Bank of America Buys Countrywide - Who Gains and Loses?

 |  Includes: BAC, CFC
by: Thomas Tan, CFA

In general, I think it is good news for CFC (of course), for homeowners, for the Fed, for the federal government, local state and city governments, semi-government agencies such as Fannie Mae and Freddie Mac, good for taxpayers like us - but bad news for BAC.

As one reader pointed out in his comment, there has been wide speculation for the last several months that the government is behind the scene to urge (or push? or beg?) BAC to rescue CFC. The government would not allow CFC to fail, since it would create a domino effect much worse than the S&L crisis and LTCM. The failure of CFC would have triggered many counterparties conducting OTC derivative trades with CFC to fail, which would have brought the whole OTC derivative market including all large investment banks into their knees, similar to the LTCM situation in 1998.

The failure of CFC would also transfer all the credit risks to semi-government agencies of Fannie Mae and Freddie Mac, which would force Fed and federal government to bail them out by using taxpayer's money, similar to the S&L crisis in the late 1980s - except this time the amount is probably 10 times larger. I don't even need to mention what that would do to other fixed income products, the general credit market, equity market and the US economy.

As I indicated in many of my previous blog posts, I think 2008 is the year banks will face a lot of legal challenges. We see today that the city of Cleveland has filed lending practice suits to 21 banks including BAC and CFC. We should see a lot more of this type of suits being filed by both local and state attorney generals' offices for the whole year. We should also see number of suits from homeowners facing foreclosure growing to sky high this year. If CFC files for bankruptcy, this kind of law suit would not be able to be compensated monetarily even if they win. However, by BAC stepping in buying CFC, it creates a deep pocket situation that all the suits now will target BAC.

It is similar to a drug from a small single-drug biotech going bad - the patients have less incentive to sue since even if they win the biotech company would just go into bankruptcy and patients and their vulture lawyers would get nothing in return. However, if this small biotech gets bought by a big pharma right before the problem surfaces, good luck to the big pharma. It is guaranteed that you would see a flood of lawsuits from everyone who has taken just one pill of this drug in their whole life.

BAC should just forget about the $2B bad investment in CFC last August. Adding to losing position is usually not a good trading strategy, not even considering all the legal ramifications and their huge liabilities. But it is great news for many people at the other side of the trade with CFC and all levels of government, with BAC now catching the falling knife and holding the bag for many years to come until the deep pocket becomes much shallower.