The marriage between Bank of America (BAC) and Countrywide Financial (CFC) was supposed to stave off bankruptcy of Countrywide. It might not work out that way. Let’s put together some pieces starting with the Bloomberg report BNY Mellon, Citigroup, JPMorgan, Ambac in Court News.

Bank of New York Mellon Corp., the world’s largest custodian of financial assets, sued Bank of America Corp.’s Countrywide Financial Corp. seeking repayment of $2 billion in notes.

Countrywide failed to inform holders of its Series B floating rate convertible notes due in 2037 that its acquisition by Bank of America on July 1 gave holders the option to keep the notes or cash them in, lawyers for BNY Mellon said July 31 in a complaint filed in Delaware Chancery Court in Wilmington.

Countrywide was required to mail notices explaining the changes by July 16, according to the complaint. BNY Mellon filed the suit as trustee for the holders of the notes.

BNY Mellon is seeking a judicial declaration that Countrywide has defaulted on its obligations under the terms of the indenture. The company is also asking a judge to order Countrywide to immediately purchase the notes surrendered in cash equal to 100 percent of the principal amount plus accrued and unpaid interest.

Implications Of The Lawsuit

The Institutional Risk Analyst discusses the implications of the lawsuit in Is Countrywide Financial Headed for Bankruptcy?

It is remarkable but not surprising that it took this long for BNY Mellon (BK) to recognize BAC’s threatened default and to finally act in its role as fiduciary, but now that it has acted the other creditors of Countrywide, which is now a direct subsidiary of BAC, cannot remain indifferent.

Given the legal filing by BK, it is not impossible that another creditor of Countrywide will decide to file a claim or even an involuntary bankruptcy petition to protect their rights. As more legal claims are filed, a judge may even take notice of the diversity of claimants and suggest bankruptcy as a practical alternative. In the event, the FDIC and other regulators may be faced with the very situation they have tried to avoid via the marriage of BAC and Countrywide, namely the failure of a large depository.

The current situation is unchartered territory to put it mildly. Most of the lawyers and banking experts contacted by The IRA could never recall a situation where the parent of an insured depository institution was made subject to the authority of the bankruptcy court. Indeed, it appears that were a creditor of Countrywide to file an involuntary bankruptcy petition, the FDIC might be forced to intervene as receiver and take control of the bank unit. If a creditor, possibly even including BK, were to file an involuntary petition against Countrywide, BAC could stand to lose the book value of the investment in the bank subsidiary, roughly $7 billion at the end of March 2008.

“Typically the bond holders do not have an incentive to come together to create the demise of an issuer, but this situation is doing just that,” says Joseph Mason, Professor of Finance at Louisiana State University. “The FDIC wanted to avoid a large bank resolution early in the credit crisis, but the legal lose ends in the Countrywide situation may cause precisely that result.”

Dogs Howling Over Bare Bones

Bank of America thought it could strip the assets of Countrywide and toss the bones to the dogs. The lead dog, otherwise known as BNY Mellon is now howling. How long will it be before the rest of the pack starts howling?

And what is unique in this case is the pack of dogs (Countrywide bondholders), now have a vested interest in pushing Countrywide into bankruptcy so they can get some of the meat (Countrywide’s servicing unit), instead of worthless bones (Countrywide’s Debt).

Countrywide has about $38 billion in outstanding debt that the dogs are howling over.

Given that the merger was approve and closed on July 1, albeit under clouds of litigation, perhaps the dogs are barking up the wrong tree. Perhaps not.

The Institutional Risk Analyst concludes with “The possible issues and permutations of such scenarios are too numerous to address here, but suffice to say that the cross-guarantee provisions alone between insured depository institutions within the BAC group could create a legal nightmare if this situation does end up in a bankruptcy litigation. What will be the position of the Office of Thrift Supervision and the FDIC in the event? Just remember that we’re making this up as we go along. And please do stay tuned.”

Indeed, stay tuned. The final chapter on this story has likely not been written.

Mike “Mish” Shedlock
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