Countrywide’s Risky Business is Starting to Slow Down…
by Graham Summers
July 31, 2006
The first signs of a sub-prime mortgage slowdown showed up last week in Countrywide Financial’s (CFC) second quarter results…
If you’re unfamiliar with the term, “sub-prime lending,” it’s basically money lending to individuals with limited or bad credit. In other words, it’s risky business.
With a $22 billion market cap and $427 billion in loans in 2005, Countrywide is the 800-lb gorilla of sub-prime mortgage lending. Inside Mortgage Finance ranked the company as the second largest retail lender, in terms of volume, for domestic residential retail mortgage lenders in 2005.
And things are starting to slow in the beast…
Countrywide’s net income rose 27% in the second quarter. However, the company lowered its loan production range to $400-$475 billion from $400-$550 billion.
This theme of increased current profitability matched with lower future expectations is going to be turning up a lot more as mortgage lenders fish deeper and deeper at the bottom of the consumer liquidity pond.
Their current quarry is the bad credit having, small-pocketed consumer. And the bait they’re using is the pay option adjustable-rate mortgage (ARM): a mortgage loan in which the borrower can choose of several pay options every month.
Among these options is a monthly payment below interest. In other words, consumers can now pay mortgages even lower than the interest due on their initial loan.
It seems like a great deal, until you realize that the interest you’re failing to pay is tacked on to your principle amount. Let’s say your loan is for $100,000 with a monthly interest of $500. A typically pay option ARM would allow you to pay only $400 a month. The extra $100 would then be tacked on to you initial $100,000 loan. So at the end of the first month, you now owe $100,100.
This idiocy can continue for several years until the loan balance hits a certain point (usually 25% more than the initial amount, so 125% total). At that point, your payments are immediately raised to the full amount required to pay off both interest and principle based on the original loan. And thanks to your option of paying off less than principle, you now owe $125,000 instead of $100,000.
But if you couldn’t even afford to pay the interest on a $100,000 loan to begin with, how are you going to cover a full mortgage payment on a loan of $125,000?
In terms of total dollar volume, pay option ARMs made up almost 10% of all residential mortgage loans in 2005. For Countrywide Financial, these loans made up 19% of total revenues. This business is banking on an extremely risky demographic for its revenues.
Subprime lending comprised 34% of all mortgage originations in the U.S. for the first three months of 2006. If a slowdown in mortgage lending is coming, this will be the first segment to show signs of trouble. Countrywide’s lowering of loan production certainly isn’t much to inspire confidence.
And neither is its insider trading…
Countrywide insiders have sold over $100 million worth of stock in 2006. A lot of these sales came as a result of options exercises. But considering that insiders haven’t bought this stock since August 2005, and that the largest purchase at that time was $32,000, I don’t think they’re counting on Countrywide’s current profitability lasting too much longer.
More on this subject to come…
Good investing,
Graham
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