Why is Bank of America Buying Countrywide Financial?

There is plenty of room to question the decision by Bank of America, "the US's biggest bank by stock market value," to proceed with an acquisition of troubled mortgage lender Countrywide Finanical, since they took a two billion dollar cash position at a considerably higher price, when the company appeared to be healthier, and are now buying the rest of the company at a cheaper price in an all stock transaction.

Herb Greenberg does his usual excellent job of digging into the deal and providing a reasonable range of speculations as to the motivations: The Real Story on Countrywide Cont'd - Herb Greenberg

To summarize:

1. The Fed brokered or facilitated the deal because Countrywide was on the verge of insolvency which would have had a significantly negative impact on the financial markets, a la LTCM. Bank of America had significant skin in the game already because of their two billion cash already in, AND significant counterparty entanglements that might have jeopardized BAC itself should CFC have failed.

a. Moody's had just downgraded thirty tranches of Countrywide's mortgage debt. Similar downgrades preceded the American Home Mortgage bankruptcy. It was well known that Countrywide was in capital and cash flow difficulties.

b. As counterparties go, they do not get much bigger than Countrywide when it comes to holding US mortgage debt. One can only speculate at this point what sort of entangling obligations CFC had with mortgage reinsurers AND the Credit Default Swaps that may have be put on Countrywide (in huge multiples of their book value).

There is little doubt in our minds that the Fed helped to broker the deal. Unlike Hank, we don't think necessarily that the Fed 'promised' anything as part of the deal, any moreso than they had done with LTCM. But we have an open mind on this topic. The Fed seems to be taking quite a bit of opaque assets on, judging by the recent precipitous drop in their Treasuries holdings in the past few weeks, to be supplanted by "other loans and repos." But this begs the question, Why Bank of America, and why now?

We'd like to add two reasons for this acquisition based on our experience in the M&A business, in our own case as both acquisitor throughout the 90's specializing in valuing high tech startups in Boston and Northern California, and as an acquiree, having sold our own company to a tech behemoth in late 1999.

1. Never, ever, discount the impact of egos and momentum in corporate decision-making, especially in a poorly managed company where personalities and not principles rule the day. We do not know enough about Ken Lewis and BAC to make any judgement here, but we can't rule it out either. They are the right size and structure for it.

Some have suggested that the company did the deal to try and salvage their two billion cash initial investment. If this is true chalk one up for egos and poor management. That initial position was a sunk cost. Period.

2. Is Bank of America paying in what they consider to be an overvalued currency? Their first tranche was cash. But the acquisition itself is for stock, as in their own stock. Let's take a look at a chart of Bank of America:

Compare the chart of Bank of America with that of Countrywide Financial. Perhaps BoA received a much closer and better look at CFC as a big investor, and decided not to acquire some of the key pieces of the operation, and avoid any of the pending litigation for various lending infractions, but decided it was strategic to buy the whole thing (with stock). Plausible? Kind of.

Or is BAC looking at its own balance sheet, its own stock price, and thinking, 'there but for a little time and disclosure goes our own stock price, down to pre-bubble levels. At 7 dollars equivalent CFC might have been 'cheap' at least compared to the 40 it was worth before it imploded. But if BAC's stock follows a similar course, then at 3 dollars equivalent and two billion dollars it looks a whole lot cheaper.

As a veteran CEO once told us, "You may think I'm paying too much for this company, based on your valuation. But in order to say that you'd have to know more about what my own stock is worth than I do, since that's what I'm buying it with." By the end of 2000, we could not help but see his point, and agree.

Yield Curve Inversion Ends, Corporate Welfare Abates

Its official. According to the Fed's economic database maintained by those hard-working folks at the St. Louis Federal Reserve, the yield curve inversion which we have seen since the middle of 2006 has just ended last week. According to the NY Fed:

An article forthcoming in the Federal Reserve Bank of New York’s Economic Policy Review—Signal or Noise? Implications of the Term Premium for Recession Forecasting—sheds new light on the sources of the yield curve’s success in predicting U.S. recessions.

As authors Joshua Rosenberg and Samuel Maurer explain, studies have shown that when the yield curve inverts—that is, when short-term interest rates rise above long-term interest rates—a recession has followed in twelve months. One view holds that the ability of the yield curve’s slope to predict recessions stems from interest rate expectations: the markets anticipate an easing of monetary policy in response to an upcoming deterioration in the economic outlook, and the decline in expected future short-term rates drives down current long-term rates.

So if recessions begin about twelve months after the inversion, it looks to us as though we've been in one since about mid - 2007.


And speaking of reversions to the mean, the spread between Baa corporates and the market yield of the Ten Year Treasury are once gain returning to something a little more 'normal.' We'll let you draw your own conclusion as to why corporate bonds of the more risky nature were so underpriced risk-wise by the markets for so long. Looks like that coincided with the reflation of the stock market bubble, and the growth of the subprime mortgage bubble. But of course, the Fed couldn't see it, didn't do it, weren't there, noway, nohow, my dog ate the risk spread, etc. in this age of innocence by the claim to managerial stupidity, ignorance, and general malfeasance.

As the neo-Keynesian academics, and logical positivists like Chairman Greenspan fundamentally have established, "Moral hazard be damned; the whole of economic law shall be do what thou will.'

Is This the Big One, Elizabeth?

On the television sitcom Sanford and Son protagonist Fred Sanford, played by veteran comedian Redd Foxx, would clutch his chest and say, "This is the big one! You hear that, Elizabeth? I'm coming to join ya, honey!" faking a heart attack in key dramatic moments, often when he was shocked (or cornered in his scheme) by unforeseen events.

With regard to the US equity markets, we're sure that many a punter had that same thought cross their mind when the major indices failed at overhead resistance, fell down to support, and then broke further plunging hard into the close. Is this it? Is this the big one?

The markets took three hard body shots today. First, the pending home sales number came in at a negative 2.6% this morning, on top of some truly gruesome financial results from KBH homes. Secondly, a rumour swept the markets today that Countrywide Financial, prince among subprime mortgage companies, was going to be in bankruptcy because of a capital funding crunch, taking CFC down another chunk in the 80% drop it has seen since its heyday last year. At one time CFC was even one of the primary dealers, those anointed among financial institutions on the best buddy list and elite crew that borrows directly from the New York Federal Reserve. Third, and taking down the markets to the floor, the esteemed CEO of AT&T, Randall Stephenson, told a group of investors that "ever since Q3 ended, the company has seen an up tick in non-paid disconnects in both broadband and traditional access (wireline) subscribers. Mobile is still growing strong—people aren’t canceling their cell phones just yet—but the market is obviously spooked."

Well, anyone who doesn't think the US housing business is in the tank has been on an extended vacation from reality. And although we don't know that CFC will be declaring bankruptcy anytime soon, with an 80% haircut in their stock in less than a year, what does it matter? They are dead men walking.

The AT&T news was a bit much, not so to hear that AT&T is struggling with their consumer business, but rather that consumers are hitting the wall with basic phone services, although we suppose a phone isn't viewed as the necessity it used to be. If it had been their mobile business that was tanking, then by God we might have seen the Crash of 2008 today, since all those texting youngsters would have undoubtedly been responsible for bankupting their poor parents.

We don't know if this is the big one or not. But as usual, we think we know what to look for, and have a couple charts to illustrate our signposts. The first chart is the long term weekly chart of the SP 500. Since this reflationary reinflating of the stock indices began in 2003, the SP 500 has not broken the 100 week moving average on a weekly close. Not one time. Ok, interesting, but not decisive.

We also like to watch the cumulative measure of NYSE Highs and Lows, as illustrated in this next chart. As one can see, the 360 day moving average has proven to be a reliable indicator of trend changes in the SP 500. Again, there is nothing written in stone, but if we get a confirming break of the moving average by the highs and lows, together with the break of the long term moving average by the SP500, then the probability becomes very high that the market is at a key turning point, and a new bear market has come back to town.

One of THE most reliable indicators of recession, hardly ever without fail, is that shortly before a recession formally commences, the stock market will have a 10+% correction. Further, the stock market will reach a clear trough and begin to rally before the recession is over.

Well, we're there, on the 10% correction at least. Now we'll have to see how deep this rabbit hole goes. Is this IT? Maybe, if IT is a bear market. Probably not, if IT is a market crash. Big crashes are always very long odds. But with the financials leading the way lower, and the dollar following, its a bit dicey. If corporate bonds join in to this fun fest, we'd keep in mind another of Fred Sandford's familiar sayings: "Beauty may be skin deep, but ugly goes clear to the bone."

Fed Policy Actions in Anticipation of Economic Recession

We've been studying and updating spreadsheets correlating market performance and various monetary aggregates and interest rates and spreads lately, in the hopes of gaining more understanding of what we think the Fed is doing. From time to time we like to share a chart because it might have some particular interest in and of itself to others.

Here is a chart of several of the primary monetary aggregates during the Greenspan - Bernanke chairmanships. We think they clearly demonstrate the Fed's anticipation of economic recessions which are also indicated according to the official NBER ruling. Keep in mind that economic weakness can be apparent long before the date on which the NBER formally declares (well after the fact) that the economy had entered a formal recession.

Although the chart is a bit dense with data, and not immediately and easily understood, it worth looking at it a bit, to get the idea of how the Fed reacts to an economic slowdown, and how the monetary aggregates react to the policy decisions by the FOMC Believe it or not this is a simplified version, not including interest rate spreads and stock market indices. Eyeballing charts like this is a first phase in our economic detective work, where we turn up suspects for more rigorous analysis using statistics and spreadsheets. But it does contain the big picture if you have the eye for it.

Does the Fed have a perfect control over the money supply and the economy? Certainly not! The analogy would be to that of a ship's captain. The ship travels in various conditions, and the captain does not personally propel the ship, does not maintain a perfect control sometimes to their dismay and that of the passengers, and may encounter previously unknown conditions. But in keeping with our analogy, we'd like to observe that both the captain and the Fed have quite a bit of influence over where the ship or the fiat money supply might be heading, and what routes they might take in getting there.

There is little doubt from our study that the Fed has seen a recession on the horizon, and is trying to balance the deflation of the housing bubble against an economic slowdown that becomes overly severe. Like a ship's captain, sometimes the tides and tradewinds are with you, and sometimes they are against you, and this will influence which actions you take to achieve your objectives. Let's wish Captain Bernanke well, as he steers us between the Scylla of Recession and the Charybdis of Currency Debasement.