Bank Of America's Incredible Shrinking Liability

By Stephen D. Simpson, CFA | January 05, 2011 AAA

At this point in the credit crisis it would seem that anybody claiming to have a firm handle on everything going on is either crazy, dishonest or a singular genius. Take the latest news from Bank of America (NYSE:BAC) - the terms of a deal to settle much of its liability to Freddie Mac (Nasdq:FMCC) and Fannie Mae (Nasdaq:FNMA) for mortgage put-backs not only surprised most observers, but angered a lot of people all over again. Moreover, there is uncertainty everywhere an investor cares to look regarding whether or not other banks will be able to strike similar deals and how these banks will deal with other claimants.

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A Quick Take on the Deal
Early in January, Bank of America announced a deal with Freddie and Fannie whereby it was settling its potential put-back obligations to these entities for a total of $2.8 billion. This deal covers just mortgages related to Countrywide (which Bank of America bought), but will avoid more litigation regarding BAC's ultimate responsibility in buying back misrepresented or outright fraudulent mortgages under the terms of the put-back agreements that it had with these agencies.

In many respects, this was a deal so favorable to BAC it was close to outright theft. The liability between BAC and Freddie/Fannie could have been anywhere from $10 billion to upwards of $20 billion depending upon the assumptions an investor wanted to make about the settlement. As it stands, even more than $20 billion would have represented only about a 1% delinquency rate for these loans, when the actual rate has been running more like 11%.

It is also worth mentioning that this is tantamount to another bailout for the banks. Freddie/Fannie are under direct government control, while Bank of America (along with Citigroup (NYSE:C), Wells Fargo (NYSE:WFC) and many others) needed very cheap government money to stay liquid. What is interesting about this move, though, is that it avoids the splashy headlines of another TARP-like program that would be announced from a White House or Congressional podium. (For more, see Liquidity And Toxicity: Did TARP Fix The Financial System?)

More to Come
Although this deal takes care of a lot of Bank of America's liability to the government-sponsored enterprises (GSEs), it is not over yet. There are still upwards of $3 billion in non-CFC-related claims to cope with, though the mortgages in this pot have had significantly lower default rates.

Beyond that is the question of how the banks will handle the monoline insurers and private investors. BAC likely owes billions of dollars to companies like Assured Guaranty (NYSE:AGO) and MBIA (NYSE:MBI), and it seems unlikely that they would take the same pennies-on-the-dollar deal as the GSEs. By the same token, given that the market caps on just those two companies alone are $3.7 billion and $2.5 billion, even a heavily discounted deal could be really good news.

Then there is the question of the private investors. Allianz (NYSE:AZ), which owns the huge bond firm PIMCO, likely has billions of dollars in claims, and who knows what the bill is for companies like Fidelity, BlackRock (NYSE:BLK), T.Rowe Price (Nasdaq:TROW) and so on. Can any of these companies give a similarly sweet deal to B of A and face their investors (or their investors' attorneys)? Even if the government called them up and asked them to "take one for the team", there is a limit to how much they can write down these obligations.

It's Not Over Yet
Investors can likely count on years of negotiation and legal wrangling for BAC, Citigroup (NYSE:C), Deutsche Bank (NYSE:DB), Goldman Sachs (NYSE:GS), Wells Fargo and a whole host of others. Hardly anybody was innocent in this affair - ranging from duplicitous mortgage borrowers to avaricious mortgage brokers, greedy banks, and opportunistic investment banks (and let's not forget the sleepwalking regulators).

While many people will be furious with what they regard as yet another bailout of major financial institutions, the fact is that this is often how business works. Right or wrong, fair or unfair, companies that are large enough to threaten the stability of the entire system don't pay the same penalties as small fry who can be punished severely with no systemic risk. For bank investors, though, this is likely good news - it is uncertain to what extent other banks can replicate B of A's deal with Freddie and Fannie, but any progress towards a resolution of this mess, at a discount to the probable real liability no less, has to be seen as good news. (For more, see Top 10 Bailout Money Recipients.)

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