As we all know, Citigroup (NYSE:C) used its second-quarter earnings release as an opportunity to announce that it finally reached a settlement with the Department of Justice over its mortgage practices. Will we see a similar announcement soon from Bank of America (NYSE:BAC) over its soured mortgage-backed securities?
Citigroup settlement sets a precedent for Bank of America
As a result of its settlement, Citigroup parts with about $7 billion to end the DOJ's probe into its mortgage business. The settlement resolution itself was astounding, given that Citigroup was previously willing to offer only around $4 billion. The DOJ, however, was going on the offensive at the time and threatening legal escalation if Citigroup didn't fork over a cool $10 billion.
After some back and forth, and probably some nasty haggling behind closed doors, it's good to see that both parties have reached a compromise. Of Citigroup's $7 billion penalty to resolve the DOJ's mortgage investigation, $4 billion will go straight into the DOJ's coffers, $2.5 billion will be used for "consumer relief," and $200 million will benefit the Federal Deposit Insurance Corp.
While the Citigroup settlement is a good thing for the bank and its shareholders, it also bodes well for Bank of America, which is working on its own settlement right now.
Bank of America, because of its outsized exposure to the mortgage market through its acquisitions of Merrill Lynch and Countrywide, will be hit with a significantly larger penalty than Citigroup's $7 billion, which will also probably consist of various components such as a DOJ civil penalty and funds earmarked for "consumer relief."
CNBC reported about four weeks ago that Bank of America offered $13 billion in the latest round of haggling to resolve the mortgage probe. That's well short of the $17 billion DOJ wants, and Attorney General Eric Holder has gone so far as to refuse to meet with Bank of America CEO Brian Moynihan in person, because the "parties remained too far apart for a meeting to be productive."
What's become clear over the past few weeks is that the DOJ is playing hardball with Bank of America, and investors should probably expect a settlement at the higher end of the spectrum -- in the neighborhood of $16 billion to $17 billion.
Investors want closure
After Citigroup reported earnings and made the settlement announcement, shares rose 3% the same day, an indication that Citigroup's shareholders were happy to get the issue off the table. Should Bank of America report a settlement in the near term, which I expect, the stock could go either up or down depending on whether investors feel they got a good deal.
Bank of America has tested investors' nerves over the past few years with a never-ending stream of lawsuits and litigation costs. In the second quarter of 2014, Bank of America reported another $4 billion (pre-tax) litigation expense, and a large part of Bank of America's persistent book-value discount is attributable to the company's ongoing litigation and settlement costs.
Any news that would indicate that Bank of America is making progress in resolving its mortgage issues will help the stock price. Getting a settlement done is fundamentally important for the stock in the long run, as the bank can start to concentrate on growth and its actual banking business, instead of being distracted by ongoing litigation headaches.
Getting the mortgage issue off the table once and for all should also be a major driver of a narrowing gap between Bank of America's stock price and its book value per share.
The Foolish bottom line
Bank of America remains an attractively valued banking business. At a current share price of just around $15.22, Bank of America trades at a whopping 28% discount to book value.
Should Bank of America's shares sell off as a result of a settlement announcement, investors will probably have a good chance to snap up a quality bank at a massive margin of safety, as Bank of America's long-term earnings prospects aren't affected by a mortgage settlement in the slightest.