Description

Attractive arb opportunity between two series of Bank of America preferred stock.  36% return over one year on a 100%-hedged, unlevered basis by going long a senior security and short a junior security.  The senior security is a Countrywide (CFC) preferred.  On Tuesday Bank of America (BAC) announced that it would be “assuming” all Countrywide debt and preferred, which means that the Countrywide securities will become obligations of Bank of America’s holding company.  Bank of America has held Countrywide in a merger sub since its acquisition closed on July 1, fostering speculation that it might eventually orphan the sub.  Bank of America has not offered a time frame for officially assuming the preferred.  The main risk is that Bank of America reverses this decision which I view as unlikely for reasons listed below.

The trade is long four shares Countrywide B preferred (7% coupon, $25 face) and short one share Bank of America 8% preferred ($100 face).  The CFC B preferred has a 15% yield to maturity at the current price of $12.20 and the BAC 8% has a 11% yield to maturity at its current price of $75.  The CFC B pref is senior to the BAC 8% because it is technically junior sub debt while the BAC 8% is regular preferred.  The CFC B preferred pays cumulative dividends while the BAC 8% dividends are non-cumulative. This means that if BAC stops dividends on the 8% preferred for a time it does not have to pay the skipped dividends.  If you assume both preferreds trade to an 11% yield to maturity over one year you make 36% (measured as a % of the long $’s invested).  If the government takes BAC over tomorrow and the prefs get wiped out, you make 54%.  I have laid out some return scenarios below. 

BAC is unlikely to reverse its decision to assume CFC debt/preferred because: (i) BAC is a huge debt issuer and needs credibility, (ii) CFC is making BAC money – contributing 6 cents to the 15 cent eps BAC reported in Q3 – because BAC already wrote down most of CFC loans through purchase accounting, (iii) CFC just settled lawsuits with a group of state AG’s so much of the litigation risk is gone, and (iv) under the Fed’s “doctrine of strength” rule a parent bank is responsible for supporting a subsidiary bank: CFC has a large bank subsidiary that BAC is obliged to support.

Catalyst