After several years, Bank of America discovered a $4 billion error in its accounting procedures. As a result, the Federal Reserve suspended its approval of the recent $4 billion stock repurchase plan submitted by the bank.
The problem originated with $60 billion worth of structured notes held by Merrill Lynch prior to its takeover by BofA in 2009 following the inception of the financial crisis. These notes contained an embedded derivative, whereby the value at maturity would be based on an entity other than the note, such as a currency, commodity or stock index.
The fair value option ruling, adopted by the Financial Accounting Standards Board in 2007, permits banks to value their financial assets and liabilities each quarter and reflect the net change in their income statements.
Following the financial crisis, bank credit ratings fell, which caused a decline in the value of their liabilities, such as loans they received in the form of bond issuance. The value fell, since the market believed there was a higher probability of default. Ironically, as a result, their profit rose. This increased the level of capital at the bank.
Years later, as the financial health of banks increased, so did the value of their liabilities, such as the bonds they issued. This resulted in lower profits or greater losses. However, these losses were not deducted from the capital levels. Hence, their capital reserves were overstated.
This huge oversight raises questions regarding the bank's internal accounting procedures and the competence of its external audit firm, PricewaterhouseCoopers, and the Federal Reserve.
BofA has a fiduciary obligation to present an accurate financial assessment of the bank to the public, investors and regulators each quarter. The bank's accountants and audit committee of the board of directors failed in this regard for several years. The same is true for PricewaterhouseCoopers.
The Fed also has a duty to accurately assess the financial condition of the bank when it conducts its stress tests. In March, BofA passed this test, suggesting it had enough capital reserves to weather a financial and economic crisis. Now, the Fed needs to reassess the bank's financial health.
The Fed and PricewaterhouseCoopers have declined to comment on this matter, according to The New York Times.
BofA recently announced an additional $6 billion in legal expense related to its tarnished mortgage assets pool, higher than expected by many investors. Faulty mortgages sold to investors may cost the bank more than $16 billion in penalties to settle with the U.S. Department of Justice, based on a recent settlement by JPMorgan Chase in a similar case. This will be added to the $9.5 billion fine from the Federal Housing Agency for $57.5 billion of toxic mortgages sold by Countrywide and Merrill Lynch, which became part of BofA.
This information was clearly significant to the investors. After lowering its capital reserves by $4 billion, BofA's stock price fell more than 6 percent, reducing its market capitalization by more than $10 billion.
The question remains, are other financial institutions accounting properly for their extraordinarily complex activities?
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