Bank Of America Cleans Up Another Mess

By Stephen D. Simpson, CFA | April 18, 2011 AAA

As part of its first quarter earnings announcement, Bank of America (NYSE: BAC) announced that it reached its first significant agreement to resolve a non-GSE claim regarding shoddy mortgages. Though it is a positive development insofar as acknowledging responsibility and helping move things back toward normal, it may still be too little too late for the mortgage insurers.

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The Deal with Assured Guaranty
Bank of America announced that it had reached an agreement with Assured Guaranty to resolve the insurer's claims against Bank of America for saddling it with billions of non-complying mortgages. The agreement covers a total of 29 first and second-lien residential mortgage trusts with an original exposure of nearly $36 billion and a current principal at risk of just under $11 billion.

Under the agreement, Bank of America will make a $1.1 billion cash payment to Assured Guaranty and enter into a loss-sharing arrangement. This reinsurance agreement will reimburse Assured Guaranty for 80% of its losses on the 21 first-lien transactions until the collateral losses exceed $6.6 billion. All in all, that part of the agreement looks to have an expected value of about $500 million right now ... assuming things do not get dramatically worse. (For related reading, see 2010: A Year Of Banking Dangerously)

It's Not Over Yet
The terms of this deal do highlight just how easy Freddie Mac (Nasdaq: FMCC) and Fannie Mae (Nasdaq: FNMA) went on Bank of America back in January when they struck a bargain to resolve mortgage put-back disputes. (For more on this topic, see Bank Of Americas Incredible Shrinking Liability). Perhaps this should not be all that surprising; it stands to reason that corporations with shareholders to answer to would be more demanding than government entities that are still carrying out a government policy to get the banks back on their feet.

All of that being said, this mess is clearly not over yet. In fact, it was only about a week ago that Assured Guaranty sued Flagstar Bancorp (NYSE: FBC) for more than $100 million tied to breached warranties on bad mortgages.

And that's how this is going to continue to play out for the foreseeable future. Bank of America is almost certainly in discussions with other insurers like MBIA (NYSE: MBI), and it seems to make more sense to strike relatively favorable bargains like this latest deal with Assured Guaranty than to fight it out in court where the banks are likely to lose and face high legal bills in addition. (For more, see The Bright Side Of The Credit Crisis.)

Too Little Too Late?
Assured Guaranty's stock reacted well to the news of this settlement (as did MBIA's), but it is an open question as to whether these companies are worth a look for aggressive investors. Ratings agencies like S&P and Moody's are skittish and seem bent on reestablishing their credibility with some new-found toughness. That matters quite a lot because if Assured Guaranty and MBIA lose their ratings, they will basically be out of the game when it comes to writing new business and they will go into runoff.

Oh, and let's not forget the muni bond market. While the predictions of doom and gloom made a few months ago are likely highly overheated, defaults are nevertheless not out of the question. Moreover, the new issue market has been weak and that hasn't done this company any favors.

The Bottom Line
It has to be irritating to bond insurance company shareholders that so much of these companies' futures rests on the actions of rating agencies; companies that themselves have been shown to be highly flawed if not occasionally inept. Still, that is how it is. Assured Guaranty would seem to have a decent chance of making it out of this mess, but there are no guarantees and the entry of companies like Berkshire Hathaway (NYSE: BRK.A) into the market would be a definite problem.

On the other hand, the major banks seem to be slouching their way towards better balance sheets and more normalized credit. Other large banks like Citigroup (NYSE: C) and Wells Fargo (NYSE: WFC) still have significant messes of their own to resolve, but if today's Bank of America news is any indication, things are definitely moving in that direction.

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