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Bank of America is the Smart Money on Countrywide

By The Prince ⋅ January 17, 2008 ⋅  Email This Post ⋅  Print This Post ⋅ Post a comment

The Prince understands that this post is little late but he has been skiing and away from his computer.  The Prince really thinks that BofA’s purchase of Countrywide announced last week is going to be one of the best acquisitions made by BofA.  This is a classic example of buying great assets at depressed value.  At $4bn CFC is a steal considering its infrastructure and market share.  Before we get into why The Prince sees value in Countrywide, let’s look at the signs of Bank of America’s management team’s prowess by examining the acquisition of MBNA. 

The purchase of MBNA for $35Bn in cash and stock made BofA one of the largest credit card issuers.  The acquisition of MBNA provided Bank of America a leading credit card issuer worldwide. The combined Bank of America Card Services organization, including the former MBNA, now has more than 40 million U.S. accounts and nearly $140 billion in outstanding balances.  Many feared that there would be serious culture class between Bank of America’s down-to-earth customer service culture and MBNA’s flashy nuevo rich executives.  It turned out that the management teams achieved amazing success integrating MBNA into Bank of America’s systems and culture.  The acquisition of MBNA will certainly be seen as one of the top financial services acquisitions in-terms of realizing value for shareholders.  The acquisition also fits with Bank of America’s focus on the U.S. while its competitors look abroad for growth.  Bank of America’s recent acquisition of ABN Amro North America and LaSalle for $21Bn was just completed in October so the results of this acquisition cannot be judged yet.  This acquisition pushed Bank of America to $1.7 trillion in assets.

The acquisition of Countrywide was a longtime coming.  In August Bank of America announced a $2 billion dollar repurchase agreement with CFC.  The purchase of preferred stock was arranged to provide a return of 7.25% per annum and provides the option to purchase common stock at a price of $18 per share.  Last week Bank of America announced it would buy Countrywide Financial for $4 billion. This acquisition will give the bank a substantial market share of the mortgage business, and access to Countrywide’s expertise, technology, and employees for servicing mortgages.  The Prince contends that the servicing operation and the market share of Countrywide are worth far more than $4bn.  When you consider that Countrywide provides mortgage servicing for nine million mortgages valued at $1.4 trillion as of December 31, 2007 it is hard to imagine that this source of steady income doesn’t have a discounted value higher than $4bn.  Bank of America will shop around the parts of Countrywide’s mortgage portfolio they don’t want to hold and get rid of it.  They will be left with a firm that is poised to regain market share once the mortgage market turns around and do a substantial business in refinancings as rates continue to drop through The Feds actions.

The Prince shorted CFC and IMB (then NDE) back in the spring and closed his position this summer, so why would he suggest that BofA is making a great investment?  BofA getting the right of first refusal as a stipulation to its initial convertible preferred investment definitively was a strong signal that Countrywide was in-play.  Countrywide has great assets and amazing reach. They technology and infrastructure for originating mortgages is second to none.  Selling a mortgage to someone will also allow BofA to create sticky relationships with that customer which will lead to cross-selling.  The possibility for market share gains is enormous for Countrywide.  Most of the specialist and smaller mortgages originators have left the market or went out of business.  Countrywide is going to capture that share and be in a better position in the future.  This deal brings Bank of America close to a dominant position in the mortgage market.  The mortgage market is cyclical and it will recover.  At that point Bank of America will look prescient.

Now there are some downside risks for BofA.   The deal increases BofA’s dependence on a slowing U.S. market.  It is buying a mortgage book that continues to deteriorate.  Countrywide also faces a slew of lawsuits over its marketing of subprime loans.  Regardless of these risks the price is alluring when we consider that it is 1/8th CFC’s market value a few months ago.  Countrywide originally got into this mess by an over-reliance on short-term wholesale funding and fast-rising delinquencies subprime, Alt-A, and prime mortgages.   It was under suspicion of becoming insolvent.  This business is about confidence, and Wall Street did not believe CFC’s claims to have excess liquidity.  Everyone was worried that Countrywide would default on a ton of derivatives contracts it had struck with them. This would of triggered a huge problem for all of Countrywide’s counterparties to derivative contracts.  Bank of America bailed everyone out but in the end BofA will profit from getting Countrywide for cheap.  Ken Lewis pretty much summed it up when he said, "Where there are challenges there are also opportunities,” after he announced the deal.

Make no mistake, BofA will take some short term pain for a long-term gain that The Prince believes will be much larger.  According to the WSJ out of nearly $80 billion in loans held for investment by CFC, 75 percent are second-lien HELs and option ARMs.  Both of these types of loans are getting killed and will continue to get worse.  Calculated Risk did a nice job covering the pain BofA would experience and suggested portfolio losses could approach $10 billion.  Some like Robert Shiller, in an interview with Bloomberg, claims that BofA is making a terrible mistake buying CFC.  He said that, "We are in the aftermath of the biggest housing boom in US history, in world history.  As prices fall and more mortgages are underwater, even prime borrowers will have incentive to default.  People who lose their job in a recession, even if they want to keep paying their mortgage, won’t."  The Prince agrees that more housing/mortgage pain is to come but for a strategic buyer like Bank of America the long-term gains will dwarf what they paid Countrywide.

This deal also helps BofA gain favor with regulators.  BofA will see advantages beyond a potential lift to its mortgage business.  The lets it go over the 10% deposit ceiling because a bank can do so if it is through a takeover of another bank with a thrift charter (CFC has this).  And the takeover will make it look good with regulators and politicians who want to see the markets calm.  Many commentators have been calling Bank of America’s investment a gamble that Countrywide is getting out of the woods.  When The Prince weighs the positives and the downsides this investment acquisition seems like a winner with small appropriate risks to BofA.  Countrywide has the best distribution system for originations in the industry and that is worth way more than $4bn.

Disclosure: The Prince does not own BAC or CFC.  The Prince does own SKF.