The New York Times reports that Bank of America (NYSE: BAC) will buy Countrywide Financial (NYSE: CFC) for $4 billion in stock -- or $7.16 a share -- $500 million below CFC's current market value of $7.75 a share, or $4.5 billion. Although this outcome is better than a bankruptcy filing or a government bailout, Bank of America may be letting its ego get in the way of sound business strategy.
Yesterday I told TheStreet.com that I thought Bank of America -- which in August bought 16% of Countrywide by buying $2 billion in preferred shares yielding 7.25% with an option to buy 111 million shares of its stock at $18 -- was doubling down on a bad bet. Since then, Countrywide's stock has fallen 63% from $21 to $7.75 -- wiping out $1.3 billion worth of that 16% stake's value. To me this proves that Countrywide's CEO Angelo Mozillo was wrong when he said last March that the subprime mess would be "great for Countrywide because at the end of the day, all of the irrational competitors will be gone."
While this deal will end Countrywide's irrational existence, Bank of America is likely to survive. For Bank of America shareholders, the question is whether the value of Countrywide's assets -- a $1.4 trillion loan servicing portfolio, a bank, an insurance company, a subsidiary that provides borrowers with loan closing services like appraisals and flood certifications; and a broker-dealer that trades securities -- exceed the cost of its liabilities.
These include bad loans which will need to be written off and big legal liabilities. For instance, 7.2% of the loans in Countrywide's servicing portfolio were delinquent last month, up from 4.6% in December 2006. Foreclosures also more than doubled last month, to 1.44% of unpaid principal balances versus 0.70% in December 2006.
And Countrywide is in the middle of some significant lawsuits. The Wall Street Journal reports that Countrywide is facing borrower suits and investigations by federal and state agencies for alleged lending and loan-servicing abuses, as well as shareholder suits stemming from its financial decline. I have no estimate of how much it will cost to settle these suits.
I don't know how this will play out. The answer depends on how big the write-downs will be for Bank of America, how much it has to pay to settle lawsuits, and how long it takes for the housing and mortgage markets to recover. I think that Bank of America is betting that the eventual recovery of that mortgage industry will leave it in a dominant position whose economic value will more than offset its $6 billion+ bet on Countrywide.
In pre-market, Countrywide investors are heavily disappointed with the deal -- valuing it at $6.72, 13.3% below yesterday's close and 6% below the deal value. Bank of America shares are down 25 cents in pre-market.
Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in the securities mentioned.
