On Monday, Bank of America said it reached a $11.6 billion deal with Fannie Mae (FNMA) to settle claims that it sold faulty loans to the mortgage insurance giant in the run-up to the financial crisis. The bank also is laying out money to resolve claims that it improperly foreclosed on borrowers -- as part of a $8.5 billion broader settlement between federal regulators and a number of large banks -- as well as some other mortgage-related costs.
None of these settlements were all that surprising. The ghost of bad mortgage past has hung over BofA for some time. And the bank has been locked in negotiations with Fannie over mortgage claims. At last count the two were wrangling over about $11 billion in mortgages. So the $11.6 billion payout is pretty close to what should have been expected. Indeed, investors appeared to shrug off the news. BofA's shares (BAC) closed Monday down just two cents, to just over $12.
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But what is truly surprising was just how far off BofA was in estimating how much it would cost to resolve all these claims.
Every quarter, all banks, BofA included, tell investors how much they have set aside to cover such things as defaulted loans and legal bills. This money is called reserves, and it's sort of a rainy day fund. Banks are supposed to put the money aside when they can reasonably expect a loss to occur. And they draw money out of the account when they have to actually pay out or take the loss. The number is supposed to reassure investors. Bank of America, for instance, has earmarked a total of $16 billion just to cover the types of deals it cut with Fannie.
But bank reserves, and in particular legal reserves, are murky. Banks only give a total amount, and not what goes into that calculation. It's the 'trust us' approach. And at least in BofA's case, it's not clear investors should. Take the Fannie settlement. BofA said it had not previously reserved for $2.7 billion of the deal. The bank is paying Fannie $11.6 billion, but that includes buying back nearly $7 billion in loans. Many of those loans may be worth as much as half of their original value. So out of a roughly $7.8 billion deal (final cost), BofA had put only 65% of the settlement aside. By that math, BofA's $16 billion reserve fund for these types of deals should really be more like $24 billion.
In all, BofA had set aside $6.4 billion, or enough to cover just 55% of the cost of the all the legal settlements and losses the bank announced on Monday.
A spokesman for BofA said that the bank was glad to have the Fannie matter behind it. He said the bank does its best to estimate future legal costs, but settlements vary. The spokesperson said the Fannie deal was larger than expected because it covers not just the loans in dispute but other related matters and eliminates the possibility that BofA would have to make any future payouts to Fannie related to mortgages the bank made in the run up to the housing bust. He said some of the charges BofA took on Friday were not things the bank typically sets up reserves for.
The SEC knows that banks often don't have a stormy enough outlook when putting together their rainy day funds. So they tell banks to tell investors how much they might possibly lose above and beyond the money they have already set aside. And even on this estimate, BofA was way off. Last quarter, it put its potential Fannie losses at $1 billion. The final bill was nearly three times that.
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And what about that other $2.5 billion in mortgage-expenses that BofA said it would take as a charge on Monday? A portion of it (BofA won't say how much) has to do with the fact that the bank said it was selling the mortgage servicing rights to 2 million home loans. Mortgage servicing rights are held as an asset on a bank's balance sheet. Well, it appears BofA had inflated that figure, though it's hard to tell how much. That's why it's taking a loss on the sale.
So while BofA shareholders should be happy that the bank has put some more legal claims, and costs, from the housing bust behind it, Monday's settlements and charges should leave investors questioning the bank's financial statements once again. BofA says its legal reserves and its much bigger, and far more important, loan loss reserves are two total different things. But if BofA is skimping on one, who's to say it hasn't been skimping on the other? And recently, BofA has been pulling money out of its loan loss reserves, saying the amount of money it needs to have on hand to cover bad loans is shrinking.
The cover story of the Atlantic this month says that four years after the financial crisis banks remain black boxes - you can't really tell what's in them and how they make money. Legal reserve funds are another example of that. If bankers really want to earn investors' trust back, actually putting aside an amount of money that approaches their real potential losses would go a long way.
Source: http://finance.fortune.cnn.com/2013/01/08/bank-of-america-fannie/
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