With no new collapses of major financial institutions and little to report other than the continuing decline of housing prices and legislative proposals to close the barn door, the subprime mortgage meltdown and the worldwide financial crisis it spurned doesn’t get headlines like it used to. But this doesn’t mean the crisis is over. There is still plenty of danger out there, as indicated by two articles (here and here) on The Institutional Risk Analyst website. And as before the utter lack of transparency in so many of these subprime mortgage transactions is a key factor.
Countrywide Financial was the biggest player in the subprime market, making their reputation on putting people into homes they couldn’t afford. In January of this year Countrywide, suffering record losses and a cash shortage, agreed to be purchased by Bank of America, the second-biggest U.S. bank by assets. The agreement must have seemed a god-send at first to Countrywide’s shareholders and creditors. Unfortunately Bank of America has so far refused to publicly assume responsibility for Countrywide’s debts.
One can hardly blame Bank of America. In addition to over $100 billion in debt on Countrywide’s balance sheets there’s the potential for an enormous amount of off-balance-sheet liability from all those subprime mortgage backed financial instruments. No one knows for certain what the terms of those instruments are or who holds many of them. As more mortgages fail it’s impossible to know what the holders of the instruments will do. Bank of America could be opening itself up to an avalanche of claims that might bury the entire company.
It is no surprise then that Bank of America has been stating privately that the company intends to keep Countrywide “bankruptcy remote”. Public details of the merger plan indicate that Countrywide will be merged into Red Oak Merger Corporation, a shell corporation created for the Countrywide acquisition. The IRA speculates that Bank of America might then remove Countrywide Bank FSB from Red Oak in exchange for an amount equal to the bank’s equity. As a federally insured institution, Countrywide Bank FSB cannot be placed into Chapter 11. Once that move was complete Bank of America could then place Red Oak into bankruptcy and flush away all the external risk, along with the claims of Countrywide’s creditors.
Were regulators to allow such a strategy under the guise of protecting financial institutions from the continuing subprime meltdown, the implications would be enormous. If a precedent were set the market for bank debt would be eviscerated. As The IRA put it, “What investor in their right mind would want to hold the debt of any bank holding company.”
The subprime meltdown has caused a crisis of confidence in our financial systems. Would regulators really be willing to inject more instability into the markets and shake that confidence even further in an effort to shield major institutions from the fallout. On the other hand, if The IRA is correct, it would seem that Bank of America has few options to protect itself from all those bad mortgages. It may well depend on whether regulators view the markets or the institutions as more important.