Happy Anniversary Countrywide! Or is it Back to the Future?

I am reminded that this is the 5-year anniversary of the emergency Fed Discount Rate cut in response to the collapse of Countrywide Financial (CFC) earlier that week.  See the Board of Governors of the Federal Reserve press release below.  Note that CFC was not mentioned in their release. Thanks to the former CFC officer for the heads up.

Release Date: August 17, 2007

For immediate release

“To promote the restoration of orderly conditions in financial markets, the Federal Reserve Board approved temporary changes to its primary credit discount window facility. The Board approved a 50 basis point reduction in the primary credit rate to 5-3/4 percent, to narrow the spread between the primary credit rate and the Federal Open Market Committee's target federal funds rate to 50 basis points. The Board is also announcing a change to the Reserve Banks' usual practices to allow the provision of term financing for as long as 30 days, renewable by the borrower. These changes will remain in place until the Federal Reserve determines that market liquidity has improved materially. These changes are designed to provide depositories with greater assurance about the cost and availability of funding. The Federal Reserve will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets. Existing collateral margins will be maintained. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York and San Francisco.”

“By Wednesday of that August week, CFC was unable to roll commercial paper (CP) necessary to fund its primary mortgage banking operations and was forced to draw $11.5 billion from backup credit lines,” notes the former CFC officer.  “CFC was immediately downgraded by Moody’s from A3 to Baa3, with CP ratings dropped to P-3 from P-2. Viewing the matter as systemic, the Fed arranged an unscheduled meeting on August 17 in which it reduced the discount rate by 50 basis points.  On the following Wednesday, BofA invested $2 billion in CFC as sole buyer of convertible preferred stock. Under the investment agreement, BofA was granted the right of first refusal to match the terms of any third party to purchase CFC, a fait accompli of a the eventual 2008  acquisition of CFC by BofA.”

“Except for a few prescient hedge fund investors, few recognized this as the starting bell for the ensuing global panic of 2008,” he adds. “The Dow went on reach its high of 14,164+ in October,2007.”

Even today, with all that has been written about the collapse of Countrywide, not enough is said about the incredible negligence of the Fed and other regulators when it came to CFC.  Here was the largest mortgage originator in the US, a bank holding company that had just converted into a thrift to maximize regulator arbitrage opportunities, which was funded by Bank of America’s deposits.  But nobody at the Fed knew or cared.

CFC was turning over its $250 billion balance sheet several times a year in terms mortgage originations and most of that funded by BAC and the commercial paper markets.  Yet the folks at the Fed were caught by surprise by the collapse of CFC.  This massive failure by the Fed’s Division of Supervision and Regulation refutes forever any notion that regulators can be effective in a democracy.  CFC CEO Angelo Mozilo, his colleagues in the mortgage banking industry and the Congress successfully intimidated regulators into a state of passivity.

Keep in mind on this count that CFC had been taking material charges since the early part of the year 2007.  Anybody with any common sense looking at the charges CFC took in Q1 and Q2 of 2007 would have had a pretty good idea that the patient was dying due to a lack of new volumes and changing risk preferences by counterparties.  CFC had a whole team of people watching liquidity issues, for example, from the start of 2007.  But again, nobody in the regulatory community said a word about CFC specifically, even though general warnings about the mortgage sector were growing at agencies such as the FDIC.

To be fair, the ratings published by The IRA Bank Monitor had CFC’s lead bank at “A” through the first part of 2007, a confirmation that public company disclosure is next to useless to help investors understand risk.  The bank was considered “well capitalized” by regulators until Q4 2007, when CFC’s lead bank showed a “C” rating with above-average operational stress compared to the industry.  By Q1 of 2008, CFC was a dead “F” in the IRA Bank Monitor with a public data CAMELS rating of “5,” the worst score on the regulatory scale.

Mozilo has admitted in depositions from the massive litigation against CFC that he was aware of the operational risks involved.  CFC had won top market share in the market for conforming and non-conforming loans by being more aggressive and also better prepared operationally than competitors.  But that also meant that the totality of CFC production included a toxic portion of bad credits.  Large banks with double digit shares are subsets of the total market and thus cannot achieve any significant diversification of risk.  So today when we look at Wells Fargo at more than 40% national market share in residential originations, does this represent a red flag?  Ya think?

Another former CFC risk officer says that the “starting bell” of the meltdown was 6 weeks earlier.  “When S&P and Moody's had emergency calls to say their models were CRAP.  That is when the run started.  Three weeks after that, CFC earnings call said that credit deterioration was really bad, for everyone.”

Five years later, the real legacy of the failure of CFC, Bear, Stearns & Co and Lehman Brothers has been a vast reduction in competition in the mortgage sector.  “Banks don’t make loans, that is the problem.  BAC is made up of 39 different banks.  Each time they acquired an institution, they lost at least half of the loan officers.”

The good news is that the non-bank mortgage sector is regenerating, green shoots if you will.  The new players in non-bank mortgage finance are not well known to the Street, but you will hear about them soon enough.  As commercial banks withdraw from many of the more capital intensive portions of the mortgage equation, new non-bank underwriters will fill the void.  But building up the scale and resources needed to originate loans in the brave new world of national mortgage regulation will take time.

So ask not why Chris is isn’t working on bank M&A deals, but ask instead what I am working on.  That would be non-bank mortgage finance.  Think CFC before Angelo bought his bank in 2001.  More on this soon.  And do enjoy the rest of summer.