BofA/Countrywide Risk Arbitrage Opportunity

The January 11, 2008 announcement of the takeover of Countrywide Financial Corporation (CFC) by Bank of America (BAC) provides for another risk arbitrage opportunity (placing a bet on the close of the deal).

Risk arbitrage is the trading strategy of owning a takeover target and selling its acquirer short after the announcement of a takeover. When a company buys another company with its own stock, the target company (the company being bought) receives in exchange the shares of the acquirer (the company doing the buying). This sets up an opportunity to sell short the shares of the acquirer and buy the shares of the target and capture the "spead" (difference) between the acquirers share price and the targets share price. Why is there a spread? Because there is a risk (thus, how the name risk arbitrage came about) that the deal may not go according to plan nor close all together. Also, there is the time value of money (the time your money is tied up waiting for the deal to close).

As most of you are already aware, Countrywide Financial, the nation's largest mortgage lender (a distinction no longer worn as a badge of honor), recently fell on hard times from the collapse in U.S. housing, the subsequent rise in mortgage defaults and a run on the "shadow" banking industry (for more on "shadow banking", see Paul McCulley, PIMCO, “Global Central Bank Focus, August/September 2007). Shareholders of the battered mortgage lender Countrywide are expected to receive 0.1822 of a Bank of America share in exchange for each of their shares.

As of the day of the announcement, Countrywide traded at a 7.6% discount to the deal closing value. Since the deal is expected to close in about nine months, this would equal little better than a 10% return on the trade, a none too attractive yield for this kind of risk (typical risk arbitrage spreads are closer to 20% depending on the time expected for the deal to close). Yesterday, the spread widened to 27% giving an investor a 36% annualized return presuming the close occurs in the nine month time frame originally disclosed.

However this is no ordinary deal. For the following reasons, I believe the chances of this deal not going through are very small and therefore it offers a very attractive risk return profile especially at today’s share prices.

• In August, and prior to announcing this deal, Bank of America had already injected $2 billion into Countrywide as the global credit crisis deepened signaling their desire to stem a failure at Countrywide.
• In the past, Countrywide has always been a thorn in the side of the banking industry due to its willingness to push up the cost of overnight and term deposits. Bank of America would like nothing more than to remove Countrywide as a competitor in the collateral markets and inject discipline in the funding market. Countrywide has been known to pay 0.5 percentage points to 1 percentage point above its competitors on some products. The $4 billion price tag that Bank of America is paying for Countrywide will easily pay for itself in reducing a rogue player in the funding market.
• Bank of America Chief Executive Kenneth Lewis is a renowned dealmaker in the banking industry. He does not do, nor announce, deals he does not intend to close.
• The primary reason I believe this deal will get done is that I believe the Federal Reserve Board wants this deal. Although I don’t know it as a fact, it is my guess that the Fed has nudged Countrywide into the arms of Bank of America and encouraged this deal. You can rest assured that unlike many deals, the Fed, and for that matter any other government agency, is not going to get in the way of this deal.

As with all such deals, these things are never foolproof. Based upon information from a recent SEC 8K filing, there are escape hatches built into the deal for Bank of America, if, for example, Countrywide has misstated its earnings or violated accounting rules. However, would Bank of America having already ponied up $2 billion really walk away from the deal or rather renegotiate the price? Would CFC management purposely lie or hide financial information from the Fed and BAC upon entering a merger agreement knowing surely there would be jail time awaiting them?

Barring some unforeseen disclosure or outsized liability that had gone undisclosed to date, you can bank this deal will close if the Fed has anything to say about it. The last thing they want is for CFC to fail creating more havoc in the funding market and running a risk of a run on more banks.

Why has the spread widened since the deal was announced? I don’t claim to have the answer, but my guess is that in light of the recent announcements by Citibank (C) and Merrill Lynch (MER), most “Street” arb desks are not rushing to put on these trades (or for that matter any others), giving the rest of us a chance to benefit from their liquidity misfortunes.

In an efficient market, “sharks” (professional risk arbitrageurs) swim in when opportunity strikes and tighten up spreads. In today’s market of illiquidity, panicked uncertainty and blood in the streets irrationality (yes, Dr. Shiller you can have it both ways, just as there can be irrational exuberance in a rising market, there can be irrational panic in a falling market), the sharks have had their fill of blood and chum to feed on. During market panics and exuberances, inefficiencies are exposed because the usual suspects are not able to perform their duties as “righters of wrongs”.

I would argue this is one of those cases. For my money, the 36% annualized return priced into the current spread on the deal is an attractive return given the perceived level of risk. Assuming a 50% loss on the spread (CFC falls and BAC rises) due to a failed deal, and assigning a 25% probability of occurrence, the difference in gain from a successful close and the loss on a busted deal results in a positive expectation arguing for doing the trade.

Disclosure: The author holds a position in this trading strategy. He is long CFC and short BAC using the same weighting as the deal terms (0.1822 BAC shares to 1.0 CFC shares). Additionally, the author wishes to disclose that he entered the trade at a narrower spread than that which exists in the market at the time of this writing. Lastly, the author wishes to emphasize that it is not advisable to enter an investment of this nature without fully appreciating the associated risks. The risk of loss from this type investment strategy could be substantial.

Comments

[Arohan]

Agreed that CFC is trading at a discount to its deal closing value even after adjusting for tvm and this is a very good strategy for above market returns in a short time frame with very little risk.

However, as a long term investor who views BAC as a great company to own for a long time and who also views BAC to be severely undervalued at this time, buying into Countrywide today actually gives a way of acquiring BAC stock at a discount to even the depressed stock price today. I am inclined to just buy CFC, let the deal close and convert to BAC stock and just let it ride

Another thing to consider. CFC has a larger dividend yield than BAC today (10.9% to 6.9%). Also the deal does not seem to have a provision to adjust the exchange ratio of shares if CFC pays out dividends in the interim. If CFC does not cut its dividend, it would appear to me that buying CFC today, and reinvesting its dividend would actually get you more BAC stock for your CFC shares at the deal closing than what was announced. Of course, this difference in dividend yields also helps in the risk arbitrage strategy you discuss as you get a net payment for 2-3 quarters in dividends just to maintain your position and do nothing.

I am surprised as you are that this kind of mispricing exists, but in todays volatile markets anything is possible

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