Mortgaging losses

Is BofA being brave, or does it have a real strategy?

It’s time for financial analysts around the world to go back to their drawing boards. For the recent decision of the North Carolina-based Bank of America’s (BofA) decision to purchase Countrywide Financial Corporation (CFC) for $4.1 billion in stock has totally confounded them. Many call it a foolhardy decision, for CFC incurred a loss of $1.2 billion for the quarter ending September 30, 2007. Kenneth Lewis, Chairman & CEO, BofA said in a statement, “Countrywide presents a rare opportunity for Bank of America to add what we believe is the best domestic mortgage platform at an attractive price and to affirm our position as the nation’s premier lender to consumers.” For every CFC stock, the company’s shareholders will get 0.1822 share of BofA’s stock. Last year too BofA had invested $2 billion in CFC, for a 16% stake in the company.

What’s more, the gamble might actually pay off, as banking experts consider this deal as an important one to rescue the US’s largest mortgage lender. It will also help in expanding the empire of BofA, the nation’s largest consumer bank. With the buyout, BofA can become the largest mortgage lender and loan provider in the country. Victoria Wagner Director, Financial Services Ratings Group, Standard & Poor’s told B&E, “It’s neither BofA’s decision to prevent recession or for the rescue of CFC. It’s just BofA’s interest in CFC mortgage facilities.” Bart Narter, Senior Analyst, Celent says, “There’s still plenty of risk involved... he’s (Kenneth Lewis) brave to do it. But I think that it’s very likely down the road to be profitable, maybe not immediately, but in the long term.” According to Mortgagedaily.com, close to 150 mortgage lenders failed last year and 43 were acquired by healthier institutions. But Lewis is quick to point out, “We’re aware of the issues within the housing and mortgage industries. The transaction reflects those challenges.”

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Source : IIPM Editorial, 2012.
An Initiative of IIPM, Malay Chaudhuri
and Arindam Chaudhuri (Renowned Management Guru and Economist).

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Bend It Like Bernanke: How Government Guarantees Shape Asset Prices

Professor Bryan T. Kelly of Booth School of Business and co-authors (Prof. Hanno Lustig of UCLA and Stijn Van Nieuwerburg of New York University) undertake a field research to understand how government intervention and economic outcomes offer new insights into the effect of bailouts on the value of the banking sector.

Europe is wrestling with structuring a bailout as its financial firms and broader economies teeter on a precipice. In America, markets look to Europe with unease while politicians bicker over whether stimulus and backstops established in 2008 and 2009 caused the current economic malaise or if it might have been worse. On top of all of this, uncertainty about the ultimate outcomes of government intervention exacerbate the deeper underlying uncertainty responsible for much or the morass.

According to a research undertaken byme, Hanno Lustig (UCLA) and Stijn Van Nieuwerburgh (New York University), we seek to better understand the interplay of government intervention and economic outcomes by offering new insights into the effect of bailouts on the value of the banking sector. When the government guarantees the survival of financial institutions that are “too systemically risky to fail,” it is effectively providing free crash insurance to anyone who holds bank stocks. More specifically, it insures the banking sector as a whole, but does not necessarily insure individual banks (contrast the bailouts of Bank of America and AIG with the failures of Lehman and Bear Stearns).

This effect can indeed be seen very clearly in the cost of put options on the financial sector ETF and put options on individual banks stocks (put options are in essence crash insurance for stocks and stock indices). We examine the prices of these insurance contracts prior to and during the 2007-2009 crisis in the US financial sector. What we find is that the cost of traded crash insurance (put options) on the entire financial sector become puzzlingly cheap during the crisis, while the prices of puts on individual banks remained high. In effect, the government substantially subsidised the cost of index puts, which drove down the prices investors were willing to pay for the traded version of this insurance. Since any individual bank may still fail amid a guarantee, the effect was much weaker for individual bank puts. The puzzling divergence in the cost of single name puts relative to index puts during the crisis is well-explained by the bailout story after all.

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Source : IIPM Editorial, 2012.

An Initiative of IIPM, Malay Chaudhuri 
and Arindam Chaudhuri (Renowned Management Guru and Economist).

For More IIPM Info, Visit below mentioned IIPM articles. 

IIPM Best B School India
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