Bank of America's Capital Fiasco in 4 Questions

Bank of America gets its sums wrong, jeopardizing its capital return program

Apr 28, 2014 at 7:00PM
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U.S. stocks managed to kick off the week on a winning note, with the benchmark S&P 500 and the narrower Dow Jones Industrial Average (DJINDICES:^DJI) up 0.3% and 0.5%, respectively. The technology-heavy Nasdaq Composite Index (NASDAQINDEX:^IXIC) finished flat to close a volatile session -- at its low for the day, the index was down 1.5%. Speaking of volatility, shares of Bank of America (NYSE:BAC) fell 6.3% after the bank announced it is suspending its recently announced capital return program after it discovered an error in the calculation of its regulatory capital levels.

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What was the nature of the error?
Bank of America overstated the amount of its regulatory capital and related capital ratios for 2013 to investors when it released its first quarter results on April 16 and to the Federal Reserve in the annual round of stress tests that concluded in March.

The overstatement is due to an error in the accounting on structured notes that Bank of America assumed when it acquired Merrill Lynch in 2009. B of A correctly adjusted for unrealized changes in value on notes that that under "fair value" accounting, but it incorrectly adjusted for realized losses on notes that had matured or were redeemed following the acquisition.

Is the correction economically significant?
The error has no impact on the company's historical consolidated financial statements or shareholders' equity. However, B of A has been forced to restate its capital ratios for 2013. The largest downward correction is to the common equity tier 1 capital ratio under the Basel 3 standardized approach on a fully phased-in basis -- the terminology alone gives you an idea of the mind-numbing complexity of bank regulatory accounting. That ratio was reduced by 27 basis points (that is, 27 hundredths of a percentage point) to 9%.

Note that the correct ratio already exceeds the 8.5% minimum common equity tier 1 ratio that globally systemic banks need to achieve by 2019 under new international bank capital standards.

What, then, are the stakes for Citigroup?
Once B of A notified the Federal Reserve concerning the error, the Fed requested that it suspend the capital actions it had announced, including the $4 billion stock buyback authorization and the increase in the quarterly dividend from $0.05 to $0.01. B of A must now resubmit its data templates to the Fed along with its requested capital actions, which the bank expects will be lower than those it had trumpeted to shareholders.

The error may not have a significant economic impact, but it is a stinging blow to B of A's reputation -- raising the quarterly dividend from a nominal penny a share was seen as a milestone in its post-crisis recovery. Citigroup has essentially tarred itself with the same brush as Citigroup (NYSE:C); at the end of last month, Citigroup was the only major bank to see its capital return program rejected by the Fed.

Is today's stock price decline warranted?
A reduced or delayed return of capital to Bank of America shareholders does have some impact on intrinsic value. Today's 6.3% stock price decline is comparable to the 5.4% decline suffered by Citigroup shares the day following the Fed's rejection of its capital return program. At the time, I wrote that the decline in Citigroup's shares was an overreaction and I think that the same probably applies to B of A.

According to data from Morningstar, B of A shares are now valued at 9.3 times next twelve months' earnings-per-share estimate and 0.8 times book value -- more than adequate value, if you ask me, particularly in a broad market that doesn't look particularly cheap. Nevertheless, today's embarrassing episode is not neutral – it's a useful reminder that banks on the scale of Bank of America and Citigroup are extremely complex organizations that are largely opaque to outside investors. As such, investing in one requires some sort of leap of faith – as well as a larger-than-average margin of safety to justify that leap.

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Alex Dumortier, CFA, has no position in any stocks mentioned. The Motley Fool recommends Bank of America and owns shares of Bank of America and Citigroup. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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