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Sometimes the worst wounds are invisible, at least in Bank of America's (NYSE: BAC ) case. Take one look at the megabank's balance sheet, and you'll be hard pressed to identify where all of its losses are coming from. The nation's second largest bank with over $2.2 trillion in assets earned only $4.1 billion last year. And that was despite the fact that it recorded $83.3 billion in interest and fee income. What gives?
The answer is two-fold. First, as I discussed at length in a series on B of A's legal problems, the bank continues to record tens of billions of dollars in off-balance sheet liability from lawsuits related to the sale of mortgages and mortgage-backed securities prior to the financial crisis. Most recently, it paid Fannie Mae $3.6 billion in cash and repurchased $6.6 billion in toxic mortgages that Countrywide Financial had previously sold to the government-sponsored agency.
And second, what is identifiable on B of A's balance sheet is only barely so. Wedged between $349 billion in cash and equivalents, $627 billion in derivative and securities, $927 billion in loans and leases, and $302 billion in intangibles and other assets, sits $5.8 billion in otherwise innocuous mortgage servicing rights, or "MSRs" for short. Is it possible that such a minuscule entry could bring this banking behemoth to its knees? If you've caught my drift, the answer is obviously "yes."
When a bank underwrites a mortgage, the loan is rarely retained on the lender's books. It's instead sold on the secondary market to Fannie Mae or Freddie Mac who then securitize it with other loans for an even later sale to institutional investors. At the time of the original sale, however, the lender that originated the loan typically retains the right to service it for a small fee -- usually somewhere between 0.25% and 0.375% of the loan's principal plus late fees. This is where MSRs come into the picture, as they represent the value of the rights retained.
You're probably beginning to see at this point how such a small entry on a bank's balance sheet could exert inordinate pressure on its bottom line. With respect to B of A specifically, at the end of last year, the $5.8 billion in MSRs related to a staggering $1.05 trillion in mortgages, the vast majority of which were originated by Countrywide Financial between 2004 and 2008. This puts B of A second in terms of third-party servicing portfolios, behind only Wells Fargo (NYSE: WFC ) and "ahead" of both JPMorgan Chase (NYSE: JPM ) and Citigroup (NYSE: C ) .
Now, don't get me wrong. MSRs aren't necessarily bad. Just ask Wells Fargo, which records billions of dollars in servicing income every year as a result of them.
But in B of A's case, the problem is that wide swaths of the underlying loans have since either gone into default or are well on their way there and, as a result, are increasingly expensive to service. In 2012, the operating segment responsible for servicing mortgages at B of A lost $11.4 billion before taxes. While this was better than the $30.5 billion that it lost in 2011, it's nevertheless an outlier compared to the gains in the other operating units -- as a side note, B of A's non-operating administrative division, known internally as "ALM," is excluded from discussion here, though it lost $9.5 billion before taxes primarily because of litigation expenses.
It's for this reason B of A is aggressively shedding its third-party servicing portfolio. From a peak of $1.73 trillion in the third quarter of 2009, it had declined to $1.05 trillion by the end of last year. In addition, it's set to shrink significantly more this year. At the beginning of January, B of A penned a deal with Nationstar Mortgage Holdings (NYSE: NSM ) and Walter Investment Management (NYSE: WAC ) in which the mortgage-servicing companies agreed to acquire the servicing rights on residential mortgages with an aggregate unpaid principal balance of $306 billion. Two days later, Reuters reported that B of A is looking to sell the collection rights on "at least another $100 billion."
The moral of the story is this: If you're either a current or prospective investor in B of A, this is an area you'll want to watch closely. The sooner B of A rids itself of the duty to service toxic mortgages originated by Countrywide and owned by legitimately aggrieved institutional investors, the sooner it can turn its attention exclusively to mopping up the still-considerable legal exposure it faces. And the sooner it can do that, the sooner shareholders will benefit in spades from the bank's progress over the last three years.
Want to learn more about B of A?
With significant challenges still ahead, it's critical to have a solid understanding of this megabank before adding it to your portfolio. In The Motley Fool's premium research report on B of A, analysts Anand Chokkavelu, CFA, and Matt Koppenheffer, Financials bureau chief, lift the veil on the bank's operations, including detailing three reasons to buy and three reasons to sell. Click here now to claim your copy, and as an added bonus, you'll receive a full year of FREE updates and expert guidance as key news breaks.