Does Bank of America Need to Split Off a Better "Bad Bank"?

A customer uses a Bank of America ATM in Los Angeles, Calif.

Was Bank of America's executive-level exfoliation this week the end of the line for the bank's attempts to clean up its image in the markets? It shouldn't be.

To recap: CEO Brian Moynihan split his reporting teams into two: the consumer businesses will report up through new chief operating officer David Darnell, and the businesses that serve companies, markets, governments and large institutions will report to former Goldman Sachs veteran Thomas Montag. Montag and Darnell will, in turn, report to Moynihan.

The political implications of this aren't so great for Moynihan. Now he has only two direct reports who are in charge of actual operating businesses. His other direct reports including the auditing, human resources, and other support functions that don't create any revenue. There is no powerful CEO in the world who would prefer to only have executives without revenues reporting to him. Moynihan is, in effect, the COO of Bank of America now and he has appointed two CEOs in Montag and Darnell - people who actually manage the major businesses.

But, as long as the bank is reorganizing itself, maybe politics shouldn't be its only motivation. Maybe Bank of America could reorganize its credibility in the markets while it's at it by tackling its "bad bank," known as its Legacy Assets Servicing unit, and expanding it to encompass every unit that could generate bad consumer loans, ranging from credit cards to mortgages.

The Legacy Assets Servicing unit, created in February, is the one that houses all of BofA's old, bad mortgage loans. A lot of its mortgage loans are limping along but still considered "alive" enough to be housed within Countrywide. That structure - some bad mortgages here, some bad mortgages over there - may not reflect how much distress those loans are really in.

With an organizational split/delayering/exfoliation already in the works, maybe Bank of America should follow in Citigroup's footsteps and create a more expansive "bad bank" to hold all the risky assets that are the target of lawsuits. That should include not just "legacy" loans - legacy means the old ones - but even the current ones - for instance, the loans the bank currently holds in consumer businesses like Countrywide.

The way investors whipsawed Bank of America's stock last month, they clearly don't have much faith that the Legacy Assets Servicing unit sheds enough light on how many bad assets Bank of America could really have. It doesn't help when giant new mortgage lawsuits are announced every month.

So maybe Bank of America needs to create a real "bad bank" that will do what bad banks are meant to do: give investors a clear idea of how much trouble Bank of America could really be in with its consumer loans. Right now, that doesn't exist.

A better bad bank might help in getting to a settlement with the FHFA, which sued 17 banks last week alleging the firms had sold Fannie and Freddie bad mortgages. Keefe Bruyette & Woods suggested that the FHFA may dig up information not just on old, distressed bad loans, but even ones that are still limping along.

Citigroup did this separation back in 2009](), when it was facing skepticism about whether it, too, could survive given the scale of its trouble and liabilities. Investors were shying away from the bank and, at one point, its stock price fell as low as the cost of a single-use ATM fee. Citigroup was struggling with heavy U.S. ownership and even vast government guarantees backing the bank's bad loans didn't provide any comfort to investors.

When Citigroup did its bad-bank split in 2009, the "bad bank" of Citi Holdings included consumer mortgages, private-label, credit cards and then the brokerage and asset management businesses .

Sound familiar? It should. All the businesses that Citigroup hived off into its "Citi Holdings" unit back then are, in fact, all the businesses that Bank of America has just separated into a single reporting unit answering to David Darnell.

And Bank of America, besieged by mortgage complaints last year, tried the "bad bank" idea in February, when it intended to hive off 13.9 million mortgages into a unit led by executive Terry Laughlin.

Laughlin had a busy tenure as the head of the "bad bank," named Legacy Asset Servicing. He negotiated several settlements, including those with Fannie Mae and Freddie Mac and an $8.5 billion settlement with institutional investors.

But after only three months in the job, Laughlin moved into another position as the firm's chief risk officer.

Former investment banker Ron Sturzenegger was appointed to take over Bank of America's bad bank in Augustn. Sturzenegger is one of the few executives who still report straight to CEO Brian Moynihan after this week's "de-layering."

But as soon as Sturzenegger took over, Bank of America faced another perception problem: whether it has enough capital to shield itself from bad loans and lawsuits.

There's no question that Bank of America was at least headed down the right path with the idea. [The idea of a good bank/bad bank split has been favored by regulators and financial-sector insiders ever since Sweden had a successful experiment with it years ago. More recently, the idea took off in 2008 and 2009, when UBS, Citigroup and WestLB all did it.

A lot of people outside Wall Street haven't heard of the concept, so here's how it works: A bank takes all of its troublesome assets - the ones attracting lawsuits - and hives them off into a smaller subsidiary, which becomes the bad bank. The bad bank is not a new company. Back in 2008, I talked to a smart lawyer who worked on the first good bank/bad bank split - you should read the interview over at Deal Journal to get a sense of the mechanics of it.

The purpose of hiving off these assets into a bad bank - or even just a separate subsidiary - would be to allow investors to understand how much Bank of America has in these loans and be able to put a more exact value on them.

Otherwise, Bank of America has a real problem: Between Countrywide and other mortgage businesses, only a rocket scientist could figure out how many bad loans Bank of America is holding within its various businesses; everyone knows that not all of them are actually located in the Legacy Assets Servicing unit.

Two weeks ago, analyst Chris Whalen told me the market will continue to punish Bank of America "for years" until the firm is completely transparent about how much trouble it could be in because of bad mortgages. So it's clear that Bank of America's bad bank isn't comforting investors as well as it should.

(Whalen, by the way, has been a big proponent of wiping Bank of America's slate completely clean. He has been outspoken that Bank of America should do whatever it takes to lift the veil on its troubled mortgages, even suggesting that the bank should file for a form of bankruptcy to clean up its balance sheet and pay its bondholders.)

I asked Michael Yoshikami, a founder of YCMNET Advisors who holds Bank of America shares, about this. As an investor, he likes the idea of a more sharply defined bad bank. He pointed out that it helped Citigroup start to dig out from its troubles. "It has actually worked well," he told me. "It actually does create a line in the sand and it provides the definition around the potential liabilities of the assets."

It might also attract wary investors back to Bank of America's shares, Yoshikami said. "When I talk to the investment committee, I can't buy things where I don't have an idea of the value of the stock."

A bad bank would not, however, be a legal fix for the raft of lawsuits facing Bank of America. Yoshikami noted wryly. "The lawsuits are going to chase everybody everywhere."

Bank of America has already created a bad bank. It could probably put a lot of people's minds at ease if it created a better one.

About the author

Heidi N. Moore is The Guardian's U.S. finance and economics editor. She was formerly the New York bureau chief and Wall Street correspondent for Marketplace.

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