Watching The Countrywide Spreads

Merger arbitrageurs were widely expected to be even more concerned about Bank of America’s plan to buy Countrywide Financial yesterday but, surprisingly, they seem to have become more confident. In early morning trading yesterday, Bank of America stock slid 6 percent and Countrywide fell 12 percent. As both stocks hit their lows for the day shortly after 10 am Tuesday morning, the spread between the share prices of the two companies and acquisition price they agreed to more than a week ago grew to its widest level since the deal was announced on January 11th. But as the day wore on, shares of Countrywide climbed back for a gain of 7.86 percent and Bank of America climbed 4 percent, the share prices and the agreed acquisition price narrowed a bit.

A bit of background for those of you just returning from Gstaad. On January 11th, Bank of America agreed to buy Countrywide in an all stock deal, swapping each share of the troubled home lender for 0.1822 Bank of America shares. That day shares of Countrywide traded at the equivalent of 0.1644 shares of Bank of America. If the arbitragers who trade on these things thought that this deal were certain to close, the spread between the offering price and the trading price would be zero plus some allowance for opportunity cost. But this big of a gap between the deal price and the trading price, implies that the arbs think the deal might be in trouble.

Although it's only rough and ready way of looking at this, you could say that on the day the deal was announced the arbs were pricing something like a 90 percent chance of the deal closing on the agreed upon terms. (We say ‘rough and ready’ because, as we mentioned, you’d have to throw in opportunity costs and other made up numbers to come to an allegedly more precise figure.)

In the first half of last week, the spread widened out to a little more than 15%, implying a chance of deal closing in the mid-eighties. Toward the end of the week, shares of Countrywide and Bank of America moved further apart. Both declined, but Countrywide declined more precipitously. By Friday the spread climbed to nearly 25 percent, implying only a 75.68 percent chance of the deal closing. There were rumors that Bank of America was considering walking away from the deal.

At their near simultaneous lows yesterday, the spread implied a 75.43 percent chance of closing. But as both stocks followed the financial sector upwards in late morning and afternoon trading, the chances improved a bit to 78.49 percent. Nonetheless, a 21.5 percent spread is on the wide end. According to at least one of our readers, the average equity spread on strategic deals is between 18 and 20 percent. The deal is expected to close in the third-quarter of this year, which means that arbs could make an annualized gain of nearly 28 return by betting that the deal closes. To put it differently, the market apparently figures that the risk of the deal not closing wouldn’t justify anything less than a 28 percent return.

The bond market seems to have a different view of the deal. On Friday, CFC 6.25%s of 2016 closed at 79.125. “The pricing reflects the expectation that BAC will assume responsibility for the CFC debt at par,” Christopher Whalen of Institutional Risk Analytics wrote yesterday. (He went on to explain that even if the deal closes, this assumption may not be sound.)

One early reader of this post pointed out, however, that the Countrywide 2016 bonds were trading at $75 dollars yesterday. This could indicate that bond trader confidence in the deal is slipping, or simply that bond traders are less confident a merger with Bank of America will guarantee the Countrywide bonds.

On Thursday, the plan of merger between Countrywide and Bank of America was filed with the Securities and Exchange Commission. It provides some hints about how Bank of America could decide to unwind the deal. If Countrywide was disproportionately affected by further deterioration in the mortgage market, suffering more than other home lenders, Bank of America could pull out of the deal. Perhaps more significantly, the agreement requires that accountants provide a clean audit report for Countrywide.

“So, if Countrywide’s auditors, KPMG, issue a going-concern qualification or otherwise find accounting irregularity Bank of America can likely terminate the merger agreement,” DealBook noted yesterday.

But if neither of these occurred, could Bank of America decide to pull the deal? The break up fee is set at $160 million, or around 4% of the $4 billion price tag the deal had when it was struck. That’s on the high side for M&A break-up fees, which typically run around 3%. And Bank of America has already sunk $2 billion into Countrywide, which makes the stakes even higher. All this could mean that the bond traders are right, at least in betting that this deal will close.

Are Countrywide Financial Bonds Bankruptcy Remote? [Seeking Alpha]
Countrywide’s Strangely Normal Deal Agreement [DealBook]