Mortgages from Countrywide

THE big question facing Countrywide Financial Corp. - and every mortgage lender, for that matter--is whether earnings will dry up once interest rates start to rise in earnest.

The explosion of new home loans and refinancings that represent a whopping 75 percent of loan volume shows little sign of slowing. Yet Calabasas-based Countrywide has been unable to shake the view on Wall Street that its earnings are highly cyclical--wedded to a mortgage cycle that is beginning to ebb.

The stock, now at $58 a share, trades at roughly the same price it did at the peak of the Last mortgage cycle in early 1999. But its earnings are 2.5 times higher today.

"Investors got burned in the previous downturns of 1994 and 2000," said Bill Roy, a Merrill Lynch banking analyst who noted that shares are 50 percent cheaper on the basis of its price/earnings ratio than they were four years ago. "The market got smart and now refuses to pay up for what it is convinced are cyclical earnings."

Countrywide is trying to convince Wall Street that its situation has changed. Industry competition should help reduce price competition in the next downturn, sympathetic analysts point out, and the company has set aside $2 billion of impairment reserves that will offset interest rate hedging losses.

In the downturn of 1999 to 2000, the industry was more competitive, impairment reserves did not exist and writedowns to the mortgage servicing rights asset were only half the level they are today, said Roy, who rates Countrywide a strong buy.

The 'macro hedge'

Countrywide and other mortgage lenders typically pool loans they originate and sell them in the secondary market, primarily to Fannie Mae or Freddie Mac, public companies that operate under government charter.

When Countrywide sells these loans, it retains the rights to service them and under current accounting rules, books an asset representing the estimated future cash flows from servicing. The asset is called a mortgage servicing right.

When interest rates decline and refinance levels are high, Countrywide is required to write down its MSRs as loans in its servicing portfolio are refinanced. Countrywide says it has been aggressive in doing so.

Conversely, when interest rates rise and refinances wane, the writedowns go away and servicing income increases, while loan production income suffers. This is what's called a "macro hedge" and has also been part of Countrywide's strategy.

Last month, Fitch Ratings placed Countrywide on notice that it could see a downgrade on its debt rating if interest rates fell further, because of concern about the valuation and durability of its MSRs.

Fitch also cited Countrywide's subprime loans, home equity lines of credit, jumbo mortgages and adjustable-rate mortgages as "far more difficult to model and hedge" than conventional mortgage products.

If rates rise, on the other hand, Countrywide's MSR amortization rates and expenses should decline, along with impairment reserves. This should allow the company to achieve modest earnings growth in a rising interest rate environment, said Stanford Kurland, Countrywide's chief operating officer.

"The burning question is always how will we do in the post-refi market," he said. "The fact is that the servicing asset performs well in a rising rate environment."

Countrywide, the nation's third-largest mortgage issuer, saw new loan fundings grew 82 percent in 2002, to $252 billion. Countrywide now controls about 10 percent of the market, and boasts a servicing portfolio of $469 billion as of Jan. 31, which threw off $2 billion in fees last year.

Countrywide has also taken steps into other business areas with units in insurance, capital markets, global operations and banking that leverage the company's existing mortgage business. The company has become a big producer of title policies, appraisals, credit reporting and flood determination.

While those added services contribute more than 30 percent to earnings, during a downturn the contribution will drop considerably.

One issue that could also be weighing on the stock is significant insider selling. In March alone, Angelo Mozilo, Countrywide's cofounder, chairman and chief executive, pocketed more than $4.7 million selling stock.

"Insider sales are troubling," said Mike McMahon, managing director at Seidler O'Neill & Parnters. "What's disappointing about that is they've been saying that the company is undervalued. But it seems to me that if you've got a great company with earnings that are exploding, and it's undervalued, you should be a net buyer."

Useful home loan links