Bankruptcy for Countrywide or Liquidation for BofA?

From: Charles Cox [mailto:charles@bayliving.com]
Sent: Tuesday, October 25, 2011 2:27 PM
To: Charles Cox
Subject: Bankruptcy for Countrywide or Liquidation for BofA?

The LATimes reported that Bryan Moynihan wouldn’t rule out bankruptcy for Bank of America. Chris Whalen urged the bank to go bankrupt. Now rumors are swirling that BofA will try to dodge all Countrywide’s lawsuit liability by putting Countrywide into bankruptcy, saving BofA in the process. Whether BofA succeeds in ducking Countrywide’s liabilities depends mostly on one question: will the bankruptcy court apply Delaware law, which prizes form over substance, or law like New York or California’s, which looks at substance over form? That choice of law factor is what got BofA off the hook of Countrywide liability in one case, and left it on the hook in another, as detailed by Isaac Gradman at the Subprime Shakeout. And if you think about it, the idea is incredibly galling. Delaware is home to many corporations, because corporate law in Delaware is unusually pro-corporation. One way of being pro-corporation is to prize form over substance. Form—drafting documents in a certain way, invoking all the magic words in the right order—can force the world to treat a business as if it’s doing what it says it is doing, even though it’s not. The corporation is in control of how the law treats it. See, if a corporation is really doing what it says in its documents, then an analysis of substance and form should get to the same place. The only time a form-versus-substance analysis ends in different places is when a corporation wants to invoke specific legal protections with magic words instead of earning them by acting accordingly. The specific issue is this: Is Countrywide a separate company within BofA, or was it merged into BofA? The documents governing BofA’s acquisition of BofA surely treat it like a separate company, but myriad actions by BofA show it integrated Countrywide, made it part of the BofA borg. So will BofA’s words or its actions control the analysis? If Delaware law applies, BofA can likely ditch its Countrywide problem, and corporate rigging of the legal system will have triumphed again. Liability Beyond Countrywide Not that ditching Countrywide’s liability solves BofA’s lawsuit problems. Consider, for example, Nevada Attorney General Catherine Masto’s lawsuit, charges that “The course of unlawful conduct described in this Complaint began with Countrywide…After acquiring Countrywide, Bank of America engaged in new, repeated and systematic violations of Nevada law…” (at paragraph 7; see also paragraphs 4-6 and the complaint generally.) Or consider that the Federal Housing Finance Authority sued Bank of America for its actions separate from that of Countrywide. Finally, bankruptcy of Countrywide can’t protect BofA from the MBIA case that has BofA on the hook for Countrywide (the New York law case above.) Just how bad the MBIA case is for BofA may be determined at an October 5th hearing, reports Patrick Gallagher of Westfair Online. MBIA is suing BofA for the insurer’s losses on Countrywide securities. At issue on October 5 is just what MBIA has to prove to get paid by BofA. Does MBIA simply have to prove that it would never have insured the securities if it knew the truth about the mortgages Countrywide was stuffing in them? Or does it have to prove Countrywide’s lies are why the securities tanked and the insurer lost so much? If MBIA has to prove the lies caused the losses, Countrywide has a chance to argue that the recession or other factors drove the securities’ collapse instead. According to analysts cited by Gallagher, what the judge says is worth about $9 billion to BofA. Still, ditching Countrywide’s liability would be a huge relief to BofA. BofA, much less Countrywide, doesn’t have the assets to pay 100 cents on the dollar of every Countrywide litigation claim. As a result, if BofA succeeds in isolating those liabilities in a Countrywide bankruptcy, everyone Countrywide defrauded will get much less than they deserve. That is, homeowners, investors (including pension funds), insurers and all Countrywide’s other victims will be victimized again. That’s why I think that if BofA tries to put Countrywide into bankruptcy, the feds should liquidate BofA and all its assets in service of paying off those liabilities. The feds can liquidate BofA anytime BofA meets the criteria in the Dodd-Frank Act, regardless of whether BofA or any of its subsidiaries, like Countrywide, are in bankruptcy. Now I realize if BofA tries to put Countrywide in bankruptcy, the Obama administration has probably signed off on it, if not actively pushed it. But that doesn’t mean the public need grin and bear it. BofA Executives Punished in a Liquidation If the feds decide to liquidate BofA, the Dodd-Frank process is swift, gratifyingly brutal to the executives, and effective: BofA would cease to exist, replaced with smaller companies not too big to fail. On paper, that is. If BofA is liquidated, no one really knows what would happen. On paper, BofA’s executives would be fired, could be made to cough up the last two years of their compensation and could be held personally liable for damages. Even Angelo Mozillo, that Countrywide crook-in-chief, could be rendered virtually middle-class, because when the issue is fraud, executives’ and former executives’ compensation can be taken back for an unlimited number of years. More: any BofA shares executives own surely would be worthless; equity holders are at the bottom of the creditor list. Finally, any of these executives could be banned from the industry for life. I say “on paper” because the fed track record for going after big bank execs is non-existent. So maybe the executives wouldn’t be taken to the cleaners, their ill-gotten massive compensation left untouched; maybe the feds wouldn’t even go after Mozillo’s money. Broader Consequences of a BofA Liquidation As grateful as I would be to see Mozillo and BofA management get hosed, I have to acknowledge that liquidating BofA would be a big risk. What would the markets think? Perhaps liquidation would be Lehman like, causing cascading disruptions. For example, I hear corporate debt markets aren’t particularly liquid, though the financial sector section of the market is; would liquidating BofA cause the corporate debt market to freeze? Maybe the market would view BofA as a one off case, and the consequences would be contained. BofA is certainly a type of worst-case scenario. Other big banks have similar problems, but perhaps to a meaningfully lesser degree. I’d be really interested to hear informed comments on what a BofA liquidation’s impacts would look like, if you know. The only thing I’m certain of is this: if the Feds wanted to liquidate BofA, they could manufacture the power to do it right now. What it Takes to Liquidate BofA Here’s the checklist before the Feds could liquidate BofA (see Title II): –Is BofA a “Covered Financial Company”? Check. –Is BofA a “Systemic Risk”? Check, though the process for making that declaration has a high bar: 2/3 of the FDIC and the Federal Reserve each must vote yes, and then Geithner would have to speak with Obama and they would have to decide yes too. They have to document their decision, tell Congress, and let the GAO check their math, after the fact. So while common sense dictates that, by definition, a too big to fail bank poses systemic risk, I suppose it’s possible that not everyone will cooperate. In justifying the decision, Geithner (the buck officially stops with him) has to find: –BofA in default, or in danger of defaulting. If BofA files for bankruptcy, this is met. Arguably—I’m persuaded—BofA’s lawsuit liability already has it in danger of defaulting. Hence BofA’s obsession with trying to minimize and settle its lawsuit exposure. Check. Or almost check, depending on the view the government wants to take. –Letting BofA fail in the usual way would have “serious adverse effects on the financial system”. Well, that’s the very definition of “too big to fail”, right? And everyone claimed BofA was, leading to its bailout. Check. –No private sector alternative is available. Check. (Who would want to take on Countrywide?) –The impacts on the financial system of letting BofA fail the regular way would be worse than using the liquidation authority. Check. Again, that’s the whole point of too big to fail and the liquidation authority. –The proposed course of action would mitigate the impacts of a BofA failure. Check. Again, that’s the point. –It’s been ordered by the government to convert its convertible debt into equity. This only applies if the government decides to require banks to hold debt that can be converted to equity at times of financial stress, meaning it helps the banks’ balance sheet while hurting equity holders. But if the feds require any bank to hold such debt, this factor isn’t really a hurdle; the government can simply order the conversion whenever it wants to liquidate. So at worst, this is checkable. In sum, if the feds find the political will, they can liquidate BofA, punish the executives of it and Countrywide in meaningful ways, and make at least one big bank no longer too big to fail. Along the way they can help Countrywide and BofA’s victims get paid as best as possible. Will the feds liquidate BofA? I doubt it, unless a) Bank of America fails to ditch its Countrywide liability; b) Bank of America’s other liabilities become overwhelmingly great; c) the markets panic because people start realizing just how much trouble the banks are in, d) people start rioting because they just can’t take the government’s pro-bank anti-person bias any longer or e) protest movements reach such a critical mass that Washington is scared into acting. In the meantime, the lawsuits against BofA and Countrywide will continue to pile up. BofA and/or the feds will eventually be forced to do something. Let’s hope they do the right thing.

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