We’ve never been a fan of the pending acquisition of Countrywide by Bank of America. In fact, BofA’s apparent eagerness to buy a company clearly on the ropes seemed odd: why not wait until it went bankrupt, or at least was on the courthouse steps with a filing? We’re clearly old-fashioned, but in our day, not reputable company would risk its good name (and substantial litigation costs) by buying a large business that can only politely be described as ethically challenged.
The alleged reason for the deal was for BofA to get its hands on Countrywide’s servicing business. People who deal with servicers tell us they are now hemorrhaging cash. I am advised that it is a standard feature of servicing agreements for the servicer to guaranteed to pay whatever interest is promised to the investors for at least 90 days after default. Some agreements also require them to pay principal during that period. Even after the 90 days, the servicer has to continue to pay real estate taxes and insurance. The servicer can use any late payment or other penalties from the borrower to offset these costs. The agreements had built in some margin to allow for these outflows, but no agreements contemplated defaults at the level we are seeing. Of course, the other reason the Charlotte bank may have stepped forward is if it were encouraged by banking regulators, or if a fire sale of Countrywide would directly have a negative impact on BofA’s book.
So it looks like Countrywide is a walking mass of liabilities. Institutional Risk Analytics discusses why the deal may not go through (the article also contains a wonderful discussion of the oxymoron of business ethics):
First, it becomes clear, to us at least, that BAC is unable to close the CFC transaction due to uncertainty regarding the target’s liabilities….in our view: BAC (and its lawyers and accountants) is not willing to do a deal that leaves BAC shareholders facing a potentially staggering loss….
Second, run the numbers. If you accept that none of the funds of CFC’s $120 billion asset bank unit are available to repay parent company liabilities, except the $9 billion or so in book value representing the CFC equity in the sub, then the calculus comes down to about $50 billion in debt, vendors and other liabilities vs. the remaining assets of the parent, roughly a similar amount of loan servicing rights, conduit and investment assets, and whatever CFC can get for the bank unit.
Thus two billion dollar questions:
1) What is the estimated haircut for the ex-bank assets of CFC?
2) What is the estimated cost of settling all pending litigation?….
For BAC, a risky but better strategy than the course at hand may be to withdraw from the CFC merger, pay the $160 million breakup fee, and allow the entire company to slide into a managed default. As CFC’s funding runs away, the OTS will be forced to invoke its statutory authority to appoint the FDIC as receiver of the insured bank subsidiary, thus precipitating a bankruptcy filing by CFC.
In the event, BAC and no doubt a crowd of other suitors will be standing by, waiting to bid for some or all of the bank’s assets and liabilities in a competitive regulatory sale. But the claimants on the CFC bankruptcy estate would have to await the resolution of the bank receivership to see whether there were any net amounts from the sale of the bank that could be reclaimed.
To that point, while retail depositors of Countrywide Bank FSB have little or no reason to be concerned in such a scenario, the jumbo depositors of CFC above the insured limit- if any remain – should take advice about their options. The jumbo deposit holders may or may not be paid immediately by the FDIC depending on their assessment of the bank’s condition at the point of seizure.
Given the outline above, our view is that the equity of CFC is worth $0….if you are a fully cognizant bond holder of CFC… you… also understand that the equity holders are essentially toast….What are you waiting for?
If the BAC deal is not happening, then the only logical course is to pull the plug on the impossible dream of Ken Lewis, shoot the equity holders and get on with the CFC restructuring.
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The Fed steps and watch the long rates go up quickly.
The obvious issue here is that BOA is using old models and outdated analysis and thus they called the bottom way, way too early and they were guessing at which way the wind might blow and they took a huge bet based on thin air! In retrospect, they overpaid and will be now be connected to massive cash burn, which will now have the effect of helping to re-set the models, fine tune analysis and thus disclose the amount of losses every qtr for the next 5 years. In a nutshell, retarded, misleading and thus a great reason for the stock to go to the moon, where thin air is the stuff of very bad dreams!
Only idiots are playing this game and as a result, we will all pay, as morons like Bernanke look for mechanisms to link taxpayer bailiouts to fraud!!!
The merger may boil down to a battle between the hubris of BAC’s Ken Lewis versus the muted voices of corporate prudence within BAC.
Also, to correct the record, the $160 million break-up fee (if it can be collected!) would be paid by CFC to BAC, NOT the other way around.
Lots of creditors, including the GSEs, are probably restraining their aggressive collection efforts against CFC as they pray for the merger to happen. If the merger looks doomed, these creditors will swoop in and the ensuing feeding frenzy could precipitate CFC’s bankruptcy filing.
Another correction to the blog:
CFC sold virtually all of its loans to the GSEs under a “special servicing” MBS option. This means that CFC will be reimbursed for virtually all of its outlays (PITI advances, foreclosure costs, etc.) by the GSE.
This is just more brinkmanship from Wall Street. BOA is pissed that they didn’t get as good a deal as JPM did with Bear, so they are making a lot of “I will launch the nukes” noise. Gentle Ben will step in with some greenbacks. It’s only inflation and moral hazard.
76s,
I’m surprised that Institutional Risk Analystics got the deal terms wrong. It’s usually reliable. I’ll have to be more careful about it in the future.
But the absence of a cost to BofA makes it even more viable for them to walk.
Agreed with the general comments, this is probably the Street and/or BofA fishing for Fed support. And I suspected from the get-go that the regulators had a hand in the deal in the first place, although by all accounts, it was only a wee nudge. There’s a proud tradition of that sort of thing (Bankers Trust-Deutschebank, for instance).
Merely pushing CFC to prepare a bankruptcy flling would lead to a serious renegotiation of terms. But given the Fed’s history, it is unlikely to stand up to serious game of chicken.
Interestingly enough when the deal was first announced, the break up fee seemed to be designed to prevent CFC from walking away. BAC thought at the moment that they had such a good deal that they needed protection. If now BAC walks away, they may have another problem, which is their $2 billion convertible with a conversion price of $18 (ah…those good old days…), made in August last year. I can imagine that in a bankrupcy or restructuring that will be a painful write-off. I do however agree that this deal may now indeed be too poisonous to pursue. The current arbitrage spread also shows a lot of doubt about the deal, but in my opinion does not reflect yet that it is off, just more risky. I wrote more on the arbitrage opportunity in March on http://www.randomfinancials.com
randomness,
Maybe I am being too clinical about this, but if you believe that CFC is worth zero, and worse, would represent a negative NPV to BofA, that lovely little $2 billion preferred is also worth zero. Yes, preferred is senior to common, CFC is still trading and therefore technically not worth zero (a price versus value issue).
But even if you work back from the common price, that $2 billion preferred is not worth anywhere within hailing distance of $2 billion. But the issue is optics: most BofA shareholders won’t see it that way. Most people have trouble with the idea of sunk cost. And that creates a nasty problem for Lewis.
And the real issue may still be that everyone wants to avoid a bankruptcy due to 1. impact on Federal Home Loan Banks and 2. what liquidation price for Countrywide assets might mean for other banks’ pricing for valuation purposes of similar paper.
The NYT has an interesting take on the legal options open to BAC. Boiled down, the author doesn’t think BAC has an easy out. Surprisingly, one of the MAC clauses is not a radical deterioration in the housing market or the value of CFC assets.
Frankly, if BAC shareholders have to choose to eat $2B now or eat $2B plus some large multi-billion number later I think those optics are fairly easy.
Of course, there will be many a comment about what idiot cut the deal to begin with but people are already saying that anyway…
Yves,
Actually in receivership the FHLB gets paid off by FDIC to obtain release of the collateral (same with the Fed). FHLB’s over-collateralization runs about 20%. FDIC made noises a while back about the up-front cost to the insurance fund of settling with FHLB to marshall the receivership’s assets.
In the case of Countrywide, FHLB borrowings exceed the balance in the deposit insurance fund, so FDIC would have to tap its line with Treasury if a purchase & assumption variant couldn’t be arranged to dispose of the bank.
I expect BoA will get some form of open bank assistance from FDIC for its Countrywide `sub’. As in, honking huge open bank assistance.