Countrywide and its FHLB Advances
UPDATE: Caused some flames… initial post was a 3am posting before details emerged. Here is my new posting.
Recently, the Bank of America announced a definitive agreement to purchase Countrywide Financial Corporation, in an all-stock transaction worth approximately 4 $Billion. Under the terms of the agreement, shareholders of CFC will receive 0.1822 of a share of BAC stock in exchange for each share of CFC. The purchase is expected to close in the 3rd quarter and be neutral to BAC earnings per share in 2008 and accretive in 2009, excluding merger and restructuring costs.
So now what? Was this worth it or could problems begin for Bank of America.
CFC depended heavily on Federal Home Loan Bank advances. As a wholly owned subsidiary of BAC, CFC is on the line for this one. Their total assets will still be used to calculate their advances but two issues remain. The FHLBanks has two requirements for their member banks: the borrower must have eligible collateral and an acceptable supervisory rating (Bennett, Vaughn, and Yeager 2005).
With 1.04% of their loans reaching foreclosure, does this really qualify CFC as having eligible collateral. While the dubious loans may be held with the CFC parent holding company, the loans in the bank must be of some higher quality. This will satisfy the eligibility requirement.
The recent rumors regarding their possible bankruptcy and the markets subjective decision to act on such rumors indicates many investors lack any faith regarding any CFC statements. Also, the forged documents used in bankruptcy proceedings could impact their supervisory ratings in addition to their increased reliance on FHLBank advances. The massive increase in advances will increase their possibility of ratings downgrade.
What happens to BAC shareholders if CFC does not live up to its promises:
“Finally, should a member fail and collateral prove insufficient, the exposed FHLBank can assert statutory lien priority on other assets—thereby moving ahead of all unsecured creditors. Because of this protection, no FHLBank has ever lost a penny on an advance. It is rational, therefore, for FHLBanks to ignore failure risk when pricing advances. A moral hazard arises because the FDIC cannot charge actuarially fair premiums to offset the unpriced failure risk. So banks can take risks with advances, keep the upside, and shift the downside to the FDIC.” (Bennett, Vaughn, and Yeager 2005)
“History may not offer a good guide because commercial-bank reliance on FHLBank funding is a post-1989 phenomenon.“(Bennett, Vaughn, and Yeager 2005)
“The FHLBanks impose only two constraints on member borrowing: the borrower must have eligible collateral and an acceptable supervisory rating. Because FHLBanks will advance funds to purchase eligible assets—including assets in abundant supply such as mortgage-backed securities—the collateral constraint is not binding. Moreover, most FHLBanks define an “unacceptable” supervisory rating as a CAMELS 4 or 5 composite. At year-end 2004, only 0.92 percent of U.S. banks posted such a rating, and just 47 of those banks were FHLBank members.” (Bennett, Vaughn, and Yeager 2005)
“FHLBank funding provides an easier escape than insured deposits. Insured deposits are expensive to raise. Indeed, the relatively inelastic supply of such deposits in part explains the popularity of FHLBank funding. In contrast, an FHLBank member can borrow as long as eligible collateral is available or can be purchased.” (Bennett, Vaughn, and Yeager 2005)
“Some FHLBanks impose total borrowing constraints on members, ranging from 35 to 55 percent of assets (GAO, 2003). Only a handful of commercial banks, however, operate near these constraints.” (Bennett, Vaughn, and Yeager 2005)
“But there are reasons to believe FHLBank funding has increased BIF exposure by more than the coefficients suggest. Banks enjoyed record earnings in the 1990s. And the brief recession of 2001 did not produce a significant uptick in charge offs. As a consequence, capital protection has risen to robust levels unseen since the 1940s—and higher levels of capital put bank owners at greater risk of loss, which in turn impels them to constrain risk-taking. When capital ratios mean revert and bank owners have less money at stake, advances may well have a larger impact on downgrade probability.” (Bennett, Vaughn, and Yeager 2005)
“Finally, unexpectedly robust economic expansion in the 1990s enabled banks to accumulate record levels of capital. These factors have combined to hold risk-taking in check. But a shock to capital could induce bankers to exploit the risk subsidy associated with FHLBank funding just as capital shocks induced excessive risk-taking in the thrift industry.” (Bennett, Vaughn, and Yeager 2005)
“A third reason the analysis may understate the problem is our neglect of FHLBank pre-payment penalties. Closing an institution requires pre-payment of outstanding advances, and all FHLBanks assess a penalty based on interest foregone from making new advances at lower rates and the cost of unwinding associated interest-rate hedges. This sum can be large for long-term advances in a falling rate environment. (And nearly 50 percent of advances outstanding to banks at year-end 2003 had maturities over three years.) Moreover, some FHLBanks apply additional charges. The FDIC as receiver must pay these penalties to get control of pledged assets for liquidation. The recent resolution of Bank of Alamo (Alamo, Tennessee) illustrates the potential size of the expense. To assume control of the $69 million asset bank, which failed in November 2002, the FDIC had to pre-pay $6.4 million of advances from the Federal Home Loan Bank of Cincinnati. The prepayment penalties came to $906,000—14 percent of the advances outstanding (Bair, 2003; Blackwell, 2003).” (Bennett, Vaughn, and Yeager 2005)
“The FDIC has not resolved a large-bank failure since Continental Illinois in the 1980s, and in the interim large banks have grown considerably more complex. Resolution costs could prove to be orders of magnitude higher than application of historical loss rates suggest, particularly if concerns about systemic risk outweigh concerns about FDIC exposure. By volume of advances outstanding, large banks are the FHLBank System’s best customers. At year-end 2003, the 424 U.S. banks with more than $1 billion in assets held 78.5 percent of outstanding advances. The position of the FHLBanks as senior secured creditors means the FDIC will absorb the extra costs arising from resolution of a large, complex bank.” (Bennett, Vaughn, and Yeager 2005)
If the bank goes bust not only will BAC be left behind FHLBanks and depositors, it may possibly end up with nothing after the prepayment penalties are assessed by the FHLBanks.
So was the acquisition to create a greater synergy worth it? If the FDIC takes the bank away and leaves BAC with CFC’s parent holding company it may have that effect but would the FDIC handle the parent holding company with kid gloves? There are implied promises in this deal. Sure BAC can just own stock, but if CFC does have more troubles, the FED and Treasury official have an implied expectation for BAC to intervene and supply capital or possibly assume the deposits and liabilities of Countrywide Bank if any further shocks occur. Do Fed and Treasury official expect the same if CFC’s holding company has troubles, the possible downgrades in CFC bank ratings imply there is more here than meets the eyes. Beyond the scope of a tax deduction, BAC is on the line for much more.
Given the risks involved, would it have been better for BAC to solely buy the mortgage operations or the higher rated mortgages?
The cautionary tale was predicted by Chris Whalen in the Insitituional Risk Analyst several months ago:
“For example, were CFC to take a significant loss on loans or other assets currently held at the parent level, the public shareholders of CFC could not “raid the bank” to offset such loss — and instead could face a fire sale or even bankruptcy. Indeed, this is precisely the situation envisioned by the Congress when Section 23A was enacted into law, to prevent the non-bank affiliate of a bank from causing a bank failure and thus a loss to the FDIC.
So, for example, were CFC to become unprofitable and eventually suffer a $5 billion loss due to loan losses or, even better, an unforeseen loss from a complex structured financial transaction, the parent’s $7 billion in capital would be seriously impaired. In the event, the FDIC, using its power as receiver of the insured bank, might then intervene, either extending an emergency loan to facilitate a sale of CFC’s bank unit or even taking over the bank to safeguard depositor funds (not to mention $30 billion in FHLB advances).
The latter course would leave CFC crippled and facing default, but without the assets of the insured bank as part of the bankruptcy estate. Such a scenario gives new meaning to the term “loss given default.” Just remember that as and when a bank or thrift holding company files for bankruptcy protection, the FDIC will probably already have taken over the insured bank.“
