Bank of America ( BAC - Get Report) on Tuesday closed its $2.5 billion acquisition of Countrywide Financial ( CFC), but the pain caused by the deal may only be beginning.

The all-stock deal, originally worth $4 billion when it was struck in January, makes Bank of America the nation's leading mortgage originator and servicer, while protecting its $2 billion preferred stock investment made in 2007, along with another $3 billion invested in Countrywide's common stock.

"Mortgages are one of the three main cornerstone consumer financial products along with deposits and credit cards," BofA Chairman and CEO Kenneth Lewis said in a company statement. "This purchase significantly increases Bank of America's market share in consumer real estate, and as our companies combine, we believe Bank of America will benefit from excellent systems and a broad distribution network that will offer more ways to meet our customers' credit needs."

The market, however, is clearly biased against the deal. BofA shares have fallen nearly 40% since the deal was initially announced in January and nearly 12% since Countrywide shareholders approved it last week. BofA shares were recently trading at $23.46 on Tuesday, or just 75% of book value.

BofA said it "will continue its long-established policy of not originating subprime mortgages" and will discontinue certain nontraditional mortgages, such as option-adjustable-rate mortgages. These are mortgages that give borrowers the option of making a monthly payment lower than the interest that accrued the previous month. When borrowers take the lowest payment option, the loan balance increases, a process called negative amortization. BofA also will "significantly curtail" certain low-documentation loans and other nontraditional loans.

What BofA is Getting

Despite BofA's de-emphasis on exotic loans, the bank is taking on $27 billion in option-ARMs among the $95 billion portfolio of Countrywide mortgages held for investment. As of March 31, the majority of the option-ARMs -- $24.8 billion -- had accumulated negative amortization of $1.3 billion. Considering that the original loan-to-value ratios of many of these loans approached 100%, most are likely to be "upside down," meaning loan's balance exceeds the value of underlying home, in light of the decline in property values.

BofA coveted Countrywide's mortgage servicing business. For 2007, Countrywide reported net loan servicing revenue of $910 million on its $1.45 trillion servicing portfolio, down from $1.3 billion in 2007 and $1.5 billion in 2006. The slide was due to impairment charges, which were partially offset by gains on servicing hedges. Countrywide's fair value estimate of the mortgage servicing rights was $19 billion as of March 31.

While Countrywide's first quarter net loss may have seemed relatively modest at $893 million, there were $3.1 billion in total credit charges during the quarter. Loan loss reserves totaled $3.4 billion as of March 31, or 3.58% of the mortgage portfolio held for investment. Reserves covered a decent 66% of nonaccrual loans. Loan loss provisions for the quarter totaled $1.5 billion, greatly exceeding net loan charge-offs for the first quarter of $606 million. "Losses absorbed by credit-sensitive retained interests" totaled $923 million, the company reported in a Securities and Exchange Commission filing.

In a June 4 research report, Merrill Lynch's Edward Najarian reiterated his underperform rating on BofA, estimating a 13% loss rate on Countrywide's mortgage portfolio, which "could produce about a $10 billion to 12 billion purchase accounting mark-to-market."

The Merrill report set a price objective of $28 for Bank of America's common shares, and stated that the collection of businesses would have considerable value "after credit related costs finally begin to normalize (in 2010-2011)."

Litigation Risk and Dicey 'Piggies'

BofA will inherit quite a few legal headaches from Countrywide, starting with civil proceedings initiated by the states of California, Florida and Illinois. Connecticut is expected to follow shortly.

California's civil complaint against Countrywide, outgoing CEO Angelo Mozilo and Countrywide Home Loans President David Sambol, alleges Countrywide pushed hybrid mortgages such as option-ARMs that were hard for borrowers to understand, "emphasizing the very low initial 'teaser' or 'fixed' rates while obfuscating or misrepresenting the later steep monthly payments and interest rate increases or risk of negative amortization."

The California complaint goes on to accuse Countrywide of encouraging costly "serial refinancing," routinely soliciting borrowers to refinance their relatively new Countrywide loans, thus generating more fees. In some cases, borrowers looking to refinance before expensive payment resets would be surprised to find out that there was a prepayment penalty.

The complaint delves into many practices that exploded industry-wide during the housing boom, including piggyback loans -- called "piggies" in the suit -- which allowed borrowers to take a simultaneous second mortgage to fund some or all of their down payments. Sometimes these arrangements would push the loan-to-value ratio above 100%.

The complaint also alleges high-pressure sales tactics and arrangements designed to encourage mortgage brokers to push borrowers into higher-rate loans than they would otherwise have qualified for, and into loans with prepayment penalties. In fairness to the brokers, the "rate spread premium" has been a common practice in the industry, and while some people have complained about it, regulators haven't considered it to be an abusive practice.

California's complaint goes on to rail about a continued lowering of underwriting and documentation standards, increasing borrowers' risk of default. These practices also were common all over the industry during the housing boom and the rapid increase in loan securitization. California stated that Countrywide's purpose was to "maximize profits from the sale of loans to the secondary market," and "earn greater profits from servicing the mortgages it sold." No surprise there. Countrywide's motivation was to grow its business and make money.

Likelihood of Success?

The complaint asks Countrywide and the other defendants each pay a $2,500 penalty per violation. With thousands of loans involved, that could be a pretty penny.

"This puts a cloud over the Bank of America deal, says Kurt Eggert, a professor at Chapman University School of Law in Orange, Calif. "No one knows how likely it is the states will succeed, and if they do, how much it will cost Bank of America."

In this kind of civil suit, the defendant will typically file a motion stating the claim is defective, as the state doesn't have a right to file this type of lawsuit. "They will try to get a judge to throw it out before the other side engages in discovery," according to Eggert.

Joel Hesch, a law professor at Liberty University in Lynchburg, Va. and a former Fraud Division Attorney with the Justice Department, said there's a possibility the Justice Department could sue BofA under the False Claims Act, in connection with the $3 billion in repurchased defaulted Federal Housing Administration-insured and Veteran's Administration-guaranteed loans on Countrywide's books as of March 31.

"The FCA, however, would not apply simply because a loan defaulted," Hesch says. "There must have been fraud at the time the loans were guaranteed."

Another potential factor in considering the impact of the lawsuits is the debate over "preemption," or federal regulators' primary role in regulating banks with national charters and their subsidiaries.

Federal regulators are of the opinion that state law enforcement authorities have no business trying to regulate national banks or federal savings and loan institutions. This is why Comptroller of the Currency Bruce Dugan was against New York Attorney General Andrew Cuomo's recent deals with Fannie Mae ( FNM) and Freddie Mac ( FRE) that require those government-sponsored enterprises to demand banks selling loans to them to stay out of the home appraisal business.

According to Dugan, Cuomo overstepped his authority, since the deals with the GSEs would affect the way national banks did business. Of course Cuomo and many others are of the opinion that their actions were only necessary because federal regulators failed to regulate.

Similarly, Countrywide's regulator, the Office of Thrift Supervision could feel that the states are over-stepping their bounds with the civil suits. The OTS declined to comment for this article.

How Bad Can it Get?

BofA faces other possible distractions from the media coverage of the loan discounts made to members of the Senate Banking Committee, under Mozillo's " Friends of Angelo " lending program.

The big question is, how bad can things get for the Countrywide's portfolio?

Merrill's $10 billion to $12 billion loss range estimate assumes a 13% loss rate on Countrywide's combined mortgage portfolio, including home equity loans. As of March 31, Countrywide reported that 6.86% of its serviced portfolio was delinquent 90 days or more. Clearly there's quite a way to go before the Countrywide's portfolio piles up the additional losses Merrill expects. Then again, maybe we're not as far along in this credit cycle as we thought.

BofA is hoping to muddle through and over the long haul remain the biggest mortgage lender with a fat loan servicing cash cow. Over the next year or two, investors will be at the mercy of the quarterly headlines trumpeting the latest quarterly loan statistics and comparing year-over-year financial results hit hard by bad loans to better times.

BofA's shares have dropped so far that the common stock is now yielding 10.4%, which indicates the market is expecting the bank to cut or suspend its dividends. BofA common stockholders face the prospects of diluted investments over the next several quarters if the company is forced to sell new common shares to raise a large amount of additional capital as it works through the Countrywide mess.

Philip W. van Doorn joined Ratings., Inc., in February 2007. He is the senior analyst responsible for assigning financial strength ratings to banks and savings and loan institutions. He also comments on industry and regulatory trends. Mr. van Doorn has fifteen years experience, having served as a loan operations officer at Riverside National Bank in Fort Pierce, Florida, and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a Bachelor of Science in business administration from Long Island University.