Ken Lewis' Savvy Countrywide Investment

 |  Includes: BAC, CFC
by: Felix Salmon

Bank of America (NYSE:BAC) has managed to nab itself a very attractive investment in Countrywide (CFC).

Yes, attractive.

Now I so realize that received wisdom is not with me on this one. Gretchen Morgenson has told me about the dodgy mortgages Countrywide might be forced to buy back; Guambat is talking about "$2 billion out the window"; Rob Cox worries that BofA's market timing might have been "horribly wrong", and Herb Greenberg defends the Merrill analyst who put a "sell" rating on Countrywide stock.

But behind all of this commentary I see a simple – indeed, simplistic – syllogism: mortgages are bad, Countrywide is mortgages, therefore Countrywide is bad, at pretty much any price. Just look at all the mortgage lenders who have already gone bust!

What I don't see is any recognition that the Bank of America deal is a coup for Bank of America CEO Ken Lewis, who has been talking to Countrywide's Angelo Mozilo, on and off, for six years. And I can guarantee you that at no point over the past six years has Mozilo had the slightest inclination to sell off a 16% stake in his company at a significant discount to book value.

During the mortgage boom, pretty much any fly-by-night operator could set himself up as a mortgage lender, get a huge line of credit from Merrill Lynch or Lehman Brothers, and make money hand over fist by originating dodgy loans and then offloading them sharpish into the MBS market. Those mortgage lenders have now rightfully gone bust, mainly because their credit lines have long since been pulled. Without credit, they can't originate loans, and they're forced to close their doors.

Countrywide, however, is no fly-by-night subprime originator. Rather, it's arguably the best mortgage shop in the US. Yes, it's still reliant on access to lines of credit. All mortgage originators are, unless they're owned by a big bank, in which case they're reliant on access to that big bank's balance sheet. But worrying about Countrywide because it needs liquidity is a bit like worrying about hiring a new CEO because he needs oxygen. The mortgage business does run on credit, but Americans will always need mortgages. So it makes perfect sense for the largest bank in America to get itself a cheap stake in a first-rate mortgage company. BofA alone has access to more than enough liquidity to tide Countrywide over if the present crunch continues.

But what about the question of Countrywide's book value? Buying in to Countrywide at 0.8 times book might seem like a good idea at first glance, but book value is ultimately the difference between two very large numbers: Countrywide's assets, and its liabilities. Its liabilities are fixed, but its assets are mortgages, and those mortgages can certainly decline in value. If they do, Countrywide's book value could be wiped out very quickly.

Ken Lewis knows this, which is why he didn't buy Countrywide stock. Instead, he bought Countrywide bonds, which can be converted into stock should he so wish in the future. And the coupon on those bonds is a very healthy 7.5% – higher, indeed, than the rate at which Countrywide itself is still willing to lend to homeowners. You know that line about the company which loses money on every sale but makes it up on volume? Countrywide, here, is borrowing at 7.5% and lending at less than 7%, and the market bid up Countrywide shares as a result, even though the real winner is Bank of America. If Countrywide can't navigate through the ARM resets which are coming up next year, Bof A will simply clip its 7.5% coupons and go home.

So really the only risk facing Ken Lewis is that Countrywide will default on his $2 billion loan. That's possible, but there's still well over $12 billion of equity in the company which would have to be wiped out first. And even if Countrywide does go bust, Bank of America, as one of Countrywide's largest creditors, would be very well positioned to snap up a large chunk of the company's mortgage expertise out of bankruptcy.

But the most likely outcome, I think, is that Countrywide will make it through the ARM resets buffetted but still intact – and that Ken Lewis will buy up a 16% stake in the company at $18 per share even as the stock is trading at a significant premium to that level.