Saturday, May 3, 2008

Bank of America Bails Itself Out of a Problem - update

When the purchase of Country Wide Financial (CFC) was announced in January I wrote that I viewed it as a clever way for Bank of America (BAC) to bail itself out of a problem loan. Here is why. BofA had invested $2bb in preferred stock last August that is convertible to common at $18 per share. By year end with CountryWide heading for certain bankruptcy, that investment would need to be written off, likely against '07 earnings. Also, BofA had long been CountryWide's principal commercial bank so would have also had credit facilities likely in the range of multiple billions of $$'s. Add-in other possible exposures on swaps, etc and the total charge-off they were looking at was quite likely in the range of $10bb. So, for a mere $4bb in BofA stock (that's not real money, after all!!) they get to soak up the problem with nary a stain left on the floor. Worst case for them is that if the net value of the assets acquired were to fall below their $4bb purchase price, they would incur good will.

When I wrote in January I noted that one significant risk to BofA was the continued deterioration in the quality of CountryWide's assets and operation. Well, it looks like this is happening in spades. At quarter end, just under 10% of CountryWide's loan portfolio was more than 90 days delinquent. That looks to be an astounding $10bb of loans on the verge of foreclosure. And in this case the "trend is not their friend" as some like to say. There is no reason to believe this deteriorating trend will not continue. Operationally, the company is facing multiple investigations including at least one that is criminal. The potential cost from these cannot be quantified. Thus, in a matter of several months what may have seemed like a clever way of dealing with a problem borrower has become very costly. Several shareholders literally begged Ken Lewis to call off the deal at BofA's recent annual meeting.

With the cost of the "acquisition" ever rising it is little wonder that BofA has now let it be known that they may take steps to avoid direct liability for debts and presumably legal issues. (Or, perhaps this was their plan all along.) In their SEC filing on Thursday BofA indicated they would likely not assume all of CountryWide's liabilities. CountryWide has some $97bb in Notes Payable. How can they, you ask, if this is a stock for stock purchase not assume the liabilities? Fortune Magazine's on-line edition today has an article filling in the blanks a bit. It seems the actual entity doing the acquisition is a new subsidiary called Red Oak Merger Corp. The plan, according to Fortune, is for Red Oak to hold the CountryWide entity and then sell certain assets, such as CountryWide's commercial bank, directly to BofA. Red Oak would then hold whatever amount of cash that equaled the fair value of the assets transferred which could then be used to satisfy CountryWide's debt. BofA could also pay for assets transferred by assuming debt but cautions in their SEC filing that they cannot give any assurance that they will assume all debt. They did indicate that some $11bb in revolving bank debt would be assumed. (A big chunk of which is likely owed to guess who ... BofA, that's who) In the end, Red Oak would itself be put into bankruptcy.

What is fascinating about this is that it starts to look very much like what happens when a bank is closed by the regulators and then sold to an acquiring institution. It is also similar to what happens in a bankruptcy liquidation. All of which raises the question, was BofA given the OK by the regulators to pursue this strategy? It will be interesting to follow the drama.

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