A Win-Win Deal?

23 Aug

Bank of America (BAC) scored itself a sweet deal, announcing yesterday that they’ve acquired $2 billion worth of 7.25% convertible non-voting preferred securities in Countrywide Financial (CFC). The securities are convertible at $18.00 per share, so they’re already in the money by over $4 per share. Assuming the preferreds trade at a price based only on the underlying common stock, at this point they’re sitting on a capital gain of nearly $500 million. Both sides are touting it as win-win, though it gives some insight into the terms B of A can garner given its reputation and solid finances.

So why did Countrywide accept terms that appear to offer asymmetrical economic benefits? Put simply, the credit market continues to be tight and it’s difficult to discern how widespread or deep the problem could go. Credit was abundant for a long time as risk premiums declined to historic lows. Now, to paraphrase Warren Buffett, the hangover may be proportional to the binge. Countrywide’s primary funding sources, or “oxygen” as CEO Angelo Mozilo calls them, are commercial paper, the repo market, and medium-term notes. The markets for each of these has more or less seized up. The Fed’s discount window is available to them, but only to the Banking division. But the bank doesn’t have sufficient assets to borrow in amounts that will put much of a dent in the needs of the Home Loan division, where most of the assets are held. Over time, as the banking business becomes the primary funding source for home loans, the discount window would be a much more viable source of funds. But it isn’t at this point.

To make a long story short, Countrywide needs capital to continue funding new loans. The transaction gives Countrywide some additional capital along with the implicit backing of deep-pocketed Bank of America. Countrywide has traded some of its economic value (offering a conversion price that is half what the shares are worth) in exchange for a strong endorsement and (at least implied) reliable access to capital.

How does this affect Countrywide value to common shareholders? It dilutes shareholder value, but because it saves them from selling off assets at fire-sale prices to continue to finance operations, it looks to be more wealth preserving than wealth destroying. Start by assuming B of A waits to convert. In this case Countrywide is on the hook for $145 million in preferred dividends, which is around 5% of the company’s 2006 net income. The 7.25% interest rate is reasonable, but does not enjoy the tax break that interest receives (preferred dividends are paid from net income, not pretax income). But the additional expense is not unduly burdensome.

In calculating per-share value, I assume B of A will convert the shares, which adds an additional 111 million shares to Countrywide’s 562 million outstanding. So the share count goes up by nearly 20% and B of A owns 16-17% of the company. Book value (as of June 30th) now is a little over $20 (down from over $24) after considering the dilution. The widespread credit market problems have destroyed some shareholder value here, which is why a margin of safety in initial purchase price is so important. Though this is only a start, Countrywide is now on more solid footing. The media, which has been a part of the problem these past few weeks should now (hopefully) cast the company in a more positive light going forward, which should reinforce confidence in the company by its investors, depositors, and other stakeholders.

Full disclosure: Long CFC and BAC shares.

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