Will BofA Bail on Countrywide?

Bank of America says the merger is still on, but its difficulty in picking up all of the mortgage giant's debt has many wondering

Could Bank of America (BAC) act like a troubled homeowner and hand the keys to Countrywide Financial (CFC) back to the lender? That's the speculation on Wall Street as Countrywide shares fell 10.4%, to 5.36, on May 5. That's well below the $7-a-share price indicated when Bank of America agreed in January to buy the nation's largest mortgage company for $4.1 billion.

Things in mortgage land have gotten much worse in just the past five months. On Apr. 29, Countrywide reported an $893 million loss for this year's first quarter, reflecting $3 billion in credit-related charges. The company wrote off $1.5 billion in losses on its residential loan portfolio, for example. That was 10 times the amount written off in the same quarter last year. Other charges were related to ongoing liabilities in mortgage securities the company has sold.

Two days later, the companies revealed in a Securities & Exchange Commission filing that Bank of America might not assume all of Countrywide's debt. The filing said Countrywide has $97 billion in total debt. Some $11 billion is expected to be paid at the merger's closing and $47 billion in borrowings from the Federal Home Loan Bank would also be repaid by Countrywide's ongoing banking business. For the remaining $39 billion, however, the filing said Bank of America was still evaluating alternatives and it could make "no assurance that any of such debt would be redeemed, assumed, or guaranteed."

Downgrades and Option ARMs

The news prompted debt-ratings agency Standard & Poor's, which like BusinessWeek is a division of The McGraw-Hill Companies (MHP), to downgrade Countrywide debt to junk-bond status. Rival Fitch Ratings put the company's debt on watch for a possible downgrade. The news has led to speculation that Bank of America may renegotiate the Countrywide purchase or simply walk away from the deal.

In a May 5 note to clients, Paul Miller, banking analyst for Friedman, Billings, Ramsey Group (FBR), said Bank of America faces $20 billion to $30 billion in additional loan losses in connection with the acquisition. He said there is an increased likelihood the bank renegotiates the acquisition price down to zero or gives up. His present price target for Countrywide shares is $2. According to the merger documents, Countrywide may owe Bank of America a $160 million termination fee if the deal falls apart. But that's only if Countrywide's shareholders fail to approve the deal or if Countrywide went out and sought other offers.

Stuart Plesser, the S&P analyst who follows Bank of America, says the biggest concern is potential losses in Countrywide's portfolio of adjustable-rate loans. Countrywide's overall delinquencies jumped to 4.6% of all loans in this year's first quarter, up from 3% in the fourth. But delinquencies of option ARMs, which give borrowers the option of not making an interest payment, jumped to 9.4% from 5.7%. "There's a lot of downside and it's unquantifiable," Plesser says. "The trends in the more standardized loans, you can see where they are going. With option ARMs, it's just an untested area. I don't know if anyone knows."

"Pity" Bank of America?

Countrywide did not return calls seeking comment on May 5. A spokesman for Bank of America says the merger deal is still on, and declined to discuss the analyst's report. The giant bank, however, is distancing itself from the Countrywide name. At its annual meeting Apr. 22, Bank of America Chief Kenneth Lewis said the Countrywide brand would disappear after the acquisition, which is still scheduled for midsummer. At the meeting, Lewis had to listen to a string of comments from shareholders unhappy about the merger.

Kathleen Shanley, an analyst for the research firm Gimme Credit, wrote in a note to investors last week that it's not unusual for financial firms to make acquisitions and not guarantee the debt of subsidiary companies. HSBC (HBC) did so when it acquired Household Finance, and American International Group (AIG) did so with American General, Shanley said. In those cases, subsidiaries exist as separate legal entities and continue to make payments on their debts.

Still, Shanley said Bank of America executives must be having second thoughts on the Countrywide acquisition given the government-backed financing that rival JPMorgan Chase (JPM) was able to negotiate for its acquisition of Bear Stearns (BSC). "Pity Bank of America," she wrote. "We can only imagine how the bank's senior executives are gnashing their teeth."

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