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Analysis

The Systemic Effects of Countrywide Going Bust…

By Nouriel Roubini

It looks increasingly likely that the deal of Bank of America (BAC) buying Countrywide (CFC) may collapse: according to many banking experts once BAC does its due diligence on this deal it will become obvious that Countrywide is effectively bankrupt (negative equity) and saddled with a mountain of litigation and potential liabilities whose size are likely to be extremely large and uncertain. The point that is becoming clear is that BAC will be better off paying the modest break-up fee and walk away from a deal that sucks in every dimension. So if CFC goes bankrupt (its bank subsidiary into a FDIC receivership and the holding company into Chapter 7 liquidation) what will be the systemic implication of the biggest banking bust in US history? Remember that CFC originated almost 20% of all mortgages in the US in the last few years. So the collapse of the biggest mortgage lender will have massive and systemic ripple effects in financial markets.

Let us consider in more detail why Countrywide will go bust and what will be the systemic consequences of such massive bankruptcy…

Chris Whalen of Institutional Risk Analyst analyzed in a recent writing why CFC is effectively bankrupt and why the BAC deal will not go through:

Now we look at the other prospect - namely a busted deal, a regulatory intervention and the sale of the bank sub by the FDIC as or after CFC enters bankruptcy…

Could it be that the torpor affecting some analysts, inertia which allowed them to believe that ratings for CFC actually would converge with those of BAC, has now ended? Did S&P and the rest of the ratings herd really believe a company facing hundreds of federal fraud, racketeering, truth-in-lending and other claims could be bought this side of a restructuring?

First, it becomes clear, to us at least, that BAC is unable to close the CFC transaction due to uncertainty regarding the target's liabilities. We know nothing new or specific here, but the delay added to the continuing disclosure to the effect that BAC cannot accept responsibility for the liabilities of CFC adds up to one thing, in our view: BAC (and its lawyers and accountants) is not willing to do a deal that leaves BAC shareholders facing a potentially staggering loss. A future write-down and likely restatement would ensure even more litigation and end the career of CEO Ken Lewis….

For BAC, a risky but better strategy than the course at hand may be to withdraw from the CFC merger, pay the $160 million breakup fee, and allow the entire company to slide into a managed default. As CFC's funding runs away, the OTS will be forced to invoke its statutory authority to appoint the FDIC as receiver of the insured bank subsidiary, thus precipitating a bankruptcy filing by CFC.

In the event, BAC and no doubt a crowd of other suitors will be standing by, waiting to bid for some or all of the bank's assets and liabilities in a competitive regulatory sale…

To that point, while retail depositors of Countrywide Bank FSB have little or no reason to be concerned in such a scenario, the jumbo depositors of CFC above the insured limit- if any remain - should take advice about their options. The jumbo deposit holders may or may not be paid immediately by the FDIC depending on their assessment of the bank's condition at the point of seizure.

Given the outline above, our view is that the equity of CFC is worth $0. This just again illustrates the point that price and value are not the same! The main point of this purely hypothetical discussion, however, is to illustrate the limited rights of shareholders and liability holders of bank holding companies, namely that the bank is subject to conservatorship by federal regulators in order to safeguard depositor funds. Bank depositors and the FDIC insurance fund are the senior creditors of any bank holding company, period. This places the full weight of losses at the parent holding company level on holders of equity and debt securities, in that order….

What are you waiting for?

If the BAC deal is not happening, then the only logical course is to pull the plug on the impossible dream of Ken Lewis, shoot the equity holders and get on with the CFC restructuring…

Just imagine the fun: Fed folks jaw boning, investors yowling, journalists wide eyed. A Chapter 7 against CFC will make for days of great headlines, maybe even congressional hearings and an interview with Maria on CNBC.

And a Chapter 7 filing by a creditor of CFC will prove once and for all that a large bank holding company can go through a market-based resolution without a subsidy from Washington.

The views of Whalen are – based on a survey I made of banking experts – shared by most bank analysts. On May 2nd S&P cut Countrywide's rating to junk; while on May 5th a number of analysts recommended that BAC walk away from this lousy deal. BAC is already sitting on a potential loss of about $1.3bn from its initial $2bn stake in CFC but as one analyst put it: "I hope Bank of America isn't throwing good money after bad".

Indeed foreclosures at CFC doubled to 1.44% of unpaid principal from last year; late payments advanced to 7.2% of unpaid balances from 4.6%; Countrywide's bank holds $61bn in deposits by end 2007, has already borrowed more than $51 billion from the Federal Home Loan Bank system and is now maxed out in its ability to borrow further. Moreover, about 75% of the $79.5 billion of loans held as long-term investments by Countrywide Bank are either option ARMs or home-equity loans.

Add to this the “hundreds of federal fraud, racketeering, truth-in-lending and other claims” that are in the pipeline and the billions and billions of implicit liabilities deriving from such tsunami of litigation.

So, unless a miracle occurs the BAC-CFC deal is now dead on arrival and CFC will end up bankrupt (the bank subsidiary into a FDIC receivership and the holding company into Chapter 7 liquidation).

Of course the bust of CFC is only a symptom of a much bigger systemic banking problem in the US: with 47% of the assets of all large US banks being related to real estate (residential, commercial, etc.) and with 67% of assets of smaller banks being related to real estate hundreds of smaller community banks and dozens of regional banks and a few national banks will be bankrupt in the likely scenario that home prices fall at least 20% (they are already down 14.7% from peak based on the Case and Shiller/S&P Index) and possibly as much as 30% by the time they bottom out in 2009-2010.

Of course hundreds of banks going belly up – this is the prediction of Whalen and most of the independent bank experts I spoke to in recent days – would lead to a systemic banking crisis. But in the short run the collapse of Countrywide alone (by far the biggest US mortgage lender) risks having systemic effects on financial markets, credit markets, credit derivative markets and equity markets.

Think of the morning where the headline goes “Biggest U.S. Mortgage Lender Goes Bust” and of the consequences of it. For the last couple of days equity markets have started to shed their recent complacency that the worst was behind us and that all was clear ahead: bad inflation news; lousy credit outlook for many financial institutions; oil at $130; and an economy contracting at a faster rate have brought a sober reality check to equity markets that had started to turn delusional after the bailout of Bear Stearns creditors. Now markets and investors are realizing that the financial storm is not over; rather we were for a short while in the eye of the storm where all looks calm right before the tempest starts raging again. So the worst is ahead of us – rather than behind us – for the economy and financial markets. And the coming bust of Countrywide will be one of the first signals that this year old financial crisis will get much worse before it gets any better.

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