America’s No.1 residential lender was one of the first to collapse in the financial crisis. Now a new report analyses what went wrong and what lessons we can learn from it.
‘Countrywide writes mortgages for the masses’ read the headline on the Wall Street Journal. It was December 2004 and the fast-growing home loans company had just overtaken the big banks to become America’s top residential lender.
CEO Angelo Mozilo told the paper that the company’s success was due to focusing on its core business and announced ambitious plans to double its market share to 30 per cent. Elsewhere the company boasted that it had ‘helped millions to achieve their dream of home ownership’.
Countrywide seemed unstoppable. Between 2000 and 2006, it gave out a staggering $2.2 trillion in loans. By the end of that period, it had a 17 per cent share of the market, an income of $2.7 billion and was ranked 122 on the Fortune 500 – hardly signs of a company at risk.
However as US house prices began to collapse, Countrywide’s fortunes turned. In the second half of 2007 its stock price crashed with little warning and the company averted bankruptcy only by agreeing to a $4.1 billion ‘fire sale’ to Bank of America in January 2008.
According to Professor Anne Wyatt, an accounting expert with UQ Business School, Countrywide has many lessons for regulators. Professor Wyatt and her fellow researchers Dr Willoe Freeman and Professor Peter Wells of the University of Technology Sydney spent months analysing the company’s accounts and business practices to understand the factors behind its meteoric growth and its sudden demise.
“Countrywide exhibited many of the business practices observed among financial institutions in the years leading up to the crisis,” said Professor Wyatt. “Therefore it offers us an important insight into the causes and how to prevent any future crash.”
So what went wrong at America’s number one mortgage lender?
An unsustainable business model
Founded in 1969, Countrywide originally raised the money for mortgage lending in the traditional way – from deposits from savers. This need to raise funds for its lending operations naturally constrained the scale of its operations.
Mortgage loans also had to be insured against the risk of borrowers defaulting, either with government or private insurers, which imposed their own lending criteria to ensure quality. Loans were called “conventional” or “conforming” loans to indicate they complied with the criteria.
However from the 1980s, the government relaxed credit rules and broadened access to home loans. Companies could also now bundle mortgages together and convert them into securities to sell on to investors.
With low returns on other investments at the time, these high-yielding securities found a ready pool of buyers. In contrast to traditional banking, where mortgages remain as liabilities on the balance sheet, they were classed as sales and provided an immediate source of income.
“Countrywide adopted a business model of originating and securitising mortgage loans that was initially profitable,” said Professor Wyatt. “However it was only sustainable while property values were rising. Securitisation was necessary to ensure liquidity but it led to the company becoming overleveraged and in crisis.”
Increased sub-prime lending
Meanwhile Countrywide was taking increasing risks. Ostensibly, the risk associated with the mortgages was passed on to investors, although in fact this was a façade. There were legal clauses in the contract under which Countrywide retained the riskiest in the securitisation tranche, as well as unwritten agreement that Countrywide stood ready to provide recourse should borrowers default. However as a result of the apparent ability to pass on the risk, there was little incentive to maintain credit standards.
From 2000 to 2005, the proportion of loans underwritten by the government dropped from 69 per cent to 35 per cent. Prime non-conforming loans increased from $11.4 billion to $211.8 billion over the same period, while subprime loans increased from $5.4 billion in 2000 to $40.6 billion in 2006.
While house prices were still rising, the problems were masked as even where borrowers did default, the homes could usually be sold at a sufficiently high price to repay the loan and return a profit.
However the risks were recognised in the media as early as 2004. Indeed, in the Wall Street Journal interview, Mozilo was forced to defend the company’s practices and deny that he was chasing growth at the expense of profitability. “I’m fairly confident that we’re not going to do anything stupid,” he said.
Lack of transparency
While securitisation can be an effective way to fund growth and diversify risk, problems can arise if the risks are not transparent. In Countrywide’s case, investors buying these bundled investments were not able to evaluate the quality of the mortgages and were not fully aware of the risks.
As they continued to invest in securities, the increased supply of available capital allowed for a dramatic, unchecked expansion of mortgage lending.
Another problem was that, because securitization allowed any gains to be made at the start rather than spread over the full term of the loans as in the traditional banking model, it allowed Countrywide to grow more rapidly, but it also made its revenues more volatile. This volatility was reflected in the financial data but was not recognised by shareholders until the company was deeply distressed.
Professor Wyatt and her colleagues state: “From the delay in the timing of stock price responses, it is clear that investors did not understand either the risks associated with mortgage securities or with Countrywide’s revenue stream.”
Poor governance
Countrywide’s ambitious CEO Angelo Mozilo played a central role in driving the company forward. A butcher’s son from the Bronx, he started work as a messenger at a mortgage company at the age of 14 and set up Countrywide with an older colleague in 1969 when he was 30. Mozilo was both CEO and Chairman, and the fact that he earned more than the next top five executives put together also suggests he held strong influence over the board.
“Mozilo’s dual role raises the issue of balance of power, and highlights the importance of having independent directors on the board to monitor the company’s activities,” say the researchers.
Rewarding risk taking
Another factor was that management compensation at Countrywide was linked to increases in stock price, which allowed Mozilo to secure large gains. In 2006 he realised stock options totaling $285 million. Later that year the company reported a loss of $703.5 million and a fall in the stock price of over 90 per cent.
Mozilo’s actions were investigated and he was charged with insider trading and fraud but agreed to a $67.5m settlement and was banned from serving as a director.
Professor Wyatt added: “The compensation structure at Countrywide provided incentives to pursue a high-risk business model and focus on short-term gains. This could have been addressed by imposing restrictions on the realisation of options or equity grants for extended periods.”
Professor Wyatt and her colleagues believe that Countrywide provides a massive reality check for the banking industry. “It’s time for a ‘back to fundamentals’ approach in banking and finance, where credit quality is sacrosanct, and success in getting the loans back in and not loan volume drives executive compensation,” they argue. “Transactions such as securitisation that are primarily designed to fund expanded operations should also be accurately classified as financing transactions and accounted for as such on the balance sheet.”