Bank of America discovers accounting error, has $4 billion less than it thought

[jimmy olsen]

Woops!

http://dealbook.nytimes.com/2014/04/28/bank-of-america-suspends-buyback-and-dividend-increase/?_php=true&_type=blogs&_r=0

Updated, 9:03 p.m. | Bank of America disclosed on Monday that it had made a significant error in the way it calculates a crucial measure of its financial health, suffering another blow to its effort to shake its troubled history.

The mistake, which had gone undetected for several years, led the bank to report recently that it had $4 billion more capital than it actually had. After Bank of America reported its error to the Federal Reserve, the regulator required the bank to suspend a share buyback and a planned increase in its quarterly dividend.

While regulators still believe Bank of America has sufficient capital, the disclosure of the accounting error will most likely add fuel to the debate over whether the nation's largest banks are too big and complicated to manage.

The error also raises questions about the quality of Bank of America's own accounting employees, who are supposed to present an accurate financial picture of the bank's sprawling operations to the public and regulators each quarter. The audit committee of the bank's board and PricewaterhouseCoopers, its external auditor, also allowed the error to slip by for so long.

"There are signs that controls are not as tight as they need to be," said Mike Mayo, an analyst at CLSA. "It's a bank. It needs to get the numbers right."

In a twist, there are plans to change the rule that tripped up Bank of America.
Some of the spotlight may also fall on the Fed. Since the financial crisis of 2008, the government has focused its financial system overhaul on increasing capital, the part of a bank that absorbs losses and helps it weather storms. The Fed conducts so-called stress tests of big banks each year to assess whether they have enough capital to withstand shocks. Bank of America passed its test in March, paving the way for the increase in its shareholder payouts. It gained approval for a $4 billion share repurchase plan and a 4-cent increase in its quarterly dividend.

But after the accounting error, Bank of America will have to go back to the Fed to try and resolve the issue. If the Fed is satisfied with Bank of America's explanations and remedies, it will probably be able to make some payouts, though the bank said on Monday that it expected the distributions to be less than originally announced.

Bank of America's missteps could be resolved relatively quickly, unlike those of Citigroup, which failed the stress test last month after the Fed found potentially deep-seated problems with the bank's financial projections, which could take several months to resolve.

"Bank of America must address the quantitative errors in its regulatory capital calculations as part of the resubmission and must undertake a review of its regulatory capital reporting to help ensure there are no further errors," the Fed said in a statement.

The error is a jarring bump in the road for Bank of America. For some years after the crisis, it was overwhelmed by the fallout of its disastrous 2008 acquisition of Countrywide Finance, the high-flying mortgage company that fueled many of the excesses of the housing boom. Bank of America took huge losses on distressed Countrywide mortgages and has had to set aside tens of billions of dollars to cover the legal costs of settling home loan abuses. Over the last couple of years, however, the bank's low-key chief executive, Brian T. Moynihan, appeared to be grinding out a steady recovery, which helped lift the bank's shares by a third last year.

But cracks appeared in the comeback narrative in recent days. As part of its first-quarter earnings earlier this month, Bank of America announced $6 billion in new legal expenses related to defective mortgages, higher than many investors expected.

Reports then came out indicating that the bank might later this year face more than $16 billion in penalties to settle claims with the Justice Department that it sold investors faulty mortgages. After these blows, the capital error weighed heavily on Bank of America's shares, which plunged more than 6 percent on Monday.

The ability of the bank to recover now rests on the scope of the problem — and the bank's ability to rebuild trust with regulators.

The error was discovered late last week, as teams of lower-level employees were routinely preparing a quarterly securities filing, according to a person briefed on the matter. The problem then went up the chain of command, rapidly reaching the attention of Mr. Moynihan. Bank executives worked over the weekend and judged that they had enough of a grasp of the problem to announce it on Monday.

The accounting mistake stemmed from Merrill Lynch, the Wall Street giant that Bank of America acquired during the financial crisis. The bank agreed to the deal, believing it had found a bargain, but Merrill had wide-ranging problems, which it bequeathed to Bank of America.

As part of that acquisition, Bank of America assumed bonds that Merrill had issued, including a $60 billion portfolio of so-called structured notes.

When Bank of America put the notes on its own balance sheet, it did so at a discount to their original value. Bank of America has since paid off many of the notes or bought them back from investors. When these payouts were higher than the value at which Bank of America assumed the notes, the bank booked a loss because it was paying out more money than its balance sheet said the bank owed.

Bank of America's capital should have been reduced by these losses. But instead, and in error, the bank did not do that, which artificially lifted its capital over several years. In the corrected numbers released on Monday, the bank's capital is now lower because it includes the realized losses.

The bank's first-quarter earnings release said that it had $134 billion of common equity Tier 1 capital, a closely monitored measurement. After discovering the error, that number fell to $130 billion. Bank of America had about $30 billion of the structured notes on its balance sheet at the end of 2013. Several Wall Street banks also issued similar notes.

The size of the capital hole, and the length of time that it was overlooked, could also raise questions about the thoroughness of the Fed's annual stress tests. In the tests, the banks are supposed to evaluate their own strength under difficult economic and market conditions, but the Fed is also meant to review the banks' numbers, using its own examination to identify potential red flags. The Bank of America mistake is expected to prompt the Fed to look more closely at this area of capital calculation.

Bank of America's mistake did not affect its earnings, as reported under generally accepted accounting principles.

[alfred russel]

Tim, to take some issue with your title, the financial statements are (supposedly) correct. It was the regulatory capital calculation that was messed up. It doesn't have $4 billion less than it said--it apparently isn't adjusting its balance sheet (its statement of assets, liabilities, and equity). What it is changing is its calculation of the value of its net assets that meet bank regulation standards.