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BAC and CFC Drama Continues

On its face, this deal seems like a merger arbitrageur's dream. The deal has tacit/implicit government support, the two companies stand to gain in both the short and long term, there hasn't been any negative news from the top counterparties regarding the deal, another suitor for CFC hasn't materialized. However, opposition to Bank of America’s proposed acquisition of CFC is continuing to grow. Now some may dismiss the actions of large shareholders as just posturing for a better price. Some may even say that we should interpret their actions as not expressing opposition to the deal being consummated but to the price at which the deal will be struck. Many of my readers have been emailing me asking if I still think BAC is getting a good deal on CFC as the mortgage crisis continues to worsen.

In case you haven't been following the BAC-CFC deal closely, here is a summary of the shareholder actions that have transpired since the deal was announced. First, there was SRM Global Fund with a 5% stake in Countrywide opposing the BAC deal . This wasn't big news because all the aforementioned reasons for deal to go through still held and it was accepted that SRM did not have enough allies to make its wishes come to fruition. Then Legg Mason told us last week that they received approval to raise their stake in Countrywide to 25%, and their stake has already been increased up to 15% of the company. Also, Capital World bought a 6.1% stake in Countrywide recently. Capital World hasn't specified whether they will take an activist role in trying to stall the deal but taking a stake that large must mean that they believe that the spread of the current price to the offer price (or the higher offer price if it is revised upwards) is attractive.

Additionally, Bill Miller of Legg Mason in a note to investors indicates that he is not in favor of Countrywide sale at the current prices believing that Countrywide's infrastructure/market position/market share are worth more than what BAC is offering. The Prince has said that the deal consummated at such a low price will be long-term accretive to BAC. So he can see Miller's argument that BAC is getting CFC too cheaply but the strongest argument that Countrywide is being sold too cheaply is the absence of any other bidders. Miller, whose Legg Mason Value Trust fund is already the single biggest investor in Countrywide, said the Office of Thrift Supervision gave him the right to raise the fund's stake on January 18. Oddly enough, CFC has put a so-called poison pill in place that makes it potentially prohibitive for Miller to raise his stake above 15 percent, he said in a letter released on Tuesday. If CFC wants to discourage activist investors or new bidders then putting a poison pill defense in would make sense for CFC management but not for CFC shareholders (The Prince doesn't find this surprising since CFC has regularly done right by management at the expense of shareholders, witness the share sales that are now be investigated by the SEC). What does trouble me about Miller's logic and my own is that if CFC was such a great turnaround candidate why wouldn't be see the PE shops (even absent financing), other banks, other mortgage originators, and even foreign investors making higher bids for Countrywide. The lack of competing higher bids does suggest that Countrywide may actually be valued properly by Bank of America's offer price.

Obviously given the fact that CFC's powerful institutional shareholders are willing to go activist on the deal there is room for investors to buy CFC and short BAC in hopes that a new higher bid will emerge or BAC will be forced to raise its bid. Even if a higher offer isn't made an investor could still benefit from appreciation in CFC as other investors interpret the actions of the large activist investors or if the deal closes at the offer price. Arohan points out that he see the most likely result is that BAC sweetens it offer by offering more BAC shares per share of CFC. He also reminds us that the possibility for CFC to declare bankruptcy is still looming out there. The Prince tends to disagree with this argument. CFC wouldn't go bankrupt with an offer from BAC on the table. CFC might become insolvent if it losses its ability to obtain short term credit especially if the FHLB cuts it off. The Prince doesn't see the FHLB cutting CFC off. Also, for other debt holders in CFC forcing CFC into bankruptcy if it became insolvent would not serve their interests, since they would recover less on their bonds if bankruptcy is forced than if the left the company alone to be subsumed by BAC. Some of CFC's corporate debt may actually be paid off at higher par values than it is currently trading in the secondary market by BAC as part of the merger.

If you interpret the developments on the ground the same way The Prince does and you have a high tolerance for risk then you should short BAC and buy CFC. If you want an alternative strategy for playing this strategy check out this post by Arohan.

Some relevant quotes from Bill Miller:

"What makes the decision puzzling is that the company was seeing solid deposit growth, has no apparent capital problems, was not forced by the regulators to seek a merger partner, and is in sufficiently sound condition to have declared its regular quarterly dividend at the end of January," Miller wrote. The portfolio manager said the Federal Reserve cutting interest rates sharply after the deal was announced was "quite beneficial to Countrywide by reducing its costs of deposits, and by setting off a wave of refinancings that should significantly increase its loan production." Miller said Legg Mason Capital Management has increased its holdings to about 86 million shares of Countrywide, or 14.9% of shares outstanding. "We will support the deal if we believe it is in the best interests of shareholders to sell to Bank of America, and we will vote against it if we believe greater value can be achieved by having Countrywide remain independent," he wrote.

An excerpt from a news story by Marketwatch (bold and underline added by The Prince):

Countrywide reported a loss of $422 million for the fourth quarter on Tuesday, a more than twice the consensus view of analysts the previous week. The loss was the first in the company's 25-year history, with overdue loans increasing to 7.2% from 4.6% and more than a third of its subprime loans in active default. That was a marked departure from Mozilo's pledge two months ago that he would return the lender to profitability by the end of the year. But is Countrywide getting out just as conditions for lenders begin to improve? The company has recently seen an uptick in deposits at its savings bank and should reap the rewards of Fannie Mae and Freddie Mac's new ability to purchase jumbo loans. In addition, a spate of new interest rate cuts introduced by the Federal Reserve could make the borrowing environment even more hospitable to strapped lenders. Gordon also points out that the value of Countrywide's existing loan origination and loan servicing platforms alone make it a very valuable asset. "There is a big shortage of loan servicers right now, and at this price, they basically gave it to them for nothing," Gordon said. The infrastructure and existing loan portfolio that Bank of America inherit as part of the deal would make it the nation's largest mortgage lender, a significant leap from the fifth place spot the bank held in 2007. Analysts estimate that if the deal does go through, B. of A. will eventually oversee or originate close 25% of all home mortgages. Close to 90% of the mortgage business is now in the hands of the top 25 lenders, making an acquisition on the scale of Countrywide's unlikely to come along any time soon. Still, there are opportunities for smart bargains. "A lot of the consolidation that happens in '08 will be through bankruptcy," he said. These could provide valuable sales of piecemeal assets, allowing many banks and lenders to snap up essential origination and servicing platforms at bargain basement prices. It may be for this reason precisely that Bank of America is staying firm in its resolve to go through with the deal. CEO Kenneth Lewis told a New York audience that despite the significantly larger losses, the bank will forge ahead with the acquisition, saying that the original deal is still "a go." Lewis's confidence could be rewarded, analysts said, as there are few possible suitors sitting on the sidelines. "I'd be hard pressed to say there's a better buyer out there," Gordon said.


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