January 11 2008: 4:53 PM EST
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B of A - Countrywide: The skeptics' view

To believe that Bank of America's Countrywide takeover makes sense, you have to accept some very tenuous assumptions, reports Roddy Boyd.

By Roddy Boyd, writer

Even with the Bank of America takoever, Countrywide may never be able to generate the kind of earnings it once did.

NEW YORK (Fortune) -- A home finance colossus is being born as Bank of America has struck an agreement to purchase collapsing lender Countrywide Financial Corp. in a $4 billion stock deal.

The deal gives Countrywide's desperate shareholders the right to exchange their stock for 0.1822 shares of Bank of America stock. Based on Thursday's closing price, that values each share of Countrywide (CFC, Fortune 500) at $7.16 each, a 7.6 percent discount to its $7.75 close.

Countrywide holders are unlikely to blink at the rare discount bid, given the growing consensus among traders and investors that the Calabasas, Ca.-based lender was heading for a massive liquidity crisis over the coming months. While the company has taken the unusual steps of denying it planned to seek protection from creditors under bankruptcy law, the fact that the only institution willing to provide it capital is the Federal Home Loan Bank of Atlanta is less than reassuring.

But even if Countrywide is in desperate straits, is this a sound bailout? Analysts cannot come to a consensus, and the market appears to be giving it a thumbs down. Countrywide stock price, which shot up just under 50 percent on Thursday as the news broke, rather unusually backed down sharply in late-morning trading to $6.44, a drop of nearly 17 percent, suggesting a negative view.

For its part, Bank of America (BAC, Fortune 500) anticipates the merger, which is slated to close in the third quarter, will start realizing savings in 2011, and that $670 million in cost savings can be recognized over two years. In a brief conference call held this morning, B of A chief executive Ken Lewis made the obvious point first: the merged company will utterly dominate the vital U.S. real estate finance sector to an extent never before seen. It will control 25 percent of mortgage originations and 17 percent of the mortgage servicing market.

Tellingly, mere seconds after discussing the bank's pending mortgage dominance, B of A's Lewis revealed what is likely one of the key reasons he rescued the collapsing Countrywide: cross-selling "credit cards and deposits and all the other financial services" the bank offers.

However, buying a loan wholesale giant like Countrywide to get exposure to retail bank customer deposits and credit spending is an untested strategy. Lewis appears to be wagering that the billions of dollars in revenue from credit card fees and interest, retail banking charges and high-margin wealth management offerings mitigates the rapid deterioration of Countrywide's loan and serving portfolios.

Conversations with credit analysts and hedge fund portfolio managers reveal two distinct views of the deal. The first is essentially optimistic, albeit with a longer-than-usual time horizon for American investors. It takes into consideration Countrywide's customer base - it originated one out of every six residential mortgages - and leading-edge technology and assumes that after the crisis has passed, Countrywide is capable of returning at least to earnings at the pre-real-estate-bubble level of $850 million - $1 billion.

Including a few billion dollars worth of restructuring charges, this camp sees a four- or maybe five-year break-even point on the $4 billion deal. (Fortune's Shawn Tully makes a version of this argument.) Put another way, in reference to B of A's $2 billion August investment in Countrywide, independent research shop CreditSights described the merger as a "Rent-to-Own" approach to picking up a franchise with millions of captive consumers.

The second sharply differs with this assessment. The skeptic argument says that Countrywide's rapid growth between 2002 and 2006, when net income more than tripled to over $2.6 billion from $841 million, was completely predicated upon two things that no longer exist: historically low rates and the absence of credit standards. In short, Countrywide, which now says it makes only razor-thin margin loans that conform to Freddie Mac and Fannie Mae standards, is highly unlikely to ever see those levels of profitability again.

Then there is the matter of Countrywide's rapidly deteriorating portfolio of loans and bonds. Last quarter, the lender booked a $2.7 billion loss on credit impairment issues and the fourth quarter is widely assumed to have been worse. CreditSights estimated that on an after-tax basis, the deal cost is likely to spike to the $8 billion-$9 billion range, implying at least another $4 billion in credit write-offs.  To top of page

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