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I’ve spent the last few days on the couch, felled by some nasty virus my children brought back from their first week of school. The week has not been a total write off . I’ve had plenty of time to plow through the financial statements of companies at ground zero of the current financial crisis. First on the list is Countrywide Financial.

Countrywide Financial is HUGE. It has 60,000 employees, about the same number as American Express. It services (i.e. collects the money) for $1.3 trillion worth of mortgages. It makes $500 billion + worth of mortgages each year.

They had a really sweet business model, at least in concept.

Countrywide sold most of the loans it originated, but retained the servicing rights. Servicing a loan entails collecting monthly payments and taking calls from homeowners. The company who services a loan gets a chunk of the interest payments, along with all the fees someone gets hit with (late fees, online payment fees, prepayment fees). The servicer also gets the float on escrow accounts (the money people pay along with their interest payments to cover property taxes and insurance) as well as some float on the interest before it goes to the mortgage owner.

Countrywide did keep some some of the loans it made. Most of the loans they kept were home equity loans and pay option loans made to prime borrowers with significant collateral. These offered higher returns than conventional mortgages yet were still fairly low risk (in theory). Countrywide created a bank to house these loans which were financed by the float from the interest payments and escrow accounts of serviced mortgagees, supplemented with retail deposits and money borrowed on the cheap from FHLB .

There are some clues that they were anticipating some problems. Early this year they converted from being a bank to being a thrift. This got them friendlier regulators and eased capital requirements at the holding company level. They stopped adding assets to the bank. The CEO decided he needed to “diversify” his financial holdings and started dumping stock.

They were not the worst offenders in the mortgage business, despite recent bad press. In the scheme of things, they issued relatively few subprime loans. They do seem to collect a lot of fees, but this nickel and diming (a couple hundred million here and a couple hundred million there) is endemic to the entire financial industry.

Countrywide’s biggest problem was (is) that their balance sheet was a train wreck waiting (starting) to happen.

I had assumed going in that Countrywide was a serious cash cow. I was wrong.

Over the last few years, Countrywide reported profits of about $2.5 billion/ year. It generated virtually zero cash. At first, I shrugged this off. Cashflow tends to be a challenging metric to apply to financial companies.

Then I dived into the numbers.

There is something about the phrase “retain” rights that made me think that Countrywide made money selling on the mortgages and then got the rights thrown in, kind of like the proverbial toaster with the bank account.

Not so. It turns out that the chunk of the interest payment a servicer receives is way more than the cost of providing the service.

The servicing rights along with rights to some residual cashflow from the mortgages, excluding the value of the float and miscellaneous fees as well as the cost of actually servicing the loans, are worth about 1.5-2% of the value of the loan on an upfront basis.

Countrywide includes the value of these rights when they calculate profit. Before expenses, Countrywide was only clearing 1% on the sale of prime loans. This means that they calculated that they got something worth 2% by only paying 1% for it. Countrywide was actually out of pocket $4 billion for the $400 billion of prime loans they originated last year and maybe broke even on cashflow basis on the subprime loans they did and somewhere in between on home equity loans. And this was before spending $4.5 billion on a massively ramped up sales force to actually make the loans.

Countrywide has to borrow a lot of money.

It needs to borrow money to pay for the mortgage servicing rights, which are one part service contract and one part interest only mortgage security, which look kind of like a 5 year bond but one that disappears if people decide to prepay mortgages early (bad) and one that turns into a longer stream of payments if people don’t prepay (good).

It needs to borrow money to make loans, even if that loan will be sold off.

It needs to borrow money to make loans that it wants to hold.

It even needs to borrow money to collateralize the hedges it has to try and lock in the value of its mortgage servicing rights which can dramatically change if interest rates change or if loans are repaid faster than they expected.

Remember, the portfolio is financed via float from the mortgage servicing business, retail and commercial short term deposits, borrowings from FHLB, and other very short financing.

The float disappears if they don’t originate mortgages to replace those that get paid off. The retail deposits are generally “hot money”, seeking the highest yield, the short financing is short. Only the FHLB money is longer term- and I have no idea how long term.

Okay, this is an organization that has some serious balance sheet “challenges”, even in the boomtime of all boomtimes. Its 2006. You are Countrywide management. You know your industry is displaying signs of “froth”. You actually stop adding to your mortgage portfolio. It might be a good time to borrow some money and get a little more capital on your balance sheet, maybe even sell some stock to get equity capital.

You do go ahead and issue some debt – but not for the purpose of bolstering your balance sheet and institutional longevity. You issue it to buyback 60 million shares of stock, and bolster your stock price. It is, of course, a complete coincidence that your CEO decides to dump sell his millions of shares at the same time.

Fast forward to August 2007. The mortgage market finally collapses. You have to sell stock to get the necessary capital to stay alive at less than half the price you bought it for 6 months early. Whoops.

Apparently the class action lawyers are circling, salivating about the CEO’s suspicious stock sales. Note to board members of cyclical companies: think twice before loading up your top executives with equity-based compensation or at least be suspicious about proposed massive stock buybacks.

If I were a shareholder (which I’m not), I would be much more concerned about the basic business model.

The hold some mortgages and finance them part of the business looks shaky – credit writeoffs will likely outweigh any profit from lending money at higher rates than you are borrowing it.

The mortgage origination business is very shaky. Countrywide published some updated financials. Mortgage volume has collapsed and the business they are doing is barely profitable.

They have cut some jobs, but with the need to continue to attract retail deposits and service existing troubled mortgagees, their ability to really downsize is limited.

The only good news is that late fees will definitely be up.

In the meantime, Countrywide will need to continue borrowing money to finance purchases of servicing rights. Who in their right mind wants to lend these guys money?

If they went to the capital markets, they would have to pay very high rates of interest. So instead, they are moving their whole business “inside the bank”. This means they can use retail deposits and CDs to finance their operations. FDIC insured deposits and CDs. At the end of the day, the US taxpayer is effectively taking the risk of a financial institution that definitely failed Balance Sheet 101 earlier this year. Countrywide’s decision to change regulators this year to one reputed to be more lenient now makes a lot more sense…

Topics: Economy, Housing Bust, Investments | Comments Off on Countrywide

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