Are Countrywide Financial Bonds Bankruptcy Remote?

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Includes: BAC, CFC
by: Christopher Whalen

"The 900 pound gorilla in the room still is counterparty risk in all the OTC derivatives. Most contracts don't have standardized terms. No one knows who holds many contracts. If present holders of credit default swaps ("CDS") either fold or deny payment by trying to litigate over terms or try to settle claiming they were defrauded, then one side of the riskless arbitrage becomes risky and will need to be marked to market. The damage from prospective CDS defaults and deteriorating credit generally could make the housing debacle look like a warm up. Many corporate credit professionals don't understand this nor are they prepared to absorb the resulting losses and accounting restatements. Corporate bad debt allowances look as seriously underfunded as bank loan loss reserves, and will need to be increased substantially even as profit margins are declining - a double whammy for forward earnings." (Jerry Flum, CEO, Credit Risk Monitor)

The announced acquisition of Countrywide Financial (NYSE:CFC) by Bank of America (NYSE:BAC) was in doubt on Friday because of reports that BAC may back away from the deal. Pity CFC shareholders, who are selling at something like 5% of book value (and this for BAC paper), but we wonder how many of the CFC bond holders understand that they may face an equal or greater haircut.

The CFC 6.25%s of 2016 closed at 79.125 on Friday or over a 10% YTM. The pricing reflects the expectation that BAC will assume responsibility for the CFC debt at par. But after hearing from some bankers in the know and reading the "Agreement and Plan of Merger" filed with the SEC by BAC last week, we think that CFC bond holders will soon get the joke.

Usually, when a company acquires another, the former assumes the debt of the latter and agrees to make timely payments of interest and principal as previously contracted. In the case of BAC's purchase of CFC, however, BAC seems to view the transaction as an option.

Bankers who've been briefed by BAC officials tell The IRA that CEO Ken Lewis intends to keep the crippled thrift holding company "bankruptcy remote" by merging CFC with a new vehicle, called Red Oak Merger Corp in the merger plan, and that BAC does not intend to consolidate the entity or take full responsibility for the CFC debt.

According to the plan: "…at the Effective Time, [CFC] shall merge with and into Merger Sub. Merger Sub shall be the Surviving Company in the Merger and shall continue its existence as a limited liability company under the laws of the State of Delaware." (BAC public affairs officials Kevin Stitt and Pamela Black did not respond to written questions sent by The IRA via email on Thursday.)

The implication is that BAC eventually will take direct ownership of the FDIC insured Countrywide Bank FSB, which now has assets of some $130 billion, leaving the remaining assets of the formerly public CFC and a good chunk of its $105 billion in parent level debt at risk of an eventual default. BAC officials are reported to have said that BAC's deposit base and debt issuing power offer significant funding advantages to CFC, but also said that BAC will keep the target separate for an "interim period" of indeterminate duration.

FDIC insured banks, you see, cannot file bankruptcy. Were BAC to even contemplate putting the company formerly known as CFC into Chapter 11, it would first need to move Countrywide Bank FSB to a different part of the BAC group. Otherwise, when BAC was about to file the Chapter 11 petition, the Office of Thrift Supervision would intervene and invoke its statutory authority as the bank's primary regulator to appoint the FDIC as receiver of the bank, potentially stripping BAC of its entire equity investment.

Readers of The IRA will recall our fascination with the televised interview between the money honey, Maria Bartiromo, and CFC co-founder and honcho Angelo Mozillo, the bronze god of affordable housing. Last September, we described ("When Flying to Quality, Be 'In the Bank'", September 10, 2007) why the phrase "in the bank" was so significant to investors holding CFC debt and equity.

According to statements allegedly made by BAC officials during private conference calls held over the past two weeks, statements which are nowhere to be found in BAC's public disclosure filed with the SEC, the CFC debt is expected to be "assumed not guaranteed," this under the theory that "the biggest risk at CFC was liquidity and that when the deal closes, that risk goes away," according to a banker involved in the conversations.

The BAC strategy is reportedly to manage the orderly liquidation of CFC, excluding Countrywide Bank FSB, and to guarantee payments of interest and principal so long as the remaining non-bank assets and liabilities of CFC support same. The BAC officials reportedly expressed the view that keeping CFC is a separate subsidiary of BAC insulates the rest of the group from legal liabilities and "arguably prevents them from ballooning out of control," says the banker.

If BAC officials are keeping CFC "bankruptcy remote" to protect the large organization from legal and financial losses from the ex-bank portion of CFC, which includes the bank's conduit and non-bank assets, the implications for CFC debt holders - and holders of bank debt generally - are quite grim. If the same fire sale valuations seen in the market for subprime assets are applied to the ex-bank assets of CFC, then the Friday close of 79 cents per dollar of face value of CFC bonds may be a tad on the high side.

More to the point, if the Fed, OCC and OTS are willing to countenance a bank merger transaction where BAC does not explicitly stand behind the parent company debt of CFC, what does this say about the debt of other relatively small bank holding entities such as Washington Mutual (NYSE:WM) and Capital One (NYSE:COF)?

If CFC is to be allowed by regulators to fall into bankruptcy once the insured bank subsidiary is secured, then how about WM and COF? Are the Fed and other regulators indifferent to the systemic implications of such a transaction? More important, don't investors in BAC and CFC securities have a right to an unambiguous statement from BAC CEO Ken Lewis regarding his intentions with respect to CFC debt?

Unfortunately we cannot participate in the BAC conference call today due to a previously scheduled client meeting, but perhaps one of our colleagues in the analyst rat pack will ask BAC to elaborate on the following:

1) Were the statements we describe regarding the acquisition of CFC, in fact, made by officials of BAC?; and

2) If so, why were these statements not immediately made available to all BAC and CFC investors?

We again put those questions to BAC.