Breaking Down Bank of America's Embarrassing Miscalculation

Earlier this week, Bank of America (NYSE: BAC  ) announced that due to a miscalculation in a small portfolio of structured notes, the bank was revising its capital ratios. As a result, the Federal Reserve halted the bank's planned dividend and share buyback.

Instead of joining in on the procession of shock, anger, and vitriol, let's take a moment to understand exactly what happened in language that non-bankers can actually understand.

BAC Chart

Some important background information
Bank of America acquired Merrill Lynch back in 2009. As part of that acquisition the bank came to possess some fancy loans called structured notes. These assets are at the center of this week's fiasco.

Those notes have a face value -- if you hold them until maturity, you'll get paid exactly what the document says. However, these types of notes are traded among big banks and other big investors. The regulators require banks to adjust the value of these notes for purposes of calculating capital based on the price of comparable notes being traded. This is called "mark to market."

Understanding mark to market
The adjustment causes an "unrealized gain or loss" on the bank's income statement, which flows through to the balance sheet. The super-simplified rule of thumb is that unrealized gains increase capital, while unrealized losses reduce capital.

Here's an example:

You buy a house, and its worth $200,000. A year later you refinance and an appraiser tells you your house is now worth just $190,000. You've lost $10,000 on paper. You still have the house. You don't have to pay out any cash. Its just a paper loss. You don't get to deduct this loss from your taxes. Its unrealized.

The next year the house is valued at $210,000. You've now increased your equity by $10,000 from the day you bought the house and by $20,000 from last year! Great news right! However, its still unrealized. You don't have any more cash in your bank account. You don't have to pay taxes on that increase.

However, in both cases your actual net worth did change. The value of your assets did in fact increase or decrease in value. You didn't realize the gain or loss, but the reality is that the value changed.

Bank of America failed to mark these structured notes to market as they should have done for their regulatory capital calculations. The bank corrected the numbers and determined that the impact of the change was only a decrease of about 0.05% in their capital ratio. Small potatoes.

The Fed's reaction
The Federal Reserve reacted to the news by forcing Bank of America to resubmit its capital plan and halt its planned dividend and share buyback. The reason is prudence.

The Federal Reserve Bank in Chicago

The Fed wants to ensure that the Bank's calculations are correct, its assumptions for future growth and profitability are correct, and that approving a capital distribution will not leave the bank under-capitalized.

Its critical that companies -- and especially banks -- maintain a solid base of capital just in case something goes wrong and the company takes losses. The capital base protects the company from losses by acting like a buffer.

When companies buyback shares or pay out a dividend, that money is cash distributed from the company's capital base. Distribute too much and it could leave capital too thin to adequately buffer the company. 

That is precisely what happened during the Financial Crisis, and its why the Fed takes such a prudent approach to approving a bank's capital plan.

The market's reaction

This uncertainty and lack of confidence, more than anything else, spooked the market. If Bank of America missed the details and incorrectly accounted for this small portfolio of loans, what else could the company have missed? Can we trust bank management to adequately prepare for the worst case scenario if the bank lacks the appropriate controls to calculate its normal quarterly capital ratios?

Every year, Bank of America and all the other large banks in the U.S. must complete a stress test on their books. The idea is that if the country is faced with another economic crisis, these banks should be prepared for even the worst eventuality.

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