How Countrywide Home Loans Was Brought Down

One of the first lenders to fail during the financial crisis was America’s No. 1 residential lender. A new report examines what went wrong and what lessons might be learned as a result.

The Wall Street Journal’s headline read, “Countrywide writes mortgages for the masses.” The fast-growing home loans company had just overcome the traditional banks to become America’s top residential lender in December 2004.

Angelo Mozilo, the company’s CEO, told the newspaper that the company’s success was due to a concentration on its core business, and he unveiled ambitious intentions to double its market share to 30%. The company also bragged that it had ‘assisted millions of people in realizing their dream of homeownership.’

The momentum seemed unstoppable across the country. It disbursed a remarkable $2.2 trillion in loans between 2000 and 2006. It had a 17% market share, $2.7 billion in revenue, and was ranked 122 on the Fortune 500 at the conclusion of that time — hardly hallmarks of a corporation in trouble.

However, as home values in the United States began to plummet, Countrywide’s fortunes began to change. Its stock price plummeted without warning in the second half of 2007, and the business was only able to avoid bankruptcy by agreeing to a $4.1 billion “fire sale” to Bank of America in January 2008.

Countrywide has several lessons for regulators, according to Professor Anne Wyatt, an accounting expert at UQ Business School. Professor Wyatt and her colleagues at the University of Technology Sydney, Dr. Willoe Freeman, and Professor Peter Wells, spent months analyzing the company’s records and business operations to figure out what caused its rapid rise and abrupt demise.

Professor Wyatt stated, “Countrywide demonstrated many of the business practices found among financial institutions in the years preceding up to the crisis.” “As a result, it provides us with valuable information into the causes of the incident and how to avoid it in the future.”

So, what went wrong at the country’s largest mortgage lender?

1. An unsustainable business model

   Countrywide was founded in 1969 and raised funds for mortgage lending through traditional means, such as depositors’ deposits. Because of the necessity to obtain cash for its lending operations, the company’s size was necessarily limited.

   Mortgage loans had to be insured against default by borrowers, either through the government or commercial insurers, who set their own lending requirements to ensure quality. To signify that the loans met the standards, they were labeled as “conventional” or “conforming” loans.

   However, beginning in the 1980s, the government began to ease credit regulations and expand access to home loans. Mortgages can now be bundled together and converted into securities for resale to investors.

   Because other investments were generating modest returns at the time, these high-earning securities found a receptive market. Unlike traditional banking, where mortgages are classified as liabilities on the balance sheet, they were classified as sales and offered an instant stream of revenue.

   Professor Wyatt explained, “Countrywide created a viable business model of originating and securitizing mortgage loans.” “However, it could only be sustained as long as property values rose. Although securitization was required to maintain liquidity, it resulted in the corporation becoming overleveraged and in financial distress.”

2. Increased sub-prime lending

   Countrywide, on the other hand, was taking more and more chances. The risk connected with the mortgages was ostensibly passed on to investors, but this was a ruse. There were formal stipulations in the contract that stated Countrywide would keep the riskiest tranche of the securitization, as well as an unwritten agreement that Countrywide would give remedies if borrowers defaulted. However, there was no motivation to maintain credit standards because of the perceived ability to pass on the risk.

   Between 2000 and 2005, the government’s share of loans underwritten fell from 69 percent to 35 percent. Over the same time period, prime non-conforming loans grew from $11.4 billion to $211.8 billion, while subprime loans grew from $5.4 billion in 2000 to $40.6 billion in 2006.

   Even where borrowers defaulted, the homes could usually be sold at a sufficiently high price to repay the loan and generate a profit while house prices were still increasing, masking the difficulties.

   The hazards, on the other hand, were recognized in the media as early as 2004. Indeed, Mozilo was obliged to defend the company’s tactics in the Wall Street Journal interview, denying that he was pursuing growth at the price of profitability. He stated, “I’m fairly convinced that we won’t do anything stupid.”

3. Lack of transparency

   While securitization can be a good strategy to fund expansion and spread risk, it can also cause problems if the risks aren’t clear. Investors buying these bundled investments from Countrywide were unable to assess the quality of the mortgages and were unaware of the hazards.

   The growing quantity of available funds allowed for a spectacular and unregulated expansion of mortgage lending as they continued to invest in securities.

   Another issue was that, because securitization allowed any gains to be realized upfront rather than spread out over the life of the loans as in the traditional banking model, it allowed Countrywide to grow more quickly, but it also increased the volatility of its revenues. This volatility was represented in the financial data, but shareholders were not aware of it until the company was in serious trouble.

   “From the delay in stock price movements, it is evident that investors did not grasp either the dangers connected with mortgage securities or Countrywide’s revenue stream,” Professor Wyatt and her colleagues write.

4. Poor governance

   Angelo Mozilo, Countrywide’s ambitious CEO, was instrumental in propelling the company ahead. He started working as a messenger at a mortgage company when he was 14 years old and founded Countrywide with an older colleague when he was 30 years old. Mozilo served as both CEO and Chairman of the Board, and the fact that he paid more than the following five executives combined implies he wielded significant power over the board.

   According to the researchers, “Mozilo’s dual job raises the question of power balance and underscores the significance of having independent directors on the board to monitor the company’s activities.”