Countrywide: Potential Short Squeeze in the Offing

Media reports that Bank of America (BAC) is targeting July 1, 2008 as the date for its acquisition of Countrywide Financial (CFC) have the potential to create a huge impact on the market if accurate. Reports that a letter sent to Countrywide branch managers specifying July 1st as the date are supported by SEC filings showing that Bank of America has shelved the appropriate number of BAC shares and CFC filings, placing a ban on Countrywide executives from trading between June 27th through July 2nd.

All of this is assuming that CFC shareholders approve the merger on June 25th, 2008.

As of June 19th, 2008 closing prices, CFC shares were trading at $4.83/share, a discount of $.29/share (fair value of the acquisition is $28.14/BAC share x .1822/shares offered per CFC share = $5.13/CFC share), or 6%.

Now where CFC really becomes interesting is in the fact that it currently has 583 million shares outstanding and short interest of over 114.8 million shares as of mid-June, according to the NYSE.

That's 19.69% of the outstanding float as short interest for a takeover that appears set to close on July 1st, 2008 - just 7 trading days away.

Given CFC's average daily volume of 22.7 million shares per day, that’s more than 5 days to cover, assuming no one else buys CFC shares in that time frame. As a result, we may see an unusual situation in which shorts are forced to cover, potentially at prices beyond the acquisition price, given the extreme amount of short interest outstanding relative to the share float and the time remaining prior to the acquisition by BAC. This could create strong upward pressure as a large numbers of shorts run to cover at the last minute, causing a classic short squeeze scenario.

Sources:

• Wall Street Journal report on July 1st closing target date
• SEC Registration of Bank of America Shares
• Prohibition on Trading by Countrywide Execs 6/27 - 7/2
• Short Interest level as of mid-July direct from NYSE
• Stock data, including saily average volume, share prices, etc. are available from a wide array of sources (see here and here).
  

Disclosure: At the time of this writing, the author is LONG shares of CFC and BAC, and is LONG on CFC Calls, although positions may change at any time.

Comments

[justintime:]

There would be no need for the shorts to cover. Wouldn't the shorts get their CFC short shares converted to BAC short shares?

2008 Jun 22 10:41 AM

[User 149584:]

Justin, that's true, but there's still the 6% premium. So the CFC shorts, knowing they will get BAC shorts that are worth 6% more than their current shares, may cover to avoid this. Or am I confused?

2008 Jun 22 11:16 AM

[ILongyou:]

"Disclosure: At the time of this writing, the author is LONG shares of CFC and BAC, and is LONG on CFC Calls, although positions may change at any time."

I hope no one overlooks the author's inherent interest in actually making this squeeze happen through his "article", even if the squeeze is not necessary. As justintime indicated above, all CFC stock positions (long and short) will convert to the corresponding BAC ones. Smart money is betting that the CFC books are soooo bad that either BAC will still wiggle out, or try to play games with the acquisition conditions to avoid paying the full price. *IF* the acquisition does go through as proposed, then the bad books *DO* move onto the BAC books and then BAC must take the corresponding haircut now or later (6%? anyone :)) and becomes a good short!. So smart CFC shorts will be happy to move to be the BAC shorts *IF* BAC still decides to move the CFC books to its own! In summary, the smart money bet is on the horrible CFC books... and will happily follow it to BAC if Lewis is dumb enough to keep to his original plans!

Not ignoring my own name "cfcshort" :), this article is no different than the stock pumping spam I receive all the time where the "author" is already heavily on the long side and is trying to make money through his articles/spam!! Beware!

2008 Jun 22 11:32 AM

[1worldcurrency:]

"Huge impact on 'market'". What a load of....

2008 Jun 22 12:18 PM

[H. Michael ...:]

If shorts see other shorts getting squeezed, it could very well create a short covering rally, which is typical in a bear market. We've had several during the recent downturn and given the high degree of short interest in the marketplace right now, it’s very possible. Add in the recent rumors of a Wachovia acquisition by JPM on Friday (courtesy of CNBC) and it has potential to be a catalyst for a short covering rally.

I believe (based on nothing but my own speculation) that most of the current CFC shorts are shorts betting against the deal going through. Shorting Bank of America, even with Countrywide's liabilities, is a very different venture than shorting CFC. Shorting a stock with a 9.5% dividend yield (as of Friday close), strong balance sheet, a large unrealized gain on an investment (the China Construction bank options and existing shares, currently have a net gain of approx. $27 billion) etc. is a nasty prospect. If CFC is not taken over by BAC, there is the prospect of a bankruptcy and that would make every short’s day. With BAC, no analyst I am aware of is forecasting the company goes out of business – as such, your potential gains are capped at some point and your potential liability is extremely high as the stock has the ability to appreciate a great deal form its current levels.

It does not help that at current prices, shorts are facing a ~ 6% squeeze immediately upon the transfer of the position. ALSO, the way the BAC deal is structured, at .1822 shares of BAC for each share of CFC, all non-integer quantities are being paid out in cash. So if you have 1,000 CFC shares, you get 182 shares of BAC and .2 x Price of BAC in cash (about $5.42 at Fridays closing price).

Plain English, shorts have to pay out the equivalent in shares of BAC AND a small amount in cash. It’s very similar to holding a short position through a dividend. This is assuming your broker allows you to hold through the acquisition (not all brokers do; retail brokerages in particular tend to place more restrictions on such events). Regarding trading at a higher price than the acquisition, it has occurred several times since this deal was announced. It would not surprise me one bit to see it re-occur, albeit briefly, in the current circumstances.

Anyways this scenario is POSSIBLE, and it appears to be developing. CFC shares, on a % basis, held up far better than BAC shares during Friday’s market and indeed, throughout much of last week. That indicates to me some shorts may be starting to cover and that is exactly how short covering rallies begin.

All in all, I felt it was worth discussing. Thank you for reading.

2008 Jun 22 03:35 PM

[Marol:]

Mr. Arguello: Thanks for a clarifying and dignified response to some undignified comments.

2008 Jun 22 11:29 PM

[No Moss:]

I have a small position in BAC that is, of course, under water. I'm also skeptical about the short-term wisdom of buying CFC. That said, I think the long-term prospects for BAC are excellent. They are focusing on being a retail bank, and I think that will be rewarded.

In the long run, the CFC purchase will be accretive to business, increasiong the bank's revenue from mortgage originations and mortgage servicing, but more importantly, funneling new mortgage loan business into BAC, with new bank accounts following. I mean, you'll get some sort of discount from BAC if you have your bank account there. Bank deposits = cheap money plus additional service revenue.

It's one way to get around that 10% cap.

Absorbing CFC would seem to require either selling some of that China Construction Bank stock, further diluting BAC stock, or cutting the dividend. We'll know the results of all this by year end, after we get a couple of quarters of writeoffs behind us.

Who knows, the economy could come riding to the rescue and make Ken Lewis look like a genius. Stranger things have happened.

2008 Jun 23 08:35 AM

[Always Elevate:]

Mr. Arguello,

I am with you 100%. If you could i would like to seeyou analysis on any other positions that you might have in your portfolio................ Keep it up.....

2008 Jun 23 10:22 AM

[viewfromnyc:]

There is no need for any short to cover CFC. Upon closing of the merger a short position in CFC will be automatically converted to a short position in BAC as required by the securities lending agreement that pertains to the borrow of CFC. Consider also that if a merger arb. player is taking a position for a deal break they will also be long BAC both to capture the potential upside on BAC (arbs. long CFC will be short BAC and cover if the deal breaks) in a break and to hedge against a siginificant move up in BAC. Not only does the 6% discount matter but also the absolute price of BAC.

2008 Jun 23 10:42 AM

[chtrplyr:]

CFC shorts would have to be committing financial suicide to hold a position through the merger.

BofA had $15B current provisions plus $13B positive net equity in CFC plus potential $7B reserves this quarter for $35 Billion total.

All the while remaining profitable.

That will more than cover the balance needed to cover losses even in poor economic conditions the next few years.

With the housing bill they will only have about a quarter of those losses and will book write ups.

This is a negativity and oil bubble that is going to burst. BofA will help that happen after they book CFC as the lower the BofA price right now the lower they book for CFC for.

Shorting CFC at this level is about the dumbest move possible.

2008 Jun 23 01:41 PM

[ILongyou:]

** So lets see the new arguments:

-- If shorts see other shorts getting squeezed, ... it’s very possible.

** So now you are reverting to the old "shorts spooking one another" for your long CFC bet profits? Yes, a lot of things are very possible, if longs see other longs getting margin-called, .... :)

-- Add in the recent rumors of a Wachovia acquisition by JPM

** aah... the rumors...


-- With BAC, no analyst I am aware of is forecasting the company goes out of business

** Don't always need the "going out of business" to make profits on shorts

-- As such, your potential gains are capped at some point and your potential liability is extremely high as the stock has the ability to appreciate a great deal form its current levels.

** Well, yes, ... shorts KNOW that the profits are capped and the losses are unbounded... not any new information... but thanks.

-- It does not help that at current prices, shorts are facing a ~ 6% squeeze immediately upon the transfer of the position.

** That is certainly a VERY valid point.. and I agree that if shorts DID want to move from CFC to BAC, its more prudent to cover CFC now and sell BAC... but as the lack of the big arbs taking positions here indicates, significant risk lies in this deal not going through... or at least not as exactly promised!

** I am glad you mentioned the Wachovia rumor.... here is a short snippet from a VERY recent history...

"We feel like we are merging with a crown jewel,” Thompson said during an interview Monday. “This is a transformative deal for us.”

ring any bells???

www.msnbc.msn.com/id/1.../

Here is more...

"We believe this combination of our two companies, both known for exceptional customer service and pristine credit quality, will generate superior long-term growth in earnings per share," said Ken Thompson, Wachovia chairman and chief executive officer, who noted that Golden West’s World Savings Bank is the nation’s only standalone savings and loan with a "AA" debt rating.

So how did THAT turn out?

2008 Jun 23 01:47 PM

[ILongyou:]

** oh... one more thing... also note that Lewis first paid $2B for about 16% of CFC and then only five months later promised $4B (which is now closer to $3B) for the 100% :) So he is not as smart as y'all think.... here is what happened to the other "smart" CEO with almost the exact same scenario...

www.clusterstock.com/2...
www.nypost.com/seven/0...

kinda like someone paid $100 for a stock, which is now $25 and the long, always scared to fess a mistake and thinking greatest bargain of his life, throws more good money after bad... only to see it drop to $0.25 :)

2008 Jun 23 02:07 PM

[H2O:]

McCain Adviser: Another Attack on U.S. Would Be "Big Advantage" For McCain


HUMMMMMMMM Americans terrorized by high gas prices - terrorized by - Mortgage companies - throwing them out of there house - terrorized by high food prices - and terrorized by will they have a job or not.

I think Americans know by now - the real terrorist are the rich-greedy - foot tapping repubs.

So basically - if the Osama "which the repubs like to let go" attacks the rich-greedy - Americans down-right don't give a "you know what”!!!!!

Here's to you rich-greedy repubs - you don't love Americans - Americans will return the favor - Cover your own back - Americans no-longer will fight for IDIOTS >>>>>&g...

The hazels at the air-ports – would show how stupid repub-security is – no border security – bring out the right wingers – yelling told you so. No port security –
Spy on Americas immunity bills ………

Go for it IDIOTS – let something happen – Americans would show-up in Washington and TAR and feather every repub out there.

2008 Jun 23 05:12 PM

[H2O:]

Same Ole Fruitcake - Dobson accuses Obama of 'distorting' Bible.

Let us count the ways – This fruit-cake - IDIOT – has used Gods word – and mangled it so much – nobody could understand it.

But – lets say no-more – then – this is the same fool that slept with haggard – and toe-tapped with other repubs….

Dobson – The GAY fool in leather with Rovey ……….

IRAQ WAR OF LIES – OR A CHRISTIAN CONSERVATIVE CAMP????

WHERE DO YOU WANT YOUR KID SLEEPING TONIGHT????

Heck you should just be sleeping with countrywide ….

But lets forget all the DOBSON gay stuff – this is the same FOOL-IDIOT that pushed the IRAQ WAR OF LIES – and told you bush-co was GOD himself….

So lets TAR and feather this IDIOT first – where is your cheap GAS? Where is your cheaper food? Where is your secure JOBS?

NOW lets talk about how these IDIOTS distorting – GODS WORD >>>>>&g...

……..

2008 Jun 23 11:26 PM

[justintime:]

A short squeeze is unlikely. For a short squeeze to occur the demand to buy would have to be a lot more than 27 million shares in volume a day. I do not see any such demand. There would have to be some other unforeseen event to artificially raise the share price to get the shorts to start coverig.

2008 Jun 24 12:22 AM

[Deep Value:]

Isn't a short sqeeze a supply/demand funtion? Buy volume doesn't necessarily have to increase so long as sales volume falls. As the time of the merger approaches there will be more certainty and therefore less risk so the spread should tighten. I don't think there will be much CFC selling as the merger approaches.

2008 Jun 24 02:24 PM

[ILongyou:]

So I guess the author of the article (as well as his ponies named Marol and Always Elevate) got an expensive lesson :) BTW, good luck with that BAC long position now...

2008 Jul 01 01:03 PM