BofA Settlement to Hurt Q2

Bank of America Corp. ( BAC - Analyst Report ) has finally reached an agreement to pay $8.5 billion for its legacy Countrywide mortgage repurchase and servicing claims. The settlement is for a group of 22 investors who had suffered substantial losses for their investments in mortgage-backed securities sold by the company prior to the housing market failure.

While the settlement is encouraging considering the fact that it lessens the overhang related to the mortgage repurchases liability, BofA’s financials will face a massive blow in its second quarter. The company is even expected to be in the red.

Settlement & Second Quarter Impact

The agreement basically covers most of BofA’s legacy Countrywide-issued first-lien residential mortgage-backed securitization (RMBS) repurchase exposure. It represents 530 trusts with original principal balance of $424 billion and total current unpaid principal balance of approximately $221 billion. The settlement, which is subject to the court approval, was reached with The Bank of New York Mellon ( BK - Analyst Report ) , the trustee for the RMBS.

BofA will make cash payment of 8.5 billion to settle the claims. Further, it would also provide an additional $5.5billion in the second quarter of 2011 for representations and warranties liability for both Government-Sponsored Enterprises (GSE) and non-GSE exposures. The company also estimates a $6.4 billion in other mortgage-related charges in the second quarter including a goodwill impairment charge of $2.6 billion.

The company’s second quarter 2011 results will bear the brunt of this settlement and other mortgage-related matters. Management currently expects second quarter net loss of $8.6–$9.1 billion, or 88–93 cents per share.

However, after excluding the impact of this settlement as well as other mortgage-related and non-operating items, the company projects a second quarter net income of $3.2–$3.7 billion, or 28–33 cents per share.

The Allegations

The group of investors, including names such as BlackRock Inc. ( BLK - Analyst Report ) , Pacific Investment Management Co. and the Federal Reserve Bank of New York alleged that prior to the financial crisis, Countrywide Financial Corp., a company that was acquired by BofA in 2008, had sold those securities that were tied to bad-quality loans.

Neither the quality of the borrowers nor the collaterals matched the standards that Countrywide assured to the buyer of these securities. The loans were not even managed well and lacked proper paperwork.

Therefore, these investors sought a buyback relief in mortgages-backed securities that were offloaded by Countrywide Financial before it was acquired by BofA. The agreement closes a nine-month tussle between BofA and the investors.

Our Take

The acquisition of Countrywide substantially increased BofA’s mortgage exposure compared to its peers. Following the collapse of the housing market, mortgage repurchases claim risk for the company grew manifold, a factor that has significantly drained the company’s bottom line and its share price in the past.

BofA even had to reach agreements of similar nature but of lesser amounts earlier this year with Fannie Mae and Freddie Mac as well as with Assured Guaranty Ltd. ( AGO - Snapshot Report ) .

We believe that such hefty payment, which represents the highest by a financial services company to date, definitely dents BofA’s reputation in addition to its financials. Revenue headwinds and issues related to U.S. regulatory reform continue to restrict the company’s earnings. Moreover, such settlements also deplete the company’s capital position and therefore any dividend increase plan might be delayed.

This settlement could also motivate other investors to ask for claims from mortgage lenders like Wells Fargo & Co. ( WFC - Analyst Report ) and JPMorgan Chase & Co. ( JPM - Analyst Report ) for their mortgage-backed securities tied to soured loans.

Yet, we note that though this settlement does not put to rest BofA’s mortgage issues, it removes a substantial uncertainty related to its potential mortgage repurchase liability. Reflecting this positive sentiment, BofA shares advanced nearly 3% on the NYSE yesterday.

Shares of BofA currently have a Zacks #3 Rank, which translates into a short-term ‘Hold’ rating.