BofA's Countrywide deal a bold bet amid crunch

By Joseph A. Giannone - Analysis

NEW YORK (Reuters) - By snapping up downtrodden mortgage lender Countrywide Financial Corp CFC.N, Bank of America Chief Executive Kenneth Lewis is betting that U.S. consumers are not poised for a prolonged slump.

Bank of America Corp (BAC.N) agreed to buy Countrywide, the nation's largest mortgage lender, for stock worth about $4 billion on Friday.

The deal will make Bank of America -- which earlier this year overtook Citigroup as the largest U.S. bank by market value -- the biggest U.S. home lender.

But it is buying a company suffering from rising losses and a cash flow crunch. Bank of America's Lewis acknowledged near-term challenges in mortgages, telling a conference call he expected loan volumes to fall. Analysts and investors say the deal could pay dividends down the road, but things will get rocky in the meantime.

"I think that when we look back two years from now, we'll say this was a smart deal. Between now and then, it will be difficult," said Peter Kovalski, who helps manage $12 billion of assets at Alpine Woods Investments. "The proverbial knife is still falling and it hasn't hit the ground yet."

Bank of America is the No. 5 lender in U.S. residential mortgages. The Countrywide deal will catapult to the No. 1 spot in this segment which is considered a revenue drive during periods of growth.

This is not one of those periods.

Sloppy mortgage underwriting industrywide in 2005 and 2006 led to an increase of defaults among risky "subprime" borrowers, which then sparked a slump in mortgage-backed bonds and related securities. By the summer of 2007, debt markets seized up and triggered massive losses among investment and commercial banks.

"We don't feel like we're anywhere near out of the woods," said Michael Mullaney, portfolio manager at Fiduciary Trust Co in Boston.

Lewis told investors the bank factored in potential credit losses and charges in calculating its offer, but he declined to explain how the bank assessed Countrywide's portfolio.

Bank of America projects the deal will not boost profit until 2009, and that assertion ignores the $1.2 billion in deal charges. Analysts see the takeover causing near term pain.

The bank "is going to have to absorb the massive losses in right-positioning Countrywide. It can be done, but the cost is going to be exorbitant," said Sean Egan, an independent credit analyst and head of Egan-Jones Ratings Inc.

Lewis also will inherit a number of legal headaches. Countrywide founder Angelo Mozilo faces lawsuits and regulatory probes for selling stock even as the company reassured investors it would survive.

WISE DEAL?

Indeed the timing of the deal fueled speculation that other factors forced the banks' hand. Some critics argued Lewis wanted to save face after the bank's $2 billion cash injection began to look ill-timed. The value of that investment has fallen by two-thirds since it was announced August 22.