Countrywide's loan portfolio has deteriorated so rapidly that it currently has negative equity and the proposed takeover of the company will be a drag on Bank of America's earnings due to the elevated credit expenses at Countrywide, analyst Paul Miller wrote in a note to clients.
He cut his target on Countrywide's stock to $2 from $7.
Bank of America, which said in January it would buy Countrywide for $4 billion, said in a filing last week there was no assurance that any of the mortgage lender's outstanding debt would be redeemed, assumed or guaranteed.
"Bank of America announced that it might not guarantee Countrywide's debt, which is most likely the first step in renegotiating the entire deal," Miller said.
If mark-downs on Countrywide's loan portfolio are less than $22 billion, then Bank of America can likely offset the adjustments with fair value debt adjustments and the difference between tangible equity and its purchase price of Countrywide, he estimated.
"We estimate that if fair-value adjustments to the loan portfolio could exceed approximately $22 billion, this would increase the odds of Bank of America renegotiating the transaction or walking away," Miller said.
The analyst said Bank of America's announced purchase price allows for some adjustments to loan values as it is below Countrywide's first-quarter GAAP tangible equity of $11 billion.
Miller, however, added that given the rapid credit deterioration and weak secondary market demand, markdowns on Countrywide's loans could easily exceed Bank of America's estimates when the company performed due diligence and the cushion was built into the deal.
He expects markdowns on Countrywide's $95 billion loan portfolio -- which includes $28 billion of option adjustable rate mortgages (ARMs), $14 billion of home equity line of credits (HELOCs), $20 billion of fixed rate second lien mortgages, and $19 billion of Hybrid ARMs -- to be material.
"We believe Countrywide has significant credit risk on its balance sheet, not only in its loan portfolio, but in its subprime and HELOC securities and residuals, its representations and warranties on loans sold, and in loans held outside of banking operations," Miller said.
On Friday, Standard & Poor's cut the credit rating of Countrywide to junk status on concerns that Bank of America may not support as much as $24 billion of the mortgage lender's debt once it completes its proposed takeover.
Countrywide, in a February regulatory filing, had said a loss of its investment grade rating would result in the acceleration of some secured debt obligations and hurt its ability to manage and hedge its inventory of loans.
In addition to increasing Countrywide's financing costs and potentially hurting its ability to attract and retain bank deposits, up to $4.2 billion of its custodial deposits could be transferred to another bank if it were cut below investment grade, the company had said.