The Wall Street Journal-20080112-Beware- Investors- of Search For Countrywide-Like Deals
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Beware, Investors, of Search For Countrywide-Like Deals
When it comes to beaten-down financial stocks, value is in the eye of the beholder.
Bank of America is buying Countrywide Financial for $4 billion, a price equal to about a third of its book value, the measure of what's left over for shareholders after liabilities are subtracted from assets. Countrywide was trading at a fifth of its book value before news of the deal came out.
The price appears to be a bargain, and the investment could turn out to be a home run for Bank of America. But for small investors looking to pick up battered financial stocks, the investment decision is not that simple, especially with the possibility growing of a recession this year.
By buying Countrywide, Bank of America, with its vast size and strong balance sheet, immediately eliminates the funding issues that helped to drive Countrywide's shares down to the single digits. And given what it paid, the bank has a big margin for error in working out the value of Countrywide's assets.
For Bank of America to profit, all it needs to do is realize value on Countrywide's assets at a level that's even just slightly higher than what it paid. The bank can then earn a return on those assets as the business stabilizes. As an added benefit, it sharply expands its mortgage business, prevents a potential bankruptcy at the nation's No. 1 mortgage lender and originator that could hurt the overall financial system, and prevents a competitor from snapping up part or all of Countrywide.
Individual investors may be tempted to follow suit and buy other financial stocks whose prices are trading well below book. Possible candidates: Washington Mutual, Capital One Financial Corp., CIT Group Inc. and AmeriCredit Corp. Indeed, several of these stocks rose Friday, and Washington Mutual was the subject of takeover speculation. CIT jumped nearly 9% despite announcing a big loss Friday.
But since few entities anywhere have Bank of America's financial wherewithal, the strategy could burn investors. That's because the test of how real, or sustainable, a firm's book value is in today's depressed environment may ultimately depend on who is buying its stock.
That isn't to say Bank of America doesn't face significant challenges. Countrywide's book value, which is based on Sept. 30, 2007, figures, could be far lower as a result of rising defaults on mortgages and home-equity loans. Consider that Countrywide has $32 billion in second-lien, home-equity loans. Of these, 44% have a loan- to-value ratio over 90%. These are among the riskiest kinds of loans out there.
Factoring in a 25% loss on just the high loan-to-value portion of this portfolio could lead to a $3.5 billion write-down for Bank of America. That would cut into its own capital. Countrywide may also suffer big hits as a result of litigation pending against it.
Plus, investors who bought securities containing Countrywide mortgages may try to demand that the lender take back mortgages as defaults rise. The bottom line could turn out to be that Bank of America is paying a higher percentage of book value than it and investors think.
This underscores, for investors, the difficulty of getting a handle on book value and an appropriate discount to such a measure in stressed times. Washington Mutual is an example. Its stock is up more than 20% from its closing price Wednesday, the day before news of Bank of America's interest in Countrywide was reported.
With Countrywide being taken out, some investors believe Washington Mutual becomes the next-most-likely takeover candidate. One potential buyer for Washington Mutual is J.P. Morgan Chase & Co., which has expressed interest in expanding its retail-banking franchise in places like California and the Southeast. Executives at J.P. Morgan, which has been relatively unscathed in the credit crunch so far, have also expressed interest in other regional banks as well, however.
And some analysts don't think Washington Mutual would get acquired for a price that much above its Friday close of $14.69, up nearly 4%.
Partly as a result of higher credit losses and the need to raise additional capital, Washington Mutual is probably worth no more than $17 a share to an acquirer, estimated Robert Lacoursiere, an analyst at Banc of America Securities, in a recent research note. In December, Washington Mutual said that in 2008 it might have to take losses of as much as $8 billion associated with reserves for soured loans.
Indeed, investors should be cautious about trying to game potential acquisitions if for no other reason than there aren't many financial institutions that can step up as buyers. Too many are licking their own wounds from the subprime-mortgage mess and ensuing credit crunch. Rumors flew Friday that J.P. Morgan was going to be an acquirer, but so far it has stayed above the fray.
Other possible investors such as private-equity and hedge funds may be reluctant to jump in at this point, having seen peers get burned by trying to call a bottom in the sector.
Private-equity firm Warburg Pincus, for instance, agreed in December to purchase $500 million of MBIA Inc. stock at $31 a share. The stock is now trading in the midteens. Washington Mutual's $12 billion market cap would also be a hurdle in the tight credit environment.
