Bank of America Invests $2B in Countrywide: Who Wins?

The Bank of America (BAC) loaned Countrywide Financial (CFC) $2 billion under the following terms:

7.25% interest rate

can convert the bond to buy stock at $18 (basically a call option).

What comes to mind is that this is a really good deal for BAC- they an't lose under any scenario.

If CFC survives, then they collect a hefty coupon (at the time of this writing, the Fed discount rate is 5.75% and the CFC loan was 7.25%), and own a call to CFC stock at $18 strike. Effectively, assuming 2 yr holding period after the loan is made, BAC would earn about 10%+ effective interest rate.

If CFC fails (and my personal opinion is that they are very likely to do so), then BAC can still make a lot of money because I imagine they will hedge the position by selling CFC common stock. Collect the coupon, then depending on where they sell the common stock, there is a net money spread relative to the strike on the convertible, plus have the opportunity to scavenge the asset later on after bankruptcy.

In short, BAC just can't lose money in the deal. In fact, BAC may actually be gunning for the "bad" outcome. The $11B CFC tapped last week can credibly last them one month of very subdued operations (30% capacity). The $2B they get from BAC may last them what then? A week? What's the use, one may ask.

CFC may enjoy a short term vote of confidence. Then very serious issues will have to be considered. First, there is a very limited amount of mortgages with acceptable credit quality which will net positive spread to the 10% convertible effective rate. In fact, there is no such mortgage currently. Therefore the purpose of this "injection" is liquidity and not for viable investment - barring ungodly amount of leverage and we know what risk that might bring?

Second, there are two painful choices contingent upon survival: continued drag on operating income or instant dilution to existing stock holder. What would CFC do, I can only imagine.

I used to work in Countrywide's trading floor in my younger days, and I truly admired Angelo Mozillo. I couldn't help but feel sad for him and my ex-colleagues that they must take this sort of financial abuse from one of our biggest arch-competitors.

There is yet still hope though: Will the 2B jump start more money into CFC? I am very skeptical as financial institutions are on cash conservation mode these days.

Would this buy enough time for CFC to negotiate a better term for potential sale of its business, say to Warren Buffett? I doubt it. Warren Buffett would, under no circumstances, be willing to purchase even the safest mortgage servicing asset from CFC because of huge information asymmetry. There is just no way for him to compute what's his "cushion" with any degree of certainty.

Disclosure: Author has a long position in some of the above-mentioned securities

Comments

[BillCust:]

In my opinion BAC will most likely make very little money in return for a sound guarantee of losing none of its previous investments with Cwide. The 30% capacity is about right: I calculated that at 30% current rate of "burn" that combined 13B might last them 4 weeks. The question is since they have 65,000 people would they rather keep 100% resources for 30% utilization, or a really massive workforce adjustment is in the works? Keep in mind the US adds a net 100k job monthly these days, so that number if done in a day is huge. One last thing, don't you all see the irony of it all? Cwide gets a subprime loan from BAC. Hahahaha.

2007 Aug 23 10:13 AM

[sliman:]

BAC is no fool. CFC will be the best mortgage company left. The business is not going away.

2007 Aug 23 10:19 AM

[Keith Gregory:]

The problem with looking at the $2B as a credit card is that it isn't - its capital & CFC has income from all their other business- such as servicing and subservicing loans

Also- there is now a lot less competition out there- so if Countrywide can originate and fund loans, they will be able to push their margins up on everything.

See Alt A fall out here:

www.mortgageindustrytr...

2007 Aug 23 12:13 PM