Gulag Blog

Bank of America Considering Countrywide Alternatives after Downgrade to Junk Status

Countrywide (CFC) sank 11% in morning trading Monday after an analyst said Bank of America (BAC) should walk away from its $4 billion deal to buy Countrywide, due to rising credit costs and souring loans at the troubled mortgage lender. Analyst Paul Miller at Friedman Billings Ramsey downgraded Countrywide to underperform from market perform and cut his price target to $2 from $7, saying Bank of America could face writedowns of $30 billion or more when it closes the Countrywide deal. He says BofA’s statement Thursday that it won’t guarantee Countrywide debt “is most likely the first step in renegotiating the entire deal.”

Miller estimates that Bank of America has a $22 billion cushion to absorb writedowns of Countrywide’s loan book. While that sounds like a big number, the analyst lays out a worst-case scenario that could see Bank of America taking $17 billion in writedowns on Countrywide’s home equity and second mortgage portfolio alone. The analyst says writedowns could reach $11 billion on Countrywide’s portfolio of option adjustable-rate mortgages (ARMs) and $5 billion on hybrid ARMs and other loans. Writedowns of that size could easily swamp the cushion Bank of America set aside when it agreed back in January to buy Countrywide for $7 or so in BofA stock.

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Countrywide’s creditors are getting nervous.

The price of insuring against a default on Countrywide (CFC, Fortune 500) debt soared by more than half Friday after Standard & Poor’s cut Countrywide’s debt ratings to junk.

The spreads on Countrywide’s credit default swaps surged as wide as 250 basis points Friday afternoon – reflecting a $250,000 annual premium on $10 million of insurance – from 165 Friday morning, traders said. The blowout came after S&P warned of “the new level of uncertainty as to the ultimate legal status of Countrywide’s creditors after the merger” with Bank of America (BAC, Fortune 500).

S&P’s decision was prompted by language in a Thursday filing by Bank of America, which agreed in January to buy Countrywide in a stock swap then valued at $4 billion. While corporate acquirers routinely take on the debt obligations of their partners, Bank of America warned in its filing that it is “currently evaluating alternatives for the disposition of the remaining Countrywide indebtedness.” There is no assurance, BofA warned ominously, that “any of such debt would be redeemed, assumed or guaranteed.”

A BofA spokesman didn’t return two calls seeking comment. But if BofA walks away from the debt, bondholders – including state pension funds – could suffer catastrophic losses.

“What investor in their right mind would want to hold the debt of any bank holding company were BAC to elect the nuclear option,” he wrote, referring to a possible decision to walk away from Countrywide debt.

Whalen envisions a situation in which Bank of America would purchase Countrywide, then put Countrywide into a shell company called Red Oak Merger Corp. He says BofA could then move Countrywide’s banking subsidiary out of Red Oak and into another part of BofA, while compensating Red Oak for the transfer. After assessing the remaining assets and liabilities at Red Oak, BofA could put Red Oak into Chapter 11. Doing so could enable BofA to escape, among other things, “liabilities from litigation and regulatory inquiries, which could be substantial.” Countrywide has come under fire since the housing boom collapsed for its aggressive lending practices.

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