Simply stated, honesty plays little part in American business. Our morality, on the contrary, in a game of cards or in sports is irreproachable. And so it is that we are gentlemen of honor when engaged in life's pastimes, but devoid of it when engaged in serious pursuits. The public has a subconscious awareness of this state of business immorality, but for some reason remains apathetic to it, and even condones it. True, a simple criminal act is condemned (and when simple it is invariably of small dimensions) but where large profits have accrued or an enormous institution erected on no matter how fraudulent a foundation we give it respect and applause. "He was clever enough to get away with it" implies only approval. Perhaps because of the size and ramification of business, the citizen rests his confidence in the law; but the law has failed him.
- from False Security: The Betrayal of the American Investor, by Bernard J. Reis & John Flynn; The Stratford Press (1937)
Last week, we described how a Bank of America (NYSE:BAC) acquisition of Countrywide Financial (NYSE:CFC) might go forward -- if BAC was willing to endure uncertainty with respect to CFC's current and unliquidated liabilities.
Now we look at the other prospect - namely a busted deal, a regulatory intervention and the sale of the bank sub by the FDIC as or after CFC enters bankruptcy. We note with some satisfaction that on Friday S&P, a unit of McGraw Hill (NYSE:MHP), took notice of the disclosure by BAC regarding CFC, disclosure that we and Bloomberg News illustrated earlier last week, and downgraded CFC.
Could it be that the torpor affecting some analysts, inertia which allowed them to believe that ratings for CFC actually would converge with those of BAC, has now ended? Did S&P and the rest of the ratings herd really believe a company facing hundreds of federal fraud, racketeering, truth-in-lending and other claims could be bought this side of a restructuring?
We don't believe that the BAC+CFC transaction can get done without a re-organization to address the litigation and other off-balance sheet, contigent claims. Are terms like loan rescission or punitive damages at all meaningful? Indeed, if a sale to BAC is not assured, we wonder if a Chapter 7 filing by bond holders is not now the logical course.
But hold that thought a minute.
Above we quote a passage from False Security: The Betrayal of the American Investor, a book which predicted the disaster with CFC and subprime generally some 70 years before the event. This wonderful volume, which a reader and reformed CDS trader named Bob brings to our attention, talks about the many aspects of the Great Crash and how Wall Street used the opaque, complex structured assets of that day to rob investors blind.
To us, part of the appeal of the expose by Reis & Flynn is the perspective that we always try to reflect in The IRA, namely that of the aggrieved consumer. But their discussion of Guaranteed Mortgages and Real Estate Bonds will make even the blood of today's professional investors run cold for, indeed, it has all happened before. Any investment manager, advisor or regulator who claims to be surprised at the subprime collapse is making a confession of gross incompetence and, more telling, of ignorance of this nation's financial history.
The fact is that the current situation in the US markets, with a growing portion of the overall financial flows trading "Under-the-Counter," closely resembles the situation prevailing in the US during the chaotic decades leading to 1929. Stocks and bonds were sold with little or no disclosure, either about the terms or the number of securities issued. Stocks and bonds were traded in doorways and salons, with little or no public pricing.
The descriptions by Reis & Flynn of the public mania regarding "new" investment vehicles in the 1920s could be applied almost word-for-word to the events in the US markets over the past decade or more. And the book beautifully illustrates the ancient precursors of structured finance with numerous examples of specific transactions and issuers drawn from the time:
In the beginning the companies sold only mortgages, that is, a mortgage on a single piece of property to one investor which they guaranteed. Later, they devised two other securities which were designed to give the investor greater safety by reason of diversification, on the principle that one should never keep all of one's eggs in one basket.
Investors in the "group series certificates" issued by The New York Title and Mortgage Company of New York would eventually experience 82% losses on their investments, about the ballpark where we think current holders of CFC debt will end up. Why do we say this? Let us count the ways.
First, it becomes clear, to us at least, that BAC is unable to close the CFC transaction due to uncertainty regarding the target's liabilities. We know nothing new or specific here, but the delay added to the continuing disclosure to the effect that BAC cannot accept responsibility for the liabilities of CFC adds up to one thing, in our view: BAC (and its lawyers and accountants) is not willing to do a deal that leaves BAC shareholders facing a potentially staggering loss. A future write-down and likely restatement would ensure even more litigation and end the career of CEO Ken Lewis.
Second, run the numbers. If you accept that none of the funds of CFC's $120 billion asset bank unit are available to repay parent company liabilities, except the $9 billion or so in book value representing the CFC equity in the sub, then the calculus comes down to about $50 billion in debt, vendors and other liabilities vs. the remaining assets of the parent, roughly a similar amount of loan servicing rights, conduit and investment assets, and whatever CFC can get for the bank unit.
Thus two billion dollar questions:
1) What is the estimated haircut for the ex-bank assets of CFC?
2) What is the estimated cost of settling all pending litigation?
Now obviously, it is in the best interest of CFC bondholders to get BAC to swallow the entire meal whole. But given that the extant civil litigation pending against CFC is vast and other civil and criminal inquiries also are pending, there seems to be no way for BAC to quantify the downside risk of CFC for its own shareholders, thus in our view no deal - at least as currently structured.
For the CFC bond holders, the best outcome other than the outright sale to BAC is a sale of the bank unit alone to BAC or another buyer at the best possible price. The remaining company could then be placed into Chapter 11 with the general agreement of current creditors in order to bring all of the litigation to a halt and force an immediate resolution of all current and unliquidated claims.
Under such a scenario, the resolution for CFC bond holders and general creditors might be better than that received by the holders of The New York Title and Mortgage Paper, but not much. Just consider what the eventual settlement amount is on claims against trillions of dollars of securitization and servicing flow originated and/or managed by CFC over the past half decade.
For BAC, a risky but better strategy than the course at hand may be to withdraw from the CFC merger, pay the $160 million breakup fee, and allow the entire company to slide into a managed default. As CFC's funding runs away, the OTS will be forced to invoke its statutory authority to appoint the FDIC as receiver of the insured bank subsidiary, thus precipitating a bankruptcy filing by CFC.
In the event, BAC and no doubt a crowd of other suitors will be standing by, waiting to bid for some or all of the bank's assets and liabilities in a competitive regulatory sale. But the claimants on the CFC bankruptcy estate would have to await the resolution of the bank receivership to see whether there were any net amounts from the sale of the bank that could be reclaimed.
To that point, while retail depositors of Countrywide Bank FSB have little or no reason to be concerned in such a scenario, the jumbo depositors of CFC above the insured limit- if any remain - should take advice about their options. The jumbo deposit holders may or may not be paid immediately by the FDIC depending on their assessment of the bank's condition at the point of seizure.
Given the outline above, our view is that the equity of CFC is worth $0. This just again illustrates the point that price and value are not the same! The main point of this purely hypothetical discussion, however, is to illustrate the limited rights of shareholders and liability holders of bank holding companies, namely that the bank is subject to conservatorship by federal regulators in order to safeguard depositor funds. Bank depositors and the FDIC insurance fund are the senior creditors of any bank holding company, period. This places the full weight of losses at the parent holding company level on holders of equity and debt securities, in that order.
So right about now, if you are a fully cognizant bond holder of CFC, perhaps somebody who bought the convergence thesis from S&P and is now long and wrong, then you might be getting a little indignant at the prospect of CFC equity holders being paid anything until bond holders have been made whole. If you appreciate that the net assets of the bank unit will be available to the bankruptcy estate and also understand that the equity holders are essentially toast, then as a bond holder you need to ask yourself a question:
What are you waiting for?
If the BAC deal is not happening, then the only logical course is to pull the plug on the impossible dream of Ken Lewis, shoot the equity holders and get on with the CFC restructuring. In terms of similar scenarios, take a look at the involuntary filing by Highland Capital Management in February 2001, another "surprise" event that forced Bridge Information Systems into an involuntary liquidation. As Highland Capital CEO James Dondero told the BBC:"…we felt creditors' interests were best served by an immediate filing."
Just imagine the fun: Fed folks jaw boning, investors yowling, journalists wide eyed. A Chapter 7 against CFC will make for days of great headlines, maybe even congressional hearings and an interview with Maria on CNBC.
And a Chapter 7 filing by a creditor of CFC will prove once and for all that a large bank holding company can go through a market-based resolution without a subsidy from Washington. For that reason alone, we'll buy dinner at Sparks Steakhouse for the holder of CFC debt that pulls the trigger first.