Wells Fargo & Co (WFC), Bank of America Corp (BAC): Still Feeling the Impact of a Deal Gone Wrong

Back in 2008, perhaps everyone thought that Bank of America Corp (NYSE:BAC) was getting an excellent deal buying troubled Countrywide Financial for $4.1 billion. Maybe everyone remembered (difficult to forget) that it was the best performing stock from the financial services sector in Fortune 500’s list between 1982 and 2003: it had a 23.000% return. Although an astonishing performance, when the housing bubble burst in 2008 it practically destroyed the company: it is estimated that BofA’s acquisition cost $40 billion in suits, settlements and other litigation. This acquisition is still generating headaches nowadays.

Bank of America Corp (NYSE:BAC)

Bank of America Corp (NYSE:BAC)’s shares are trading at x11 2013 earnings compared to JPMorgan Chase & Co. (NYSE:JPM) and Citigroup Inc (NYSE:C) which are trading closer to 8.5x. Currently, it is overvalued as it is trading at 0.89x P/TBV (and a low ROE of 4.05%) compared to JPMorgan at 1.2x (ROE 10.7%) and Wells Fargo & Co (NYSE:WFC) at 1.6x (ROE 12.7%). Bank of America has a higher operating efficiency, a key issue in the banking sector and more nowadays in a revenue-challenged environment: 74.2% in 4Q12 compared to Wells Fargo’s 55% and JP Morgan’s 65%.

Let’s see some highlights that could indicate an improvement in the company, although they may take some time. Below you can find where the management is focusing in order to generate better results:

The settlement with Fannie Mae is the key for burying Countrywide’s issue. Bank of America Corp (NYSE:BAC) will pay around $11 billion to settle claims linked to mortgages. Also, the sale of Mortgage Servicing Rights (MSRs) will generate $306 billion of servicing assets being transferred out of the bank. Both actions could lead to $5 billion of cost savings in the coming years.

The company has announced a cost cutting scheme which could give $8 billion in total cost savings by 2015. This could help lower the efficiency ratio which is really important to reduce expenses and re-calibrate the expense structure.

It’s Tier 1 common ratio has improved substantially to 11.4% in 3Q2012. This is mainly due to improvement on RWA mitigation and in capital deduction items. This implies that management is actively trying to reduce risks in its portfolios. This ratio is in line with its peers: JPMorgan Chase & Co. (NYSE:JPM) at 10.4% and Wells Fargo & Co (NYSE:WFC)’s 9.9% for 3Q’12.

However, the company still shows signs of distress:

Bank of America Corp (NYSE:BAC) has incurred about $13 billion in litigation and legal costs in the past four years and these costs will likely remain high: ~$3 billion for 2013.

Taking into account the $5.5 billion allocated in 2011 for private label mortgages and adding the range of loss of up to $4 billion, this adds up to $9 billion in potential losses.

It is still heavily exposed to the mortgage business. If the housing market shows an improvement and credit quality gets better, it might have some upside as it could recover some of the loan loss reserves ($42.6 billion).

The bottom line

Bank of America Corp (NYSE:BAC)’s performance will depend on how quickly it can deactivate the Countrywide Financial issue. The Fannie Mae deal, the cost cutting scheme and the sale of the MSRs will definitely impact the company as it could give an aggregate saving of $13 billion. Total deposits at $1.1 trillion could help the company get better earnings if interest rates do increase in the next years. And as it is properly capitalized this could lead to a better dividend and payout ratio. However, it is still exposed to the housing market recovery and the economic upturn.

Damian Illia has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup Inc , JPMorgan Chase & Co., and Wells Fargo.

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