Billionaire Warren Buffett has predicted Bank of America Corp. (BAC) will become a profit powerhouse once it finally resolves legal battles that have sapped funds and distracted managers. Now we’ll find out if he’s right.
Chief Executive Officer Brian T. Moynihan yesterday settled what he has called the firm’s last big fight over faulty home loans, reaching a record deal for almost $16.7 billion to end U.S. probes of mortgage-bond sales that fueled 2008’s financial crisis. Since he took control in 2010, the bank has agreed to more than $70 billion in deals to resolve claims from the housing bust.
If the surge in litigation does abate, investors inured to years of unpredictable earnings can focus squarely on the underlying performance of businesses at the Charlotte, North Carolina-based bank. Moynihan, 54, has blamed past disappointments on legal costs and related distractions.
“We believe they have a wonderful franchise -- the question now is, ‘Do they?’” said Greg Donaldson, chairman of Evansville, Indiana-based Donaldson Capital Management LLC, which manages $950 million. “If they do, their earnings will move sharply up, because all of their energies will be poured into making their businesses better. If that isn’t the case, it will show up pretty fast.”
The settlement with the U.S. Justice Department will cut third-quarter pretax profit by about $5.3 billion, or 43 cents a share after tax, the company said in a statement. Bank of America shares surged the most in more than a year and were the best performer yesterday in the 84-company Standard & Poor’s 500 Financials Index, climbing 4.1 percent to $16.16. The stock, which had dropped 0.3 percent this year through yesterday, is now up 3.8 percent for 2014.
The deal resolves claims from U.S. authorities including the Justice Department, Securities and Exchange Commission and Federal Deposit Insurance Corp., and six states. Like many of the bank’s other mortgage-related settlements, most of the liability stems from the firm’s 2008 purchase of subprime lender Countrywide Financial Corp.
Bank of America’s net income will surge past $17 billion next year, the most since 2006 and up from $11.4 billion in 2013, according to the average of 15 analysts’ estimates in a Bloomberg survey. That still probably won’t be enough to eclipse JPMorgan Chase & Co. (JPM), the biggest U.S. bank, or Wells Fargo & Co., the one producing the most profit. Analysts estimate each of those firms will reap more than $22 billion of profit next year.
On a conference call with analysts in May, Moynihan blamed unexpectedly severe legal claims for crimping past profits, eroding Bank of America’s brand, limiting shareholder payouts and distracting executives.
“It made everything harder,” he said. “It takes a lot to really fully understand.”
Yesterday, Moynihan said the settlement will allow Bank of America to focus on the future.
Buffett’s Berkshire Hathaway Inc. injected capital and confidence into the lender with a $5 billion investment announced in August 2011. The bank’s stock plunged 58 percent that year amid concerns that mortgage demands would force it to issue new shares.
Since then, Buffett, 83, has been Moynihan’s highest-profile cheerleader, endorsing the CEO’s strategy and shrugging off a $4 billion accounting mistake disclosed in April that forced the bank to scrap stock buybacks. As part of the investment, Buffett’s firm received preferred stock and warrants to buy 700 million Bank of America shares at $7.14 apiece, which would make Berkshire the lender’s biggest shareholder.
At the current share price, Buffett’s paper profit on those contracts tops $6.3 billion.
Moynihan “is nurturing a huge and attractive underlying business that will endure long after today’s problems are forgotten,” Buffett, Berkshire’s chairman and CEO, wrote in an investor letter published in 2012, in which he faulted the bank’s previous leaders for “huge mistakes.”
At midyear, Bank of America had $1.13 trillion of deposits, second in the U.S. after New York-based JPMorgan’s $1.32 trillion, and a vital source of cheap funding, according to Buffett. The investment bank generated more than $40 billion in earnings since the 2009 takeover of Merrill Lynch & Co.
While a drop in legal costs will make it easier for investors to gauge the firm’s underlying prowess, that won’t necessarily make life easier for Moynihan.
“It’s true that we’ll start to get more visible numbers without the big legal issue, but that’s not always a positive,” said David Konrad, Macquarie Group Ltd.’s head of U.S. bank research. “Sometimes clean numbers show lower earnings power than what people are expecting.”
Konrad, who has an underperform rating on Bank of America shares, says the lender has had lower loan growth than competitors and that its retail bank has weighed down results.
Return on equity, a measure of how well a company reinvests earnings, was 3.15 percent at June 30, compared with 7.26 percent for JPMorgan and 14 percent for San Francisco-based Wells Fargo.
Since Moynihan took over in 2010, Bank of America shares have returned 9.1 percent, including reinvested dividends. That trailed returns of 56 percent for JPMorgan, led by Jamie Dimon, and 110 percent for Wells Fargo and its CEO, John Stumpf. The 24-company KBW Bank Index returned 81 percent in that span.
Moynihan previously has struggled to accurately predict the end of claims. In January 2011 he said he was “pleased to put” demands from Fannie Mae and Freddie Mac behind the bank after a $2.8 billion settlement. He went on to agree to more than $20 billion in further settlements with the two government-owned mortgage firms.
At the start of 2013, Moynihan likened his job to an uphill race in which he was carrying a 250-pound backpack, while competitors were relatively unencumbered.
“It looks like I’m sweating and working, and they look pretty comfortable halfway through this race,” he said. “What we did in 2012 is we’ve emptied out that backpack, and now guess who wins the race?”
The bank had almost $30 billion in mortgage-related settlements after those remarks, including yesterday’s deal. Moynihan said in May that it took longer to clean up those issues than he hoped. All told, he settled more than a dozen disputes with the government, investors and bond insurers over shoddy loans, fueling five quarterly losses.
Bank of America still faces investigations into whether it was among firms that manipulated foreign-exchange markets and the London interbank offered rate, or Libor, a benchmark for more than $300 trillion of contracts and loans worldwide. It also faces claims from bond insurer Ambac Financial Group Inc. and remaining demands from private investors outside of an $8.5 billion settlement announced in 2011.
“You never know exactly what the size of the box is going to be anytime you’re involved in litigation,” Buffett said in a January 2013 interview. “There’s no question that they will get through it.”
To contact the editors responsible for this story: Peter Eichenbaum at firstname.lastname@example.org David Scheer, Dan Kraut