“In the world of securitization, there are mortgage brokers, there are mortgage originators, there are packagers — perhaps multiple levels of packagers — there are rating agencies, and then eventually there are investors. As a result, there is a set of agent-principal problems that do not exist in the traditional banking model of lender and borrower. In the securitization model, each level or levels in the chain must to some extent trust that the previous level has done its job. Clearly in the past few years, there was too much short-run focus, too much “take the money and run” behavior. This was partly driven by the belief that housing prices will always go up and partly by the belief that if a problem with a loan occurs, it will be somebody else’s problem. What is galling in all of this is that the guys at the major commercial and investment banks kept telling us, “We understand risk and we can manage risk and get higher returns;” but it turns out that most of them did not understand anything about risk. There are stories coming out now about the few risk officers who did try to dig in their heels at major firms, but they were over-ridden — or ridden over — in an environment where there was no risk management, there was no risk control. Everybody thought “Hey, I’m getting better returns because I’m smarter,” and not realizing that mostly they were fortunate enough to land temporarily in the right hand tail of a distribution that would eventually bite them.”
Lawrence J. White Professor of Economics NYU Stern School of Business May 2, 2008
We received so many comments and questions on our previous missive regarding the pending acquisition of Countrywide Financial (NYSE:CFC) by Bank of America (NYSE:BAC) that we are going to feature reader comments and our responses in this issue of The IRA.
A couple of readers rightly asked whether Chapter 13 is the correct section of the US bankruptcy laws to cite.
Richard in Chicago writes: “Corporations can be brought into bankruptcy court under chapter 7 or 11. chapter 13 is reserved for individuals only, I believe. Great coverage for us, by the way, as we are sitting on a pile of CFC bonds at this moment. We still believe BAC will reduce its equity offer, and use the difference to call CFC bonds at a price lower than par. Of course, we were wrong on Refco, so it is a bit of white-knuckle time for us.”
We were mistaken. An involuntary filing by a creditor would usually be made under either chapter 7 (liquidation) or chapter 11 (reorganization). A chapter 13 bankruptcy enables individuals with regular income to develop a plan to repay all or part of their debts. Our previous copy and post on www.SeekingAlpha.com have been changed to reflect this correction.
From David is South Africa: “I was wondering whether BAC not guaranteeing CFC debt or CFC seeking a bankruptcy on said debt could cause any fallout in the credit default swap or “CDS” market?
The IRA: Answer is definitely, yes. While spreads on CFC were converging on BAC spreads – call it market risk entropy — the renewed awareness of the risk remaining caused by BAC’s disclosure to investors caused these same spreads to widen. Should BAC walk away from the transaction, we expect CDS spreads on CFC debt to blow out and a bankruptcy filing to follow shortly thereafter. Remember, the Countrywide Bank FSB unit of CFC is at the limit of FHLB advances, so a widening of spreads means CFC’s days are numbered without an immediate acquisition by BAC or another suitor.
Ralph in New York comments: “Several of the larger bondholders I have spoken with recently would contend that, contrary to what seems to be implied by you last article the BAD ASSETS are almost all in the Bank itself, while the parent actually owns the servicing and many of the other interesting pieces that BAC is really interested in. That would mean that a break-up of CFC in the new Red Oak sub is unlikely. Assets in the bank ‘available to repay parent liabilities’ are in fact beside the point. The problem is the assets in the bank in the first place.”
The IRA: First, remember that we are talking about an issuer that owns an FDIC insured bank. That makes treating CFC as a going concern a fragile assumption. The assets at the parent level are certainly a mixed bag. We are not sure that these assets, assuming a zero value to the CFC investment in the bank sub, will cover the extant liabilities at par. But for the sake of argument, let’s suppose that the ex-bank assets will make all CFC claimants whole. When you factor in the litigation and the prospect of a serious loss on the bank sub’s resolution, then the picture for CFC’s liability holders seems to darken.
Indeed, if you are correct about the bank being the source of the problems at CFC, were the FDIC to take a loss on the resolution of the bank, then CFC (and its officers, directors, auditors, lawyers, etc) might be facing a claim in an enforcement action by the FDIC acting as receiver. That’s why an acquisition is a much better alternative to a regulatory intervention.
Of interest, the default experience of Countrywide Bank FSB is not that high, just 46bp vs 32bp for peers in 2007. A number of the performance and risk metrics are clearly showing red flags, to us anyway, but the bank is far from evidencing distress – at least based upon regulatory filings we use in The IRA Bank Monitor. Perhaps most ominous is the drop in core deposits. But, of note, it looks like some generous soul parked a big chunk of money at Countrywide Bank FSB in the form of non-interest bearing deposits, some 6% of total at year-end. Maybe this is some of Uncle Sam’s TT&L cash?
Ralph again: “It seems to me what BAC is really looking for a way to do here is not to JUST re-negotiate the price of the transaction (or bondholder participation in absorbing future losses), either of which would still likely result in BAC capital write-downs; but instead to arrange for some kind of a taxpayer backstop along the lines of the Bear Stearns deal (which changed EVERYONE’S understanding of what the FED and the regulators are now willing to do to get the toothpaste back in the proverbial tube). Using the threat of a partial or no guarantee of the CFC debt — everything BUT the CDs and maybe not the Jumbos – compromises the sub-debt capital channel for ALL future bank transactions. The FED clearly wants to keep the sub debt alternative available as new capital of all kinds must be raised in the banking system… The logic here becomes even more evident if the whole deal (post the preferred investment that is) was the FED’s idea in the first place, as many have suggested. In a nutshell, maybe BAC is playing a much bigger game of chicken –with much stronger cards in the hole (to mix my metaphors), than the market is suggesting at this point.”
The IRA: We agree completely on the negative effect a CFC default will have on the market for bank debt. It may be that BAC thinks it is playing chicken with the Fed et al regarding a CFC default, but we don’t see the threat of such an event as a big bargaining chip. The best thing that could happen to the US market and Fed Chairman Ben Bernanke, in our view, would be to have a clean, privately managed default process for CFC that allows the bank to be sold or unwound, and the non-bank liabilities settled in an orderly process. In our view, you cannot buy CFC until you quantify the legal claims and other contingencies, such as a possible claim by the FDIC or even the Department of Justice. To us, the only place to manage such a process is bankruptcy. Once the bank is out of the picture, managing the liquidation of CFC is pro forma. Bernanke et al at the Fed should watch the process and monitor – but no more.
David in Dallas writes in like manner: “But I wonder, maybe Mr. Lewis is playing hardball with the Fed. Maybe he realizes that CFC is really a turkey, so he’s telling the Fed, ‘If you want this deal to go through, I want the same level of support you gave to JPMorgan (NYSE:JPM) when they took Bear, Stearns (NYSE:BSC).'”
The IRA: Support is one thing that CFC will receive when Countrywide Bank FSB is either sold or taken over by the FDIC. But the non-bank assets of CFC are not special or unique and can be easily dealt with in bankruptcy. Hundreds of non-bank loan origination and servicing businesses have failed over the past 18 months. Once CFC is “ex-bank,” the remaining rump is no different than say New Century Financial, CIT or any other non-bank financial firm. The “systemic” argument for bailing out CFC disappears once the federally insured bank and $60 plus billion in deposits is gone.
Jonathan writes: “Assuming I were holding CFC bonds (thank goodness I have nothing to do with them) just how could a bondholder pull the trigger? I assume CFC is current on its bond principal and interest payments. Has CFC been found in violation of a covenant? Are CFC bond covenants drawn tightly enough to be enforceable or are they covenant-lite? I agree with the general thrust of the post, though. I couldn’t for the life of me figure out why BAC was in such a hurry to buy CFC in the first place, given that CFC’s desirable assets will almost certainly be on the block before too long. Thanks much for the post.”
The IRA: The basic process is fairly straight forward. A creditor must file a complaint with the bankruptcy court asserting that the debtor, in this case CFC, is at or near insolvency and that a bankruptcy court filing is in the best interest of all creditors. The debtor obviously has an opportunity to object and thus begins a litigation before the bankruptcy court. Because the filing is a default, however, all of the issuer’s creditors are thereby put on notice of the debtor’s position and all current and potential creditors have an opportunity to be heard. Moreover, the primary regulator would immediately appoint the FDIC as receiver of the subsidiary bank, starting the wind-down process in earnest. This fact is one reason why filing an involuntary petition against a corporation that owns an FDIC insured bank is different from other involuntary filings. We can’t remember the last time, or whether ever at all, an involuntary petition was filed against the parent of a federally insured bank.
And our friend Bob Feinberg writes: “Please put me down for the RGE event on May 20, 2008 at the NYAC. It looks manageable, and I haven’t seen Martin Mayer for years. The quote from False Security: The Betrayal of the American Investor is great, but recall if you can that a couple of years ago you wrote that abuse and crime aren’t rampant on Wall Street, and I said they were.”
The IRA: Yes Bob, you were correct. Forgive us for believing that Wall Street was ever not a criminal enterprise. Our old friend Mark Melcher at PruSec used to say the same things. Come to think of it, we’ll have to interview Melcher soon.
Feinberg continues: “In talking to Ed Kane after the Shadow FOMC press conference, he said the TBTF banks are governed by gypsy ethics, that bad is good. I’ve always thought that, but the gypsy analogy may be useful, although it might be a little unfair to gypsies. In a similar vein, Bob Eisenbeis at Cumberland Advisors said the banks are borrowing short and lending long, where short is overnight and long is two weeks.”
The IRA: Kane’s monograph in the Journal of Financial Services Research , “Basel II: A Contracting Perspective,” is wonderful. One of the funniest – and saddest – things we’ve read in some time. Says Kane: “An agent builds trust by making itself accountable for results.” There is no accountability for the banks or the regulators, even our friends at the FDIC.
Feinberg: I’m not as sanguine as you that the FDIC will follow any rules. I think Sheila Bair is full of herself right now and would like to show that she can come up with a creative solution that will save collateral damage and provide a rationale for bailing out unsecured creditors, or at least secured creditors. As I think of what such a rationale might be, I would at least consider the FHLBs. I know they’re supposed to have good collateral, but it’s part of the risk landscape. I wouldn’t be surprised if the deal were noncompetitive, because there wouldn’t be time to do “due diligence” or whatever. Think gypsies.
The IRA: Indeed, Bob. If there is a loss to the bank insurance fund resulting from a resolution of Countrywide Bank FSB, maybe the FHLB won’t be paid at par on advances after all.
Originally published at The Institutional Risk Analyst and reproduced here with the author’s permission.