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Will Countrywide Sink Bank of America?


Did Bank of America get the deal of the century or the biggest headache in recent financial history?

Did Bank of America (BAC) get the deal of the century or the biggest headache in recent financial history?

This weekend's WSJ shed some light into the particulars of the deal, but ultimately the question becomes whether the long term value of Countrywide's (CFC) mortgage franchise will outweigh the near term difficulties B of A just bought on the 'cheap.'

Hoofy and Boo both have compelling arguments in this case, so it is no wonder views on The Street and in the 'Ville are wide ranging as to the wisdom and motivations of the takeover/bailout/forced sale.

Many view the move as opportunistic and contrarian. Evidence a savvy Ken Lewis making a bold call that the mortgage market is approaching a bottom and mortgage-related assets already offer attractive values. Others, however, question whether B of A may have been forced to bail out its troubled partner amid mounting writedowns and pending litigation and is now faced with the daunting task of cleaning up the golden child's mess.

Despite the immediate troubles Countrywide (and now BofA) faces, Hoofy's camp has firepower in its corner. Countrywide is the biggest independent mortgage lender in the country and its vast network of mortgage and banking services will increase the scope of Bank of America's product offerings and national presence.

A successful merging of Countrywide's industry-leading mortgage platform will make B of A the largest mortgage lender in the country. If B of A is able to stabilize the situation, its low cost of funds will help increase the profitability of Countrywide's once-venerable mortgage business.

Many analysts point to Countrywide's servicing platform as a source of revenue and loan-term value. At the time of origination, a value is placed on the rights to collect payments over the life of the loan. As each payment is made, a servicer takes a fee for its efforts, while the owner of the loan keeps the principal and interest. The longer the loan survives, the more a servicer makes for that small initial investment for the rights to collect payments. Since the harder it is for a borrower to refinance the longer the loan lives, a tight mortgage market makes the servicing business more profitable.

But despite these positives, Boo will give his bovine brother a run for his money by the time this one is fully hashed out.

In the understatement of the year, Bank of America inherits a giant mess.

The Journal's weekend piece states that of Countrywide's nearly $80 billion loan portfolio held for investment, three-quarters is either second lien home equity or Pay-Option ARM paper. Second liens are second in line to grab quickly evaporating equity, and although Option ARMs stand in the first lien position, the vast majority of borrowers are making only the minimum payments and watching their loan-to-value ratios rise with a painful combination of negative amortization (see #5) and falling home prices. Many believe Option ARMs are the next subprime and with a sizeable percentage of the loans backed by homes in California's foreclosure-ridden Central Valley, it's a hard viewpoint to argue.

On top of this, Countrywide is currently battling of deluge of lawsuits and although B of A may be able to expedite the cleansing of the bad apples and pacifying regulators, there will be irreparable harm done to the value of the Countrywide brand.

Countrywide faces significant liquidity challenges, and while Bank of America should be able to step in with its sheer size, B of A may have a harder time fixing the machinery of the giant loan machine Mozilo built during a time of unprecedented profitability in the mortgage business.

Mortgage origination is the ultimate scale business, with increasing returns to each mortgage written as the fixed costs required to process the paperwork are spread out over an ever-larger world of loans.

Countrywide used superior technology and enormity to drive down costs and simply out-price the competition. It is unclear how the impending regulatory crackdown on mortgage brokers coupled with Countrywide's diminished size will effect its ability to set the bar on loan pricing and remain competitive.

Finally, Boo could argue the fundamental assumption that servicing is more valuable during tough times may be proven false. Booming home values and good economic times make loan servicing an easy business. But servicers are some of the most poorly run companies in the country with archaic and inefficient processes, atrocious employee retention and incentives which are not always aligned with their clients or borrowers.

With proposed loan modifications rules under The New Hope Alliance, servicers will be forced to increase staffing and change procedures, making an already messy business more expensive and harder to keep in the green. Industry specialists often cite one of the top three reasons for delinquency as "incorrect borrower phone number." That the government is relying on this group to bail out the industry and right the economic ship is somewhat troublesome.

Ultimately, time may be the true arbiter of the success or failure of Bank of America's bet. Troubles ahead may soon become troubles behind and Lewis may be proven a crafty bottom-fisher, but if the real estate and mortgage markets continue their slide and begin to drag prime borrowers into the subprime slime, Bank of America may find out just how dangerous averaging into a weak stock can be.
No positions in stocks mentioned.

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