Are Countrywide Financial Bond Holders Bankruptcy Remote?

Includes: BAC, CFC
by: Christopher Whalen

"Ever since the government bailout of Chrysler in 1979-80, this country has been on a course of raising the safety net so that the market's discipline, in a capitalistic economic system, has been truncated. We have witnessed a growing level of decisions that are based upon expediency rather than sound long-term decision making. Each time these expedient decisions are made, the level of risk within the U.S. economy has been increased. The market's discipline is not allowed to work for fear of the potential economic fallout." (First Pacific Advisors, LLC, March 30, 2008)

Back in January of this year, we asked whether Bank of America (NYSE:BAC) intends to stand behind the debt holders of Countrywide Financial Corp (NYSE:CFC) when BAC acquires the latter later this year. See our January 22, 2008 comment: "Are Countrywide Financial Bonds Bankruptcy Remote?"

On April 30, 2008, BAC filed a draft form S-4 with the SEC describing the formal terms of the offer to CFC shareholders. The draft document does not yet contain a date for the special meeting of CFC shareholders nor does it contain a final offer price for the CFC shareholders. When the deal was struck back in January, the indicative value of a CFC share in BAC stock was about $7. At the time, CFC debt was trading about 70 cents per dollar of face value.

In our earlier comment, we reported that BAC had made no public commitment to the debt holder of CFC. More, we reported that BAC officials, in private discussions with risk officers at other institutions, were explicitly stating that CFC would be kept "bankruptcy remote" from BAC and its affiliates after the close of the acquisition. And since January, BAC officials have refused to make an unequivocal commitment to stand behind the CFC debt.

The BAC S-4 states: "Bank of America has made no determination in this regard, and there is no assurance that any of such debt would be redeemed, assumed or guaranteed," the company said in a filing with the SEC. The clear implication of BAC's refusal to take responsibility for the $40 billion or so in parent-company debt is that BAC CEO Ken Lewis is considering a bankruptcy filing for CFC as one possible strategy after the transaction closes.

As a banker who spoke to BAC told The IRA back in January: "The BAC strategy is reportedly to manage the orderly liquidation of CFC, excluding Countrywide Bank FSB, and to guarantee payments of interest and principal so long as the remaining non-bank assets and liabilities of CFC support same. The BAC officials reportedly expressed the view that keeping CFC is a separate subsidiary of BAC insulates the rest of the group from legal liabilities and arguably prevents them from ballooning out of control."

At yesterday's close around $6, CFC had a market cap of $3.5 billion and an enterprise value of $70 billion, reflecting the consolidated liabilities of CFC including Countrywide Bank FSB. Once you net out the balance sheet of Countrywide Bank FSB, including the $50 billion or so in FHLB advances due from the $120 billion asset bank, there remains about $40 billion in parent company debt as well as general creditors who stand at risk.

Keep in mind that in terms of liability funding options, the clock is ticking. CFC is already at the limit in terms of FHLB advances, which are set at 50% of the bank unit's ending assets for the prior month. Also, upon the close of the CFC transaction, BAC has committed to repay the FHLB advances at par.

This morning, CFC's short-term debt is currently trading around 92 cents on the dollar or par value or a spread to the two-year note of about 650bp. So here's the question: If BAC closes the CFC transaction and moves Countrywide Bank FSB to another part of the BAC group, what is the likely recovery value to bond holders of the remaining assets? Is it 90% of face value, as the current market suggests, or lower?

Let's imagine for the sake of argument that BAC closes the CFC acquisition, but the US economy and the housing market continue to sink into the mud, forcing prices for mortgage paper, servicing, etc., lower. In that event, BAC may consider a possible "nuclear option" scenario:

First, BAC closes the transaction with CFC, paying the CFC equity holders some nominal amount to win approval of the transaction. CFC is merged into Red Oak Merger Corporation, the de novo shell created for the CFC acquisition. BAC, however, does not take responsibility for Red Oak's liabilities.

Second, BAC acquires Countrywide Bank FSB from Red Oak and moves the bank to another part of the BAC group, contributing an amount equal to the book value of the bank's equity to Red Oak. This reduces the assets and liabilities of Red Oak by about $100 billion, and also weakens any future claim by Red Oak creditors against BAC for fraudulent conveyance in the event of a bankruptcy filing. But acquiring Countrywide Bank FSB, which had $9.4 billion in book equity at year-end 2007, does not significantly improve the overall recovery value for CFC bond holders. Given the generous $7 price for CFC shares as of January, BAC paying well less than book for the bank unit would not be unreasonable.

Third, BAC allows a period of weeks or months to go by, enabling BAC management to get a better sense of the net asset value of Red Oak, including both the liabilities to bond holders and other creditors of Red Oak, as well as other contingent liabilities from litigation and regulatory inquiries, which could be substantial.

Fourth, if BAC determines that the net asset value of Red Oak is far below the value of current and contingent liabilities, then BAC could place Red Oak into Chapter 11, in one fell swoop flushing both the debt holders, general creditors and also the extant litigation and other contingent claims.

There are more than a couple of questions arising from such a "what if" scenario. First and foremost, a bankruptcy filing by an affiliate of BAC might trigger default covenants in all BAC debt and contracts. A filing might also provoke a broader response from investors and regulators, who could construe a bankruptcy filing by Red Oak as a default by the entire BAC group.

But perhaps more troubling, a deliberate strategy to use a "bankruptcy remote" vehicle like Red Oak to insulate BAC from the ongoing value destruction of the subprime meltdown could adversely affect the entire market for bank debt. What investor in their right mind would want to hold the debt of any bank holding company were BAC to elect the nuclear option and place Red Oak into a bankruptcy?

As we wrote bank in January: "More to the point, if the Fed, OCC and OTS are willing to countenance a bank merger transaction where BAC does not explicitly stand behind the parent company debt of CFC, what does this say about the debt of other relatively small bank holding entities such as Washington Mutual (NYSE:WM) and Capital One (NYSE:COF)?"

Now, of course, Ken Lewis and the BAC bankers may be playing chicken with all of us. If the threat of a bankruptcy by Red Oak drives down the secondary market value of the CFC debt, then BAC could buy it back at a discount rather than redeem it at par. If this is BAC's true strategy, then Ken Lewis is playing a very dangerous game indeed.

But how else do you explain BAC's refusal to make an unequivocal statement that they will stand behind the CFC debt? It is BAC's behavior, not the deteriorating financial condition of CFC, which is injecting potentially dangerous instability into this situation. Stay tuned.

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