Stephen Foley: Spectre of sub-prime lending is still haunting Bank of America

 

US Outlook: Anyone searching for terrifying echoes of the 2008 financial crisis need have looked no further than what happened to Bank of America this week.

How much of this sounds familiar? Shares in one of the biggest banks in the US are pinging about as if they were a penny stock, and the cost of insuring its debt is soaring. Analysts openly speculate about a "black hole" in its finances, where mounting and unquantifiable mortgage losses may force it into an emergency fundraising. Most terrifying of all, the chief executive finds it necessary to go on business television to calm frayed nerves.

Who can forget Bear Stearns's boss Alan Schwartz going on CNBC in March 2008 to deny aliquidity crisis at his firm, a declaration of complacency that only exacerbated the run and sank the bank within days?

These were the similarities that got everyone's attention whenBrian Moynihan, BofA's chief executive, took to the airwaves. Thedifferences were actually more apparent – BofA is not facing an existential crisis, and it has many more sources of liquidity than a pre-crisis investment bank like Bear ever did – but my goodness, Mr Moynihan is in a mess.

BofA is the quintessential "systemically important financial institution" (Sifi is the new jargon term for banks popularly known as too big to fail). It touches one out of every two households in the US. Its branches are on almost every street corner in the nation and it owns Merrill Lynch, the powerhouse investment bank.

Importantly for understanding why it is in such a state, it also bought America's largest subprime lender, Countrywide Financial, in 2007. Countrywide is now the imploding star at the heart of the company.

Four years after the collapse of the subprime mortgage market, we still don't know the total losses involved. How can we? Banks have resisted a once-and-for-all programme of loan forgiveness for underwater borrowers, and are instead pursuing piecemealrefinancings and foreclosures, all of which are gummed up in paperwork. Meanwhile, the ailing economy threatens to bring about another drop in house prices (which BofA worryingly claimed this week it was not planning for).

What is becoming clearer is where the bulk of the losses are going to be concentrated.

Almost since the first overstretched borrower defaulted on his first payment in 2007, everyone in the chain has been suingeveryone else. Remember, these outrageous and frequently fraudulent mortgages were pooled first into mortgage-backed securities, then into collateralised debt obligations and then even more exotic derivatives.

The buyers, sellers and insurers at each stage are in dispute over who lied to whom – and the bulk of the financial penalties look set to fall on the underwriters of the original mortgages.

This is as it should be. These were the firms that made a packet by flipping mortgages, careless of whether the borrower would ever be able to keep their house and careless of the toxic sludge they were pumping into the system.

Unfortunately, Mr Moynihan has repeatedly claimed that BofA has fully provisioned for its mortgage losses and legal settlements, yet they keep costing more. An $8.5bn settlement in June with hundreds of investors, the last attempt to draw a line in the sand, is now being challenged by AIG, which insured Countrywide-based derivatives and which wants a $10bn (£6.1bn) settlement of its own.

At the moment, it looks as if BofA can earn enough to top up its legal fund and stay ahead of the rising capital requirements being imposed on Sifis by federal and international regulators – but if shareholders want a dividend soon, they may have to pay for it themselves by stumping up some new equity in a refinancing.

And if the June settlement does not hold or the US economy takes a tumble, matters may come to a head even sooner and shareholders can expect more pain.

Ken Lewis, Mr Moynihan's predecessor, lost his job because BofA came close to collapse in 2009 as a result of losses at Merrill Lynch. It turns out his other empire-building purchase, Countrywide, was by far the more reckless. It would be unfair if Mr Moynihan pays with his job for that one, but sometimes that is how the cookie crumbles.

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