Saturday, January 12, 2008

BofA and Countrywide

by Bill McBride on 1/12/2008 11:32:00 PM

First a couple of excerpts:

From MarketWatch: B. of A. gets a bargain in Countrywide deal

Bank of America is getting Countrywide for less than a third of book value (the mortgage company's assets minus its liabilities) and roughly 2.9 times forecast 2009 earnings, Chief Financial Officer Joe Price said. Lenders typically change hands for at least one times book and seven times estimated future earnings.
...
But the bank has also taken on a huge chunk of new credit risk ... How big a bargain the deal ends up being will depend on how badly Countrywide's mortgage portfolio performs as house prices fall and foreclosures climb.
How big is that credit risk? From the WSJ: Behind Bank of America's Big Gamble
As of Sept. 30, Countrywide's savings bank held about $79.5 billion of loans as investments. Three-quarters of these loans were second-lien home-equity loans ... or option adjustable-rate mortgages...
Just using BofA CFO Joe Price's numbers, if Countrywide didn't have the credit risk, Price suggests a good price would have normally been about one times book value or about $12 billion (the article states that $4 billion is less than one third book value). So basically - in the simplest view - BofA is gambling that the losses on that $80 billion portfolio are $8 billion or less ($12 billion minus the $4 billion BofA is paying).

Even without the actual details of Countrywide's mortgage portfolio, a $8 billion write down might be optimistic. According to another WSJ article:
...Countrywide has $32 billion in second-lien, home-equity loans. Of these, 44% have a loan-to-value ratio over 90%.
This suggests there are about $28 billion in option ARMs in the portfolio. When a house goes into default, the loss on the 2nd lien is frequently 100%. For homes in foreclosure with option ARMs, a 50% loss might be common.

Much depends on how far house prices fall, and how many homeowners with negative equity walk away from their homes. We can be pretty sure that house prices will fall significantly, but no one knows how homeowners will react to owing significantly more than their homes are worth.

Although we don't know all the details, it is possible to imagine scenarios with losses of more than $10 billion on this mortgage portfolio (we really haven't seen the pain from the option ARMs yet, but it is coming).

As an example, if 25% of the second liens go into default, the losses would be $8billion ($32 billion X 0.25 X 100% loss rate). And if 15% of the first lien Option ARMs go into default, add another $2.1 billion in losses ($28 billion X 0.15 X 50% loss rate). These default rates might seem too high right now, but no one is really sure how many homeowners will default when house prices fall 15%, 25% or more over the next few years.

This does look like a good strategic fit for BofA, but I agree with Robert Shiller:
``There's a tendency for people to underappreciate the risk of the housing market,'' Shiller said. ``I might have a lower valuation of Countrywide than Bank of America does.''
...
``Maybe Countrywide and Bank of America are going to have some problems going forward,'' he said. ``When people see that their houses are worth a lot less than their mortgage balance, they have an incentive to default. The troubled mortgages that Countrywide already has will be followed by even more troubled ones.''