"I don't believe in the no-win scenario." (Captain Kirk to Lt. Saavik, Star Trek II: The Wrath of Khan)
"In 2002, Moody's noted that servicing quality can be maintained if the underwriter/servicer is able to obtain debtor-in-possession financing and sell liquid receivables. But cash transfer requirements imposed in the event of servicer downgrade effectively reduce the bankrupt servicer's ability to attract debtor-in-possession financing so crucial to its restructuring. At the same time, increased leverage in the industry-that is, greater reliance on securitization-reduces the amount of liquid assets the underwriter/servicer has available for sale (and collateral). Hence, today's more highly leveraged underwriter/servicers have lower probability of emerging from bankruptcy than those of even a few years ago… The FDIC does not yet have a template for dealing with mortgage or other consumer loan servicing rights, and such rights have yet to have been smoothly transferred in resolutions to date without the FDIC doing the servicing themselves." (Joe Mason, Resolution Strategies, Market Commentary)
We are heads down working on a new index of credit conditions in the US banking industry, but we had to come up for air to update our views on the pending merger of Bank of America (NYSE:BAC) and Countrywide Financial (NYSE:CFC). Why? Because we believe that the CFC transaction is shaping up to be a serious risk not only to CFC bondholders, but to BAC, its shareholders and CEO Ken Lewis.
First let's talk about the CFC creditors. With CFC preparing to hold a special meeting to approve the acquisition by BAC, we continue to wonder why the CFC bondholders are not moving to derail a deal that diminishes their prospects for full repayment of principal. The answer, unfortunately, is that the indenture trustees of the various CFC bonds are not likely to take an aggressive position with respect to the BAC transaction so long as there is some hope - no matter how slim - that the bonds will eventually be redeemed at par.
Fact is that individual bond holders do not have standing to object to the BAC transaction. Unless a super majority of holders of a given issue notify the indenture trustee that they believe CFC is unable to honor its commitments, the trustee - who is selected by CFC - is unlikely to act. While the indenture trustee has a fiduciary duty to protect the interests of bond holders, the likelihood that he or she will get proactive is slightly worse than pigs taking flight. Count this as yet another of Wall Street's dirty secrets made visible by the widening credit crisis in the financial sector.
If investors cannot depend upon an indenture trustee to be a zealous advocate, then the entire framework of structured finance collapses. But that's not the only wrinkle. It has been suggest to The IRA that a substantial portion of the CFC bonds are held by Buy Side firms which also are holders of CFC equity, thus there is a certain conflict of interest at work. The "Friends of Angelo" or FOAs, it is also suggested, hold enough CFC debt to block any creditor intervention in the BAC acquisition. It appears that the FOAs will get what they can get for the CFC common and then take their chances on the bonds.
Read our earlier comments on the BAC/CFC combination for thoughts on why the bond holders should not sit idly by and watch as BAC pays billions to CFC shareholders when the prospects of full repayment of creditors remain entirely uncertain:
- 'An Involuntary Transaction: Why BAC + CFC May Never Close', May 6, 2008
- 'Update: Are Countrywide Financial Bond Holders Bankruptcy Remote?', May 1, 2008
BAC continues to refuse to confirm that it will stand behind the CFC bond holders and other creditors, thus it appears that the only way this decidedly peculiar transaction will be derailed is if a general creditor is willing to call a spade a spade, engage counsel and file an involuntary bankruptcy petition against CFC before the deal closes - if it closes.
Now consider the plight of BAC shareholders. Talk in the marketplace is that BAC is considering whether to attempt to close the CFC deal before the currently stated September target date. From Washington's perspective, closing this deal sooner rather than later is probably a good idea given the rapidly deteriorating financial condition of CFC and particularly its subsidiary bank, Countrywide Bank, FSB.
Given the rising loss rate of the subsidiary bank and the related drop in the institution's core deposits and capital, we question whether BAC can actually wait until September to close this deal. Alternatively, it has been suggested to The IRA that BAC may be dragging its feet, hoping that CFC's declining liquidity and capital will force the Office of Thrift Supervision to intervene and appoint the FDIC as receiver of the subsidiary bank. In the event, CFC would have to immediate file bankruptcy, but this would give BAC a way to escape what seems an increasingly problematic situation.
Why problematic? As we have noted previously, the ex-bank assets of CFC may not be sufficient to repay bondholders and other creditors. When you factor in the contingent and OBS liabilities of CFC, particularly the hundreds of civil lawsuits, criminal inquiries and other unliquidated claims, we cannot understand why CFC's debt is trading anywhere near par. But hope springs eternal, it seems, when an acquirer the size of BAC is involved, even though BAC has repeatedly stated in its SEC filings that it cannot explicitly guarantee the target's liabilities and that intends to segregate CFC from the rest of BAC after the deal closes.
So let's assume for the sake of argument that BAC accelerates the CFC purchase to, say, the end of July, in part because federal regulators make clear that no subsidy a la the Fed's deal for JPMorgan's (NYSE:JPM) purchase of Bear, Stearns is in the offing. BAC buys the equity of CFC, sending the FOA's home with a very generous consolation prize of $4 billion or $7 per share in BAC stock, and merges CFC into the Red Oak acquisition vehicle described in BAC's February 2008 prospectus.
BAC then moves Countrywide Bank to another subsidiary and contributes the book value of the equity of the $121 asset bank unit to Red Oak, an amount that by July could be less than $7 billion. Let's also assume that BAC moves the $1.5 trillion CFC servicing portfolio out of Red Oak, again paying near the $17 billion book value to provide a cushion to subsidize the CFC bond holders. These intra-BAC transfers effectively forestall a claim of fraudulent conveyance by bond holders and other creditors in the event that Red Oak is placed into bankruptcy.
Sounds great, right? Well, here's the problem. Neither the bank unit nor the servicing portfolio are worth anything like book value in the current market. Between the end of 2007 and the end of Q1 2008, the bank unit and the servicing book lost more than 10% of book value as stated by CFC. And remember that BAC is paying CFC shareholders just a fraction of book. Thus the cost of protecting BAC from a claim by Red Oak's creditors in a bankruptcy could be a nasty fair value loss to BAC shareholders.
If BAC pays a full price for assets transferred from Red Oak, it arguably will need to take an immediate write-down of these assets, perhaps as much as 50% of the amount paid for each. This could mean a $10-15 billion loss for BAC in Q3, a truly ugly situation for BAC's shareholders and one that will come at precisely the time when the bank may be in the market trying to raise new equity. And this immediate $10-15 billion loss estimate does even start to factor in the cost to BAC shareholders of settling the litigation and other unliquidated claims. Our guess as to the total cost to BAC for CFC? Stick a zero on the $4 billion cost of buying the CFC equity and you may a little high, but not by much.
Remember, BAC cannot put Red Oak into bankruptcy so long as Countrywide Bank and the servicing portfolio remain. Bankruptcy means an FDIC receivership for the insured bank unit and a slow death for the largest servicing portfolio in the US, which BTW may lose REMIC status in bankruptcy. As our friend Joe Mason notes in the excerpt at the top of this comment, bankruptcy is not a friendly forum for a loan servicing portfolio.
Without the threat of bankruptcy, however, there is no way for BAC management to bully the various plaintiffs and other claimants into a settlement. And without a settlement of the current and unliquidated claims on CFC, the entire transaction becomes an open wound for BAC and its shareholders. So again, we ask, why isn't BAC walking away from this hideous deal?
Ken Lewis is a smart guy and one of the best CEOs in the banking industry. He terrifies members of the Buy Side, a quality we find most attractive. His desire to acquire CFC and thereby launch BAC into clear leadership in the US consumer mortgage sector is understandable. But like many successful CEOs, Ken Lewis also does not like to be told that he cannot go through with a strategy he has already set in motion, especially involving a prize such as CFC that he has long coveted.
Despite the obvious dangers, Ken Lewis believes that he can somehow, some way rescue the Kobayashi Maru. But we believe that if Lewis goes through with the CFC acquisition without first letting the badly wounded organization slip quietly into a regulatory takeover of Countrywide Bank and a bankruptcy for what's left of CFC, it will cost him his job and hit BAC shareholders with a huge loss. Our view, for what it's worth.
That's why we suspect that BAC is playing a very dangerous game and is going to continue to drag their feet on closing the CFC deal. We believe that Ken Lewis is playing chicken with Washington, hoping to force the Fed and FDIC to provide some type of subsidy to help shield BAC from the still massive unliquidated claims pending against CFC, claims that could total in the tens of billions of dollars. Without a bankruptcy to flush the litigation and other unliquidated claims, buying CFC may be a no win scenario for BAC shareholders and Ken Lewis.