On January 11th, Bank of America (BAC) announced a definitive agreement to purchase Countrywide Financial (CFC) in an all-stock transaction valued at approximately $4 billion. Under the terms of the agreement, shareholders of Countrywide will receive 0.1822 shares of Bank of America for each share in Countrywide. At the time of announcement, parties expected the deal to be completed in the third quarter of 2008.
This merger agreement followed an investment by Bank of America in Countrywide, announced on August 22nd of last year, in which Bank of America made a $2 billion strategic investment in Countrywide. This was done through a 7.25% non-voting convertible preferred security, with a conversion price of $18 per share. With the merger announcement almost five months later, Countrywide is valued at just over $7 per share.
Arguments have been made both in favor of the deal and against the deal. The main argument in favor of Bank of America is that they are acquiring Countrywide at a very attractive price, with a valuation far below book value, while they get access to the mortgage capabilities, including distribution networks of Countrywide. These assets are expected to be very profitable again once the dust in the credit markets settles. Bank of America also expects substantial cost savings from the merger. The argument against the deal for Bank of America is the fact that there still may be more and unpredictable losses to come, while also the completely different corporate cultures may be an issue.
The argument in favor of the deal for Countrywide is that they really had no choice and would have gone into bankruptcy without a bailout from Bank of America, who already came to the rescue in August last year. The argument against the deal for Countrywide is the fact that the company is sold far below book value and that the purchase price does not properly reflect the profit potential of the company. In other words, what may be a good deal for Bank of America shareholders may be a not so good deal for Countrywide shareholders.
Although I am fully convinced of the intentions of Bank of America, it has been argued that the SEC filings can be interpreted in such a way that Bank of America effectively has a call option on Countrywide. The argument is that there is enough wording in the document to allow Bank of America to walk away from the deal if dramatic adverse developments take place in Countrywide before closing of the deal. Interestingly enough, Countrywide also seems to have a put option on Bank of America, as Bill Miller noted in his latest letter to shareholders of the Legg Mason Value Trust. Shareholders of Countrywide can still turn down the deal and even at a later stage a potential termination fee of $160 million, or 4% of the current deal value, does not seem insurmountable should business developments increase significantly and a better opportunity presents itself to Countrywide shareholders. The proposed merger agreement explicitly allows for the possibility to negotiate a restructuring of the transaction and resubmission to Countrywide shareholders, in case they do not approve of the current proposal. If the deal were to indeed fall through, Bank of America would, of course, still have its $2 billion investment in Countrywide, which would otherwise disappear when the merger does take place.
With this background in mind, and realizing that we are still many months away from closing, an awful lot can still happen with respect to the turmoil in financial markets that may influence the final outcome of this deal. Maybe it would be interesting to turn to the market in order to determine how the current deal is perceived. The graph below (left) shows the discount of the actual share price of Countrywide measured against the actual share price of Bank of America, multiplied with the conversion factor of 0.1822. The graph on the right is almost a mirror image of the other graph, but represents the value that can be realized by short selling 1 Bank of America share and buying 5.49 shares of Countrywide. At finalization of the merger, this position in Countrywide shares should generate exactly enough shares of Bank of America to offset the short position.
click to enlarge
At the end of trading on January 11th, the closing share price for Countrywide and Bank of America was $6.33 and $38.50 respectively. With the conversion factor of 0.1822, the theoretical value of Countrywide shares was $7.01, meaning that Countrywide ended the trading day with a discount of -9.8% to its acquisition price. In the week after the announcement, this discount increased sharply to a level of -24.3%. When Countrywide announced the results for the fourth quarter of 2007 on January 29th, Bank of America confirmed its commitment to buy Countrywide and called the announced losses “consistent with our due diligence”.
Subsequently on January 31st SRM Global Fund announced it had acquired a stake of 5.48% in Countrywide, and believed that the merger agreement significantly undervalues Countrywide. The price discount rapidly decreased to a level of just -7.4%. Since that day, the discount has increased again and has been within a range of -10% to -15% for the last 4 weeks, with a level of -12.9% at the end of February. The graph on the right side shows that after the announcement on January 11th, positive cash flow could have been generated of $3.76, followed by low of $3.32 and high of $8.75 in the period until the end of February. This shows that new information and different perceptions in the market about the likelihood of the merger, even in the short period since the announcement, have already lead to significant opportunities and risks.
A similar merger arbitrage position as described above can also be constructed with options. Instead of short selling Bank of America shares, an investor can sell call options and buy put options with the same maturity date and exercise price. In the same way, Countrywide call options can be purchased and put options sold as an alternative to buying the shares. The following example shows the different outcomes, based on observed prices on Friday afternoon, February 29th.
Bank of America shares were trading at a price of $39.92 and Countrywide was trading at $6.22.With these prices, the sale of 1 share of Bank of America and the purchase of 5.49 shares of Countrywide gives a positive cash flow of $5.77. With the use of options the following could be achieved:
Sell 1 Call BAC Jan’09 40 @ 4.90 +4.90
Buy 1 Put BAC Jan’09 40 @ 6.60 -6.60
Buy 5.49 Call CFC Jan’09 5 @ 2.00 -10.98
Sell 5.49 Put CFC Jan’09 5 @ 1.00 +5.49
Net cash flow -7.19
The maturity date of January 2009 was selected because it is after the third quarter in 2008 and it is the first month with expiry of options in both Countrywide and Bank of America. In this example, it is assumed that the merger is effective immediately after the expiry of the options, but this is not very relevant. In case the merger takes place before the expiry of options, the positions can be reversed and a similar return as calculated here will be achieved.
On expiry and exercise of the relevant in-the-money options, the investor will pay 5.49 x $5 = $27.45 for the Countrywide shares and receive $40 for the delivery of Bank of America shares. These shares will net against each other in the merger closing and the investor keeps the difference of $12.55, which is $5.36 higher than his initial investment. The difference between the value of $5.77 and this calculated $5.36 is caused by the effect of dividend, time and price spreads.
The advantage of the options strategy is that an investor may tweak the structure to reflect his own preferences and / or expectations, by changing maturity dates, strike prices and number of options traded.
It is possible that the discount of the Countrywide share price versus the acquisition price will become very stable while gradually moving to 0% as the planned finalization date in the third quarter approaches. With the current uncertainty in financial markets, and the certainty that much knowledge and many new facts will come to the market in the months ahead, I would however not be surprised if we still see quite some movement of the discount before we reach the final outcome of this merger. As we have seen, the level of this discount will have a significant effect on the returns that can be achieved with a merger arbitrage position on this deal.