Before we get to the evolution of the bailout, some pending business from the land of restructuring, where the Countrywide Financial saga continues.

On or about October 10, 2008, Bank of New York Mellon (NYSE:BK) and mortgage lender Countrywide Financial, a subsidiary of Bank of America (NYSE:BAC), agreed to settle a Delaware Chancery Court lawsuit involving Countrywide bondholders.  "Under the settlement agreement, Countrywide has agreed to commence a tender offer by Oct. 20 for its Series B floating rate convertible senior debentures due 2037. The purchase price for the tender offer will be $980 per $1,000 principal amount of bonds, plus accrued interest," reports CNN Money.

A reader named Michele writes in agitated spirit, accusing us of poor journalism and worse for not predicting that BAC, behalf of the Countrywide Financial bond holders, would fold so quickly and make these creditors whole.  Could Michele be short the CDS?  Remember dear friends, The IRA is not an investment advisory service, merely our thoughts on the world.  Those of you who speculate on the possible default on a given name or security should seek the counsel of a cleric or bartender.

Says Michele: "There are 2 tranches of convertible debt, the series A and the series B. How do you explain that the series A which are puttable at par this week have been paid off voluntarily by BAC? Secondly the series B action was regarding change of control language, nothing to do with fear of bankruptcy, and finally did you know (apparently not) that BAC in exchange for the MSR put in a 20 billion $ on demand promissory note to pay off all CFC debt obligations. I can't imagine any explanation on your part other than you got this one wrong."

No Michele, we was and are right. But let us again go through the saga, the final endgame of which even we still don't entirely understand. The key to being a good analyst/journalist is always say when you don't know.

First, even with the $20 billion consideration paid by BAC for the Countrywide servicing business, there still may not be enough assets remaining to satisfy the liquidated and unliquidated claims.  This is the key point we made with respect to BAC's peculiar handling of the Countrywide purchase, a point which was confirmed by the trustee's lawsuit in Delaware Court. For our original report on the Countrywide/BAC union, (See "Are Countrywide Financial Bonds Bankruptcy Remote?").

Second, to the holders of Series B floating rate convertible senior debentures due 2037, all we can say is don't count your chickens until 90 days have elapsed since the payment date. An aggressive bankruptcy trustee might well seek to recover the funds paid out in the tender.  But it may not come to a restructuring.  And just where are the other indenture trustees behalf of the other countrywide debt holders given the action in DE court?

A cynic might say that BAC has had it both ways with Countrywide; BAC purchased the servicing portfolio out of Countrywide as Michele correctly states, keeping this asset safely out of the way of a bankruptcy, and paying well for same with a $20 billion IOU. This generosity caused the indenture trustee for at least one class of Countrywide Financial debt to rouse itself and to demand repayment, but that still leaves the other creditors and, most important, the unliquidated claims currently in litigation, unresolved. Do we discern a pattern?

Keep in mind that the FDIC-insured bank subsidiary of the firm now known as Countrywide, Countrywide Bank FSB, is losing money at a pretty rapid clip. ROE as of June 30, 2008 was -36% and ROA was -2.58% vs. the bank's $118 billion in total assets. From a creditor perspective, you have to wonder what if anything will be left if Countrywide Bank must be recapitalized with the remaining assets in the parent holding company. The bank had over 6% tier one capital leverage as of the end of Q2 2008, but look at the negative ROE and the 275bp of default (annualized) through the same date and do the math.

Third, no, we see nothing nefarious in BAC paying the Series A as contracted. To us, the key pattern of consistency in this strange saga has been that the BAC personnel (a) have nothing to say on or off the record and (b) have played the liquidation of Countrywide Financial entirely straight.  There is nothing we know of in the public record that suggests that BAC has been anything but fair in administering the claims against Countrywide Financial. Who is to say that BAC is not hoping to pay all or most of the liquidated claims against Countrywide Financial, and then allow one of the remaining creditors to flush the litigation in a bankruptcy?

Note the way in which BAC has been content to allow other parties to make the moves with respect to Countrywide Financial. BAC has allowed one creditor to extricate themselves from the Countrywide mess sans bankruptcy. Given the settlement announcement Friday, there appears to be sufficient basis for the other indenture trustees to demand repayment as well. Meanwhile, various civil plaintiffs and state AGs continue to press their as yet unliquidated claims in the courts.

We see BAC strategy with respect to Countrywide as the classic passive aggressive. The BAC managers won't do anything unless compelled to do so, so as not to create the basis for an adversarial claim in a possible bankruptcy.  But what happens when the bank sub starts consuming the remaining assets?  Our view only, you understand.

Why Bailout the Banksters?

And now to the crisis. The equity infusion concept seems to have penetrated the thick cranial cavities of the Washington elite, yet according to today's headlines some $250 billion in public largesse seems to be flowing to the investment banking friends of Hank Paulson instead of to support banks. What gives?   

According to our friend Josh Rosner, the money gets distributed accordingly:  New capital for $25 billion each to Citi & JPMorgan; $20 billion to BAC & Wells Fargo (NYSE:WFC); $10 billion each for Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS); $2 to $3 billion for BK and State Street (NYSE:STT); WFC will get additional $5 billion for Wachovia and BAC gets additional $5 billion for acquiring Merrill Lynch (NYSE:MER). 

Click here to see the September 23, 3008 letter to member of Congress by John Allison, Chairman & CEO of BB&T (NYSE:BBT).  Writes Allison:  "We think it is important that Congress hear from the well run financial institutions as most of the concerns have been focused on the problem companies.  It is inappropriate that the debate is largely being shaped by the financial institutions who made very poor decisions."  We support equity injections into solvent depositories to support loans and customer deposits, but subsidizing the broker-dealer operations of the remaining banksters and their rancid derivatives books seems a tad ridiculous. 

In the wake of the bankruptcy of Lehman Brothers, it is clear to us, at least, that the GS and MS should be sold to or merged with commercial banks and as soon as possible.  The legacy, "franchise value" of these firms will never be higher. And of course the Mitsubishi UFJ Financial Group (NYSE:MTU) arrives in the nick of time. Yet again our friends in Tokyo are shown to be a lagging indicator.

But do we really want to lend taxpayer support to floating the last dinosaurs on Wall Street? Please. The reason we are a seller of the GS and MS franchises has to do with the changing business model. That special culture that made GS, MS and other independent dealer firms swashbuckling, borderline criminal enterprises is heading for extinction. Why? Because both of these securities dealers are about to become regulated banks or part of banks, that is, utilities, where payouts to deal guys and gals will be constrained.

Within a matter of weeks or even months, the exodus of smart people will begin as the deal makers migrate to alternative platforms where they can best be compensated for ideas and relationships. Investment banking, after all, is about communicating ideas, nothing more, so the lower the SG&A, the better the yield to commission. The rise of new boutique banking firms is already well underway, but they may well be spending most of their time on restructuring.

In practical terms, due to the depth of the hole which the financial markets have dug for themselves in the US, EU and elsewhere, there must be a substantial role for the government as market maker and capital provider for depository institutions. But we should not expect the government to replace private capital or banking professionals in making the markets function, nor use public funds to bailout speculative activities.

It's All About Deflation

Six months ago, the problem affecting the markets was perceived to be liquidity or lack thereof. More recently, we have seen the emphasis shift to solvency or the fear of not getting paid, the difference between a market disturbance and a systemic panic.

But ahead lies the prospect of global deflation as the combination of greatly reduced credit availability and sharply lower consumption send the US and the Rest of the World into a prolonged period of economic contraction. It's not that we are bearish, you understand, but instead we merely observe the global economic system adjusting to significant changes in the underlying financial model.

Just as the financial system skewed to the downside during the 2004-2007 mortgage bubble, pretending that risk equaled zero and value was price, now we are skewing to the other extreme, where risk is infinite and price is effectively zero for many asset classes, whether performing or not. This environment makes writing new business difficult if not impossible for banks.

James Bianco observed to a thread the other day: "The problem is more than banks unwilling to lend to each other, they are also unwilling to borrow from each other. Banks can get all the funding they need (and then some) from their central bank so they do not need to seek a loan from another bank." True, but we have also eliminated trillions of dollars in financing capacity from the global economy.

We can foresee a situation where it may be necessary to allow counterparties in the interbank/interdealer markets to face the DTCC, with the federal reserve banks and clearinghouse members in each district guaranteeing trades for a short period, say from now through the end of 2008. This could help to eliminate counterparty risk and restore function to the markets.  But to Bianco's point, such moves may not even be necessary.

In fact, maybe the first sign of true recovery will be when the Fed slowly starts to force banks back into the private markets to seek funding, this even while Treasury very publicly makes capital available.  To this end, it might be useful for the banking industry to proactively embrace some type of cross-guarantee structure, using the carrot of lower insurance premiums and the stick of enforcement actions to keep all institutions in line when it comes to performance and safety and soundness. Given the FDIC's power to tax bank capital and earnings, a cross-guarantee scheme seems an obvious way for banks to bolster confidence and claim credit for being proactive.

In our view, the FDIC should combine an aggressive program to work through the troubled bank list with an enhanced regime of performance benchmarking to bolster the industry for approaching losses in 2H 2008 and 2009. Remember, just as the risk skew on the downside during 2004-2007 period was extreme, the mean reversion process now underway could take bank loan loss rates in the US well above early 1990s levels, the highest peak loss rate period since the Depression.  The $250 billion in capital injections for the Friends of Hank will be just the down payment to get through the wave of loan losses headed for some of the larger players in the US banking sector.  But don't forget that most smaller, better managed banks in the US will neither want nor need government assistance.  More on this next week.

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