Bank of America: Countrywide’s White Knight

In the past, I’ve stated my belief that Countrywide Financial (CFC) would survive either as a separate company or as a unit of another company through an acquisition. Well, the news came out yesterday that Bank of America (BAC) has just invested $2B into Countrywide Financial. The deal is for preferred stock with a yield of 7.25% and a strike price of $18.00 when converted into common stock.

From Forbes:

Countrywide Financial Corp. said Wednesday that Bank of America Corp. has made an equity investment of $2 billion in the company, a deal that comes as the nation's largest mortgage lender tries to weather a credit crunch that's rocked Wall Street and the mortgage industry

The transaction was completed and funded Wednesday, Countrywide said…

[…]

Under the terms of the deal, Charlotte, N.C.-based Bank of America acquired $2 billion in the form of nonvoting, convertible preferred stock yielding 7.25 percent annually, Countrywide said. The shares can be converted into common shares of Countrywide at $18 per share, with certain restrictions…

[…]

Kenneth D. Lewis, Bank of America's chairman and CEO, said in the statement that turmoil in the stock market has led some to underestimate the value in Countrywide's operations and assets.

"This investment reflects our confidence in their business and recognizes the importance of the company in providing home financing across the country," Lewis said.”

Whilst the full details of the deal haven’t been disclosed, it stands to reason that BAC stands to make a HUGE return off of this investment. At the time the deal was announced, the stock was trading at about $21.80, a 21.11% premium over the strike price of the convertible shares, and as of the writing of this article (7:19 PM EST – 8/22/07) the stock had risen in after hours trading to $26.60, or a 47.78% premium over the convertible share’s strike price.

If BAC were to convert the preferred shares to common shares in two years, even if the stock remained flat at $26.60, BAC would see roughly $1.25 billion worth of gross profits and a total return of about 62.28% between the yield and the stock’s appreciation. If Countrywide’s stock were to touch the low to mid 40s within the next two years, Bank of America could see nearly $3 billion worth of profits and a ROI of nearly 150%.

This is not to say that this is a “risk free” investment for Bank of America, but the downside in Countrywide is relatively minimal at this point, as the $2 billion should help them make the transition to funding most of their loans through their retail bank, as well as only originating loans that can be sold to either Fannie Mae or Freddie Mac. Additionally, the investment from BAC should go a long way towards restoring investor confidence in Countrywide.

Situations like Bank of America’s investment in Countrywide are why Warren Buffett sees the current market turmoil as an opportunity, because if you make significant investments in the right companies, there is an amazing amount of money to be. Of course, the situation is a bit different for us little guys, as putting Junior’s college money in a beaten down stock isn’t going to move markets and perhaps save the company from bankruptcy.

However, the situation does provide a clue as what constitutes “true value”. True value isn’t a beaten down financial stock that should survive due its size or because “XYZ lending isn’t going away”; instead, it’s the profitable company that’s suffering more from the state of the credit markets and larger macroeconomic concerns, then from bad business practices. When evaluating a financial stock as a “value investment”, the first question should always be: “Is this company suffering due to bad business practices or from problems with the larger market?”

Remember, one of Warren Buffet’s “value tenets” is to invest in good companies with solid management teams, not just in a company with a “chance”, seemingly low book value or a high analyst target whose stock appears to be on sale.

Disclosure: The author doesn’t own positions in either Bank of America, Berkshire Hathaway or Countrywide

Comments

[Quaker:]

What would Buffets return have been if you took out his 700% gain in PetroChina?

The CFC investment is being misinterpreted by the same yahoo's who've been talking up mortgage banks for a year now. CFC is a $5 stock waiting to happen.

Explain to me how CFC makes money borrowing at a 21% premium and a 7.5% rate and lending at 6.8%, the current rate for a 30 year mortgage? This is an effective 9.4% rate. Are they making subprime snowmobile loans?

CFC's investment was for one reason. This quarters losses will probably put them in technical default on their loan covenants.

CFC has $464 million in amortized interest. Amortized interest DOUBLED year over year. That means it has 7 billion in ARMS that aren't making principle OR INTEREST payments in an environment of rapidly falling home prices, an illiquid housing markets. All this and ARMS have JUST STARTES resetting!

Between 2005 and 2006, CFC amortized 464 million in interest and dropped depreciation 2 billion and STILL only earned 145 million more than the prior year.

Next year, CFC won't have loans that are bad, they'll have reposessed homes they can't sell. People today still think collateral is a good thing. That idea won't last.

2007 Aug 23 09:14 AM

[Markham Lee_:]

To be sure, CFC isn't LEND or NFI - is it expensive short-term financing to avoid trouble? Sure. But the light at the other end of the tunnel is a lender capable of funding its loan volume via its retail banking operation and then selling the loans to the mortgage GSEs.

The investment is a costly way to help ensure that happens, but once it does CFC should be able to survive IMO, it won't be a pretty trip, but I don't see the company collapsing.

$2B is a fraction of their loan volume, so it's not quite accurate to say it's the equivalent of borrowing at 21% and lending at 6.8...when you fold the investment into their overall loan volume, the effective cost (assuming it helps ensure continuous operations) is actually quite a bit smaller.

Either way, time will tell


-M

2007 Aug 23 01:25 PM

[Hayweed:]

Hooray a takeunder or a prop up. Whatever, this just shows how bad real estate mortgage lenders are really in.

2007 Aug 23 10:12 AM

[Hasib:]

I think Countrywide deserves to be a $5 stock as it generated so much toxic mortgages with any scruple whatsoever.

2007 Aug 23 12:05 PM

[Paul Meisel:]

BAC was rumored to be looking at a takeover, now they get a better deal on a smaller piece, less risk, still lots of upside, and a potential blocking position against another suitor should CFC turnaround.

Meanwhile CFC may have had to sell the whole company, they only have to sell a piece (although at a big discount), protecting their investors.

Smart.

2007 Aug 24 10:50 AM