With Legal Reserves Low, Bank of America Faces a Big Lawsuit

Bank of America has been underestimating its legal risks for years, and brazenly so, according to its critics. Is that strategy about to pay off with the Federal Reserve

On Thursday, the Fed will release figures on how much capital the nation’s biggest banks must have to cover a “stress” situation. The following week, investors find out whether those banks will be able to return more of their capital to shareholders by paying dividends or buying back stock.

Last year, the Fed passed most of the big banks and let them pay out billions. Bank of America, picking up an unwelcoming vibe, didn’t even ask. This year, however, WallStreet expects that Bank of America will get the green light.

Yet the bank continues to face gargantuan payouts to clean up legal disputes from the bubble years. Now a lawsuit suggests that the bank’s mortgage portfolio could cost it tens of billions more than it had planned. In one big case, if things go wrong, Bank of America may be required to make good on many more billions worth of bad mortgages from Countrywide Financial, which the bank acquired, in the sense that one acquires Ebola virus, in 2008.

Bank of America, however, has kept its legal reserves low â€" perhaps dangerously so.

The dispute involves a 2011 settlement that Bank of America reached with some of the world’s biggest investors, including Pimco and BlackRock for $8.5 billion. That amount covers more than $400 billion of Countrywide loans, on which there have been tens of billions of losses. The actual loss total is in dispute because they are estimates, but it ranges from $70 billion or so to well over $100 billion. That means, at the high end of the range, the settlement was for pennies on the dollar. On a conference call last week held by Mike Mayo, the CLSA bank analyst, a legal expert suggested that if things went south in the courts for Bank of America, the settlement might rise to $25 billion to $30 billion.

Bank of America contends that its reserves are reasonable, based on its estimated probable payouts. The bank wouldn’t raise them “based on speculation from third-party observers who are not directly involved in any of these matters,” a spokesman said.

Even in the fun house of litigation about mortgages, this one is particularly comlicated. The dispute revolves around the question of whether another bank, BNY Mellon, working on behalf of mortgage-backed securities investors, was reasonable and acted in good faith in agreeing to the settlement. It is being hashed out in New York State Supreme Court. BNY Mellon is the trustee on 530 securitizations, or bundles of Countrywide mortgages, that were sold to investors.

The insurer American International Group, along with some others, including the New York and Delaware attorneys general, are fighting about the settlement. Eric T. Schneiderman, the New York attorney general, has accused BNY Mellon of breaching its fiduciary duty! . A BNY M! ellon spokesman said, “We believe we have fulfilled all of our duties as trustee in this case.”

The small settlement doesn’t sit right. The group of investors who agreed to it hold only about a quarter of the securities, making it appear as if a minority has forced a bad deal on the majority in order to get few quick bucks and resolve any dispute. The Pimcos and BlackRocks of the world don’t like to sue big banks. Things can get a little uncomfortable on the golf links. (They contend it was reasonable, given all the legal uncertainties of a protracted dispute.)

And who blessed the $8.5 billion figure anyway To figure out whether it was fair, BNY Mellon relied on a firm called RRMS Advisors, a mortgage analysis firm.

The RRMS estimate has been in dispute for some time now. The firm relied on information from Bank of America, and critics contend it underestimated problems in the loans and the total losses. How BNY Mellon found little RRMS isn’t clear; the bank wouldn’t comment. RMS’s Brian Lin, who conducted the analysis, stood by his report, but declined to comment further.

Recently, other court rulings have boded ill for Bank of America. Judge Jed S. Rakoff of the Federal District Court in Manhattan has ruled that an insurer called Assured Guaranty was able to dispute mortgages that it backed and that were made by a small bank called Flagstar, without having to show that the contractual breach was the direct cause of the loss. In other words, the borrower may have defaulted, but Assured didn’t have to demonstrate that it was because she didn’t make $150,000 a year as a tarot card reader, as had been claimed on the borrower’s loan appli! cation. I! f Bank of America is hit by such a ruling too, it might have to pay more. It argues its contracts are different.

So is Bank of America vulnerable Not surprisingly, it is keeping whole swaths of expensive Manhattan law firms working all hours of the day to make the case that it isn’t. BNY Mellon, too, contends it acted reasonably.

And the banks contend the $8.5 billion settlement is in line with other similar settlements. Of course, the investors continue to face huge hurdles even if rulings in this case start to go their way.

But even if the chances are low that the cases don’t go in Bank of America’s favor, an increase in legal reserves could be huge. So this is a low-probability, high-risk event. Another way of saying that is that it is a “stress” situation. And who just put banks through stress situations Ah, right, the Federal Reserve.

The Fed, whose earlier decisions have been generous to the banks, declined to comment for this column.

As Professors Anat Admati and Martin Hellwig, authors of the new book, “The Banker’s New Clothes,” have argued, the big banks are undercapitalized and the simplest way for them to start building capital is to keep their profits instead of returning them to shareholders.

A look at Bank of America’s estimates for how much it will have to pay for its mortgage liability is telling. It has gone up steadily each year. In 2009, the bank had a reserve of $3.5 billion. By last year, it had jumped to $19 billion, with an estimate of additional loss of up to another $4 billion.

And so Bank of America seems to have been consistently underestimating its legal exposure. (And it has other, undisclosed legal reserves for different cases. The incentives to lowball those are much greater, because the public cannot scrutinize them.)

In keeping the reserves low, Bank of America has already won. If it turns out that! the bank! loses its cases and has to fork over much more money, it nevertheless has managed to make its books look that much better for years. That surely helped as it has tried to dig itself out of its financial crisis hole.

“This is an accounting arbitrage,” says Manal Mehta, a hedge fund manager who has been on a lonely crusade for years to follow the complexities of these cases. “The accounting rules give you a lot of latitude in setting reserves,” he says. Bank of America is “hiding behind that.”

Fortune may favor the bold, but regulators just give them a pass.