January 23 2008: 4:11 PM EST
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Betting against the BoA - Countrywide deal

With no obvious barriers to the merger, why is there such a spread between Countrywide's stock price and the value the deal puts on it?

By Roddy Boyd, writer


NEW YORK (Fortune) -- At first glance, the consummation of the merger between Countrywide Financial Corp. and its savior, Bank of America, looks like a no-brainer.

There is no conceivable reason that Countrywide's board or shareholders would get in the way of the deal, given that bankruptcy was its only other likely option to maintain viability. Bank of America, for its part, has made clear that despite the omnipresent risks from Countrywide's deteriorating home-equity and sub-prime loan portfolio, the deal has a chance to offer strong returns once the mortgage collapse runs its course.

So why have many risk arbitrageurs, who are paid handsomely to speculate on the likelihood of mergers and takeovers, apparently doubting that the deal as it stands will come to fruition?

Here's the deal's math. Countrywide's bruised shareholders get the right to exchange their stock for .1822 shares of Bank of America stock. In midday trading, with BoA stock at $39, the deal's terms value their new stock holding at $7.1058 per share. If the world's investors had complete certainty in this deal, then theoretically that would be the current Countrywide stock price.

Yet Countrywide's (CFC, Fortune 500) stock is in fact trading at $5.54 a share, meaning that there is roughly a 77.9 percent consensus among Wall Street's risk arb desks and their hedge fund brethren that the deal goes through at the agreed upon terms. That also means that more than 22 percent of risk arbitrageurs don't think the deal will go through. (Bank of America (BAC, Fortune 500) declined to comment for this article.)

The spread between the two numbers represents a prism into Wall Street's view of the world. Looked at one way, with funding costs for BoA dropping - with 30-year fixed mortgage rates now at 5.25 percent, highly profitable residential mortgage refinance becomes viable - BoA is likely to get an almost immediate and much-needed boost to its income statement. As such, it can more readily afford to absorb Countrywide's legal and portfolio problems in the hopes of acquiring Countrywide's massive franchise and dominating U.S. real estate finance.

Put another way however, the deal's spread shows another, less flattering view. That is: as risk arb analysts pore over Countrywide and its portfolio, and as the financial sector reports continuing hits to balance sheets and income statements, there is a concern that Bank of America might seek at least a modification to the deal's terms. After all, when the Countrywide-Bank of America merger was announced two weeks ago, the spread was just under eight percent. It widened out to 25 percent prior to Tuesday's rate cut. Given the lack of apparent barriers to the deal's completion, the persistence of the spread is baffling.

One likely culprit: Not many risk arbs are betting on the deal (thus narrowing the spread), because they've been spooked by the collapse of several high-profile leveraged buy-out deals. Indeed, investors have begun pulling capital from hedge funds and many brokers like Citigroup and Merrill Lynch have sustained huge hits to their equity capital bases.

To George Yared, the chief investment officer of independent research shop Yared Investment Research, skepticism over the deal is pretty natural. "When the announcement was made, there was no discussion of numbers, no visibility. [Bank of America] actually doesn't have their arms around the real value or risk of Countrywide, even though they've been under the kimono since July," said Yared. He emphasized, however, that he felt the deal would ultimately be done.

A hedge fund credit default swap trader who has a long standing - and remarkably profitable - short position in Countrywide's swaps took the bearish tack. He told Fortune: "Anyone who does fundamental research into the credit performance of that $70 billion [home equity loan] portfolio simply cannot get comfortable, period."

So will the deal go through as planned this summer? Keep your eye on that spread.  To top of page

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