The BofA/Countrywide follies continue. Earlier in the week, the Charlotte bank, in an SEC filing on the pending Countrywide acquisition, remained silent on the question of the fate of Countrywide bonds. As we had mentioned some time ago, BofA plans to use a deal structure that would leave the debt in a subsidiary so that creditors would have recourse only to Countrywide assets, and not BofA resources, for repayment (forgive me if I have oversimplified the structure). However, the Countrywide bonds had nearly doubled in price on the assumption that BofA would assume liability.
Reader Scott forwarded an article from the always-informative Institutional Risk Analytics. It tells us that BofA has agreed to take on Countrywide’s $50 billion of Federal Home Loan Bank borrowings. IRA discusses some options for how BofA might proceed, which includes putting Countrywide into Chapter 11.
That begs the question: why didn’t Countrywide go bankrupt in the first place? It would have been cleaner for Bank of America to stand aside, wait for Countrywide to crater, and cherry pick the assets it wanted, or buy the whole thing after negotiating a haircut with creditors. That clearly was the best course for shareholders. And Mozilo would not have fared very well in a bankruptcy. It will be harder for the big retail bank to defend its decision to rescue Countrywide if it promptly puts it into bankruptcy.
So despite the claims at the time the deal was announced (that BofA had been keen to buy Countrywide for some time), there was more here than meet the eye.
From Institutional Risk Analytics:
Back in January of this year, we asked whether Bank of America (NYSE:BAC) intends to stand behind the debt holders of Countrywide Financial Corp (NYSE:CFC) when BAC acquires the latter later this year. See our January 22, 2008 comment: “Are Countrywide Financial Bonds Bankruptcy Remote?”
On April 30, 2008, BAC filed a draft form S-4 with the SEC describing the formal terms of the offer to CFC shareholders….
In our earlier comment, we reported that BAC had made no public commitment to the debt holder of CFC. More, we reported that BAC officials, in private discussions with risk officers at other institutions, were explicitly stating that CFC would be kept “bankruptcy remote” from BAC and its affiliates after the close of the acquisition….
The BAC S-4 states: “Bank of America has made no determination in this regard, and there is no assurance that any of such debt would be redeemed, assumed or guaranteed,” the company said in a filing with the SEC. The clear implication of BAC’s refusal to take responsibility for the $40 billion or so in parent-company debt is that BAC CEO Ken Lewis is considering a bankruptcy filing for CFC as one possible strategy after the transaction closes.
As a banker who spoke to BAC told The IRA back in January: “The BAC strategy is reportedly to manage the orderly liquidation of CFC, excluding Countrywide Bank FSB, and to guarantee payments of interest and principal so long as the remaining non-bank assets and liabilities of CFC support same. The BAC officials reportedly expressed the view that keeping CFC is a separate subsidiary of BAC insulates the rest of the group from legal liabilities and arguably prevents them from ballooning out of control.”
At yesterday’s close around $6, CFC had a market cap of $3.5 billion and an enterprise value of $70 billion, reflecting the consolidated liabilities of CFC including Countrywide Bank FSB. Once you net out the balance sheet of Countrywide Bank FSB, including the $50 billion or so in FHLB advances due from the $120 billion asset bank, there remains about $40 billion in parent company debt as well as general creditors who stand at risk.
Keep in mind that in terms of liability funding options, the clock is ticking. CFC is already at the limit in terms of FHLB advances, which are set at 50% of the bank unit’s ending assets for the prior month. Also, upon the close of the CFC transaction, BAC has committed to repay the FHLB advances at par.
This morning, CFC’s short-term debt is currently trading around 92 cents on the dollar….what is the likely recovery value to bond holders of the remaining assets?
Let’s imagine for the sake of argument that BAC closes the CFC acquisition, but the US economy and the housing market continue to sink into the mud, forcing prices for mortgage paper, servicing, etc., lower. In that event, BAC may consider a possible “nuclear option” scenario:
First, BAC closes the transaction with CFC, paying the CFC equity holders some nominal amount to win approval of the transaction. CFC is merged into Red Oak Merger Corporation, the de novo shell created for the CFC acquisition. BAC, however, does not take responsibility for Red Oak’s liabilities.
Second, BAC acquires Countrywide Bank FSB from Red Oak and moves the bank to another part of the BAC group, contributing an amount equal to the book value of the bank’s equity to Red Oak. This reduces the assets and liabilities of Red Oak by about $100 billion, and also weakens any future claim by Red Oak creditors against BAC for fraudulent conveyance in the event of a bankruptcy filing. But acquiring Countrywide Bank FSB, which had $9.4 billion in book equity at year-end 2007, does not significantly improve the overall recovery value for CFC bond holders. Given the generous $7 price for CFC shares as of January, BAC paying well less than book for the bank unit would not be unreasonable.
Third, BAC allows a period of weeks or months to go by, enabling BAC management to get a better sense of the net asset value of Red Oak, including both the liabilities to bond holders and other creditors of Red Oak, as well as other contingent liabilities from litigation and regulatory inquiries, which could be substantial.
Fourth, if BAC determines that the net asset value of Red Oak is far below the value of current and contingent liabilities, then BAC could place Red Oak into Chapter 11, in one fell swoop flushing both the debt holders, general creditors and also the extant litigation and other contingent claims.
There are more than a couple of questions arising from such a “what if” scenario. First and foremost, a bankruptcy filing by an affiliate of BAC might trigger default covenants in all BAC debt and contracts. A filing might also provoke a broader response from investors and regulators, who could construe a bankruptcy filing by Red Oak as a default by the entire BAC group.
But perhaps more troubling, a deliberate strategy to use a “bankruptcy remote” vehicle like Red Oak to insulate BAC from the ongoing value destruction of the subprime meltdown could adversely affect the entire market for bank debt. What investor in their right mind would want to hold the debt of any bank holding company were BAC to elect the nuclear option and place Red Oak into a bankruptcy?
As we wrote bank in January: “More to the point, if the Fed, OCC and OTS are willing to countenance a bank merger transaction where BAC does not explicitly stand behind the parent company debt of CFC, what does this say about the debt of other relatively small bank holding entities such as Washington Mutual (NYSE:WM) and Capital One (NYSE:COF)?”
Now, of course, Ken Lewis and the BAC bankers may be playing chicken with all of us. If the threat of a bankruptcy by Red Oak drives down the secondary market value of the CFC debt, then BAC could buy it back at a discount rather than redeem it at par. If this is BAC’s true strategy, then Ken Lewis is playing a very dangerous game indeed.
But how else do you explain BAC’s refusal to make an unequivocal statement that they will stand behind the CFC debt? It is BAC’s behavior, not the deteriorating financial condition of CFC, which is injecting potentially dangerous instability into this situation. Stay tuned.
If, as we alluded above, the Powers That Be prodded BofA to acquire Countrywide to keep it from failing, and BofA resorts to the strategy outlined above, we will once again find ourselves in the land of unintended consequences.
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S&P’s downgrade of CFC today could trigger a funding crisis (loss of billions in custodial and commercial accounts that require an investment-grade rating; CFC spelled out the consequences in their last 10-Q.)
Of course, I would never speculate that BoA could ever, ever, ever have foreseen this downgrade when it filed the S-4, and can’t imagine how a funding crisis at CFC could be to BoA’s advantage in gaming the Fed and FDIC.
Supposing BoA did a fleece-n-grease of stripping out CFCbank while putting the rest of Countryfried into a shell and igniting C-11, the financial equivalent of arson for profit, the effect on the bond market generally, not just for financials, could be catastrophic and would be at least horrific as implied in the IRM article here. I just can’t see the Feds standing by and letting that play happen, and one could anticipate a highly punitive market response to BoA if they tried.
No, this seems more to me like a move to provoke a Fed bailout BSC style, where the Fed rotates out bad assets at a price that pays off bondholders at par while BoA themselves end up with all of the real remaining assets in Countrydied’s portoflio. Of course, we knew that we would see more of these mega (st)deals in putting down zombie financials, right? If the Fed won’t nationalize, they are cash-fat mooks for being gamed by the industry, yesterday, today, and tomorrow. Lewis and his board are playing very, very high stakes cardsharpin’ with _someone_ here. As a straight acquisition, Countrycousin never made a lick of sense for BoA. As a crooked one, though . . . .
In 2005/6 Countrywide was quite public about its drive to lower underwriting standards of sub-prime and Jumbo mortgages. Shiller was warning that a housing bubble was developing.. The buyers of CFC debt helped sustain the bubble’s inflation and made the crash all the more painful. CFC debtholders do not deserve a Federal bailout.
BoA bought CFC hoping to make a profit. If they lose money it is of little concern to the Fed or to taxpayers. It appears that BoA feels it has no obligation to CFC bondholders. Let the courts decide what BoA’s obligations are.
I’d agree with john. The greater contribution to moral hazard in the bailout of BSC was not that equity holders received 10 dollars per share but that bondholders were made hold. I think bondholders of Countrywide should lose their money – or at least as much as is humanly possible. If the only way to do this is by back-door machinations, then so be it.
above should read “…bondholders were made whole…”
Assuming no bail out from the Fed, and CFC is insolvent, I’d guess BAC will have it file chapter 11, and propose a plan of reorganization that wipes out current equity, writes down bond and other unsecured debt, and takes the equity for a new investment of cash.
IRA is nutty at saying BAC can take assets from CFC by buying them at “book value”, that has no relation to fair value, and so buying them at that price is no protection against claims by creditors.
If this bankruptcy speculation is true, wouldn’t it make sense for Countrywide’s current creditors to force Countrywide into involuntary bankruptcy right now rather than wait until later when all the good assets are gone?
It would be beyond pathetic — more like collusion from my point of view — if the Fed bails out BAC and the CFC bondholders on this one.
I love the way Buffet comes out and says the crisis is almost past today and the FED expands its lending facility and lowers the quality of assets it will swap for as well.
What a mess… :(
Yves and all,
I think one aspect has been overlooked so far.
I would be very inprudent for BAC to take over the practically unlimited legal liabilites once the tort bar gets its hand on some of CFC scelletons.
I think the construction is a necessity for this reason – screwing debt holders or blackmailing the Fed is probably more an add-on where BAC will try to test how far it can go with the courts and Barnanke.
Just a guess, though……
If Countrywide had gone into bankruptcy without intervntion by BOA then maybe those assets they want would have “spoiled” nad become worthless.
My understanding is that BAC wants the lucrative servicing business and the bank. All the trained people may have left for other jobs had the business crashed into bankruptcy. The files dumped into the dumpster and the computers sold to a pawn shop by employees owed money.,.
It isn’t a pretty picture and once that happens who knows if the business has any value left.
The bondholders of CountryfriedCorp lost most of their investment in July, to all intents and purposes given CFCs portfolio. Nobody has booked a loss, yet, though. The question was, Would some great fool step in and assume the liability to pay them off? BoA now seems to be saying, “We’re not that kind of fool.” Next in line is the Fed which, yes, sinned against Mammon and man in standing good for the payoff of BSCs bondsmen at face . . . So long as CFC is current and not too severely downgraded on its bonds, it may be difficult for the bondholders to act directly, and even if they did that would simply lock in their loss where instead they are hoping fervently no doubt that someone, somewhere will makes their holes whole.
I can’t get past the idea that the BoA-CFC pas de deux of Sept, 07, the WaMu deal earlier this year, and several other major ‘private rescues’ we have seen have significant Fed involvement behind the scenes. These deals just don’t look like smart money—unless the Fed offered guarantees to the offwhite knights stepping forward. Why do I think something like that is in play, here?
Well played…
a few thoughts on BAC/CFC:
1. the fed gave BAC something to facilitate this deal. no one is talking, but BAC has a chip. it may be that the Fed will look the other way when BAC lets CFC fail.
2. BAC is not going to allow CFC to fail right away. CFC only started originating loans in Countrywide Bank in late 2006. therefore, a good chunk of the MSR's (what BAC wanted out of the deal) are in CHL, which is a sub of CFC. if BAC puts CFC in Ch11, then it loses access/control of cashflows from the MSR. given current prepayment speeds, it will take another 2-3 years for the bulk of the MSR's within CHL to wind down. however, once the majority of the $1.5T svc asset is in BAC and the servicing skills have been transferred to new subsidiaries, CHL will probably be allowed to fail.
3. the bank sub debt market is dead as it is. with current yields on existing paper well north of 10% – and +15% for the gamier companies – no one is tapping this source of capital anytime soon. furthermore, if you are BAC which is too big to fail and has access to oceans of liquidity via the Fed, FHLB and FDIC, why WOULDN'T you destroy this market? you don't need it.
i'll finish with one last point. the fed & tsy tried to convince the equity market to bear the brunt of the costs of the credit crunch via large equity issuances. their benign rhetoric and easy monetary policy were designed to get the animal spirits of equity investors aroused so that they would solve the financial system's problems. the market got wise to that gambit in june, and drove equity prices down to a level at which no financial company will issue equity. they will all de-lever instead.
the equity market is in effect telling the regulators & politicians that it's time for other parts of the economic system to begin bearing some of the pain of the credit crunch. equity holders have given enough. it's time for borrowers to do their part.
the next phase of the crisis is the forebearance phase. regulators will begin looking the other way on things like capital ratios, etc, in an attempt to give the banks an incentive to lend.
in the meantime, we haven't even begun to see the real impact of the crunch on the economy (outside of housing) yet. we're in the bottom of the 1st inning of that game.