. The standard practice in the banking industry is to deny repurchase claims that relate to loans on which at least 25 monthly payments have been made. As thinking goes, if two full years of timely payments have been received, it's not a manufacturer's -- or in this case, an underwriter's -- defect which caused the delinquency.

The second factor is the so-called loss severity rate. When a bank repurchases a loan, the entire repurchase amount isn't lost, as it can still sell the collateral to mitigate the damage. The severity rate is the proportional difference between the repurchase amount and the proceeds from the sale of the collateral, less any associated expenses. In B of A's case, its loss rate on repurchased loans has averaged 31%.

With this in mind, it's relatively easy to come up with a range of potential losses associated with government-backed repurchase claims. The worst-case scenario occupies one end of the spectrum, under which B of A is forced to accept all $132 billion in potential repurchases, and absorb a $41 billion loss (31% of $132 billion). The best-case scenario occupies the other end, under which B of A approves only $45 billion in repurchases, and experiences a comparatively modest $14 billion loss. T he $45 billion figure relates to loans that don't meet the 25-payment threshold.
 

Payments Made by Borrower

Nonperforming Loans Held by GSEs (billions)

Anticipated Loss upon Repurchase (billions)

Less than 13

$15

$4.7

13-24

$30

$9.3

25-36

$33

$10.2

More than 36

$54

$16.7

Total

$132

$40.9

Source: Bank of America's 2Q12 10-Q.

Of course, the more likely outcome is that the claims and losses will fall somewhere in the middle, which is where we find ourselves today, with Fannie Mae claiming the 25-payment threshold doesn't limit repurchase claims, and B of A asserting that it does. According to B of A's CEO Brian Moynihan, speaking on its second quarter conference call: "The way [this] gets resolved is obviously through one of two ways, either [Fannie Mae] would look to bring an action or alternatively there would be a settlement."

B of A must slay this albatross
While I could be accused of talking my own book, as I'm long B of A, I strongly believe that it will reach a solution with Fannie Mae that is palpable to both sides. Will it markedly erode the bank's capital? Absolutely. Will it delay a prospective dividend hike? Without a doubt. But will it represent a huge step forward for the bank? Yes, there is no question about that. Indeed, in my opinion, B of A simply cannot put its deleterious past behind hide without slaying this albatross first.

If you're a B of A shareholder, or are thinking about becoming one, I implore you to download our in-depth report on the lender, which enumerates and expands on how it makes money, the three things every B of A investor must watch, and the biggest risks that it faces. To access this report, as well as regular updates on the company, simply click here now.

Fool contributor John Maxfield owns shares of Bank of America. The Motley Fool owns shares of Bank of America, Citigroup, and JPMorgan Chase. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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