Bank of America settles $16.65 billion lawsuit with the Department of Justice 8/22/14

The Department of Justice levied their largest fine yet on a financial institution Thursday, as Bank of America, the second largest bank in the U.S. by assets agreed to pay $16.65 billion in cash and consumer aid to settle the government’s accusations that it sold faulty mortgage securities in the run up to the 2008 crisis. 


BAC shareholders hope this is the final punch in a long drawn out fight with regulators.  CEO Brian Moynihan said the settlement, “is in the best interests of our shareholders, and allows us to continue to focus on the future.”  If the surge of litigation does indeed abate, investors will now be able to focus on future earnings and the underlying performance of the business. 


Thursday’s settlement with the DOJ is expected to cut Bank of America’s third-quarter pretax profit by about $5.3 billion or 43 cents a share after tax.  Bank of America also got approval from regulators to increase their quarterly dividend to 5 cents each quarter, up from the current 1 cent a quarter. 


Bank of America has been the largest target for regulators since the 2008 crisis, but they have not been the only target.  The acquisitions of Countrywide Financial and Merrill Lynch helped push BAC’s total settlement costs to over $74 billion since the 2008 crisis.  That is over $47 billion more than the second highest targeted bank, JPMorgan, who has paid over $27 billion in settlements.  Overall, the largest U.S. banks have paid approximately $127 billion to settle cases related to the 2008 credit crisis.  Below is a chart that highlights the latest DOJ settlement along with the total settlements paid since the financial crisis by the largest financial institutions. 


The DOJ is expected to now turn their attention to other financial institutions accussed of selling flawed mortgage securities, including Goldman Sachs Group and Wells Fargo. However, these cases are expected to be smaller than the previous three settlements with Bank of America, JPMorgan, and Citibank. 


Although many believe the DOJ settlements will be the final large scale settlements facing U.S. financial institutions, there are still risks of additional litigation.  Bank of America still faces investigations into whether it was among firms that helped manipulate foreign-exchange markets and the London Interbank offered rate (LIBOR).  It also faces claims from bond insurer Ambac Financial Group Inc. and remaining demands from private investors.  These claims, if settled, are expected to be much more manageable for the bank.


Shareholders feel the bite from tax inversions:

As U.S. corporate tax rates sit amongst the highest of developed nations, American corporations have been establishing their tax domicile abroad through what is known as tax inversions.  By doing so the U.S. company will acquire an international corporation and reincorporate on the foreign soil where there is a more favorable tax rate.  


This has become a popular tax savings tactic in recent years for U.S. companies as about forty corporations have reincorporated over the last twenty two years, including twelve companies in the past two years.  While corporations believe this greatly benefits the company, shareholders have incurred significant tax consequences due to these inversions.   Investors owning shares in qualified accounts (IRAs) have not been impacted by this as the tax is deferred.  However, those with shares in nonqualified (after-tax) accounts have found themselves with an unexpected tax bill.  When the U.S. Company inverts it triggers a sale of the company shares and the shareholder realizes the capital gains on the shares sold.  With the 20% capital gains tax for those in the highest tax bracket andadding the additional 3.8% surtax on investment income, investors could be paying as much as 23.8% on long term gains (orordinary income tax rates on short term gains).


While paying some tax may not significantly impact the average investor, an employee or former employee of thesecorporations could own a large concentrated position in the shares that they intended to hold and instead suddenly find themselves with a large capital gain.    This could also impact those with plans to hold their zero basis shares until they passed away to allow for the next generation of their family to receive a step-up in basis at their death to avoid paying the capital gains tax.   When a tax inversion occurs, not only has the realization of the gain been accelerated, but the ability to manage and spread it out over multiple years has been lost.


Those in Washington DC have voiced criticism of this strategy and President Obama has vowed to put an end to it going forward.  But until that occurs this is something to keep in mind for investors with significant unrealized gains in the stock of one company.