Gamble−Thompson:
Essentials of Strategic
Management: The Quest
for Competitive Advantage,
Second Edition
Case
II. Cases in Crafting and
Executing Strategy
15. Countrywide Financial
Corporation and the
Subprime Mortgage
Debacle
© The McGraw−Hill
Companies, 2011
15
Countrywide Financial Corporation
and the Subprime Mortgage Debacle
Ronald W. Eastburn
Case Western Reserve University
Angelo Mozilo, founder and Chairman of
Countrywide Financial Corporation, was the
driving force behind the company’s efforts to
become the largest real estate mortgage originator in the United States and, according to
some, was also the driving force behind the
company’s eventual collapse. Mozilo and partner, David Loeb, founded Countrywide in 1969
in New York with the strategic intent of creating a nationwide mortgage lending firm. The
company opened a retail branch in California in
1974 and, by 1980, had 40 offices in eight states.
Mozilo and Loeb launched a securities subsidiary in 1981 that specialized in the sale of mortgage-backed securities (MBSs).1 The company’s
annual loan production exceeded $1 billion in
1985 and began to grow at dramatic annual
rates on the back of the U.S. housing market
bubble which began in 1994 and ended in 2006.
The company’s greatest number of annual loan
originations had occurred by the time of David
Loeb’s death in 2003, with more than 2.5 million
mortgage originations that year. Countrywide
Financial Corporation originated more than
2.2 million loans totaling $408 billion in 2006.
By 2007, the company had 661 branches in 48
states and, in July 2008, was acquired by Bank
of America (BoA) for $4 billion in an all-stock
transaction. The market value of the company
had reached $24 billion in 2006, but fell rapidly
in 2007 when it became evident that many of
Copyright © 2010 by Ronald W. Eastburn. All rights reserved.
the mortgages Countrywide made during the
housing boom were overly risky and likely to
go into default.
Problems with Countrywide’s loan portfolio and lending practices were evident to BoA
management even before the acquisition
was consummated, with BoA investing over
$2 billion in Countrywide in return for a 16
percent stake in the company in August 2007
to stabilize the troubled mortgage firm’s balance sheet. Shortly after the acquisition BoA
management agreed to enter into an $8.7 billion
settlement with a group of state attorneys general over Countrywide Financial Corporation’s
(CFC) predatory lending practices. BoA allowed
Mozilo to retire from the Countrywide’s management team and, in June 2009, the Securities and Exchange Commission (SEC) indicted
Mozilo and two other key CFC executives for
fraudulent misrepresentation of the credit and
market risk inherent in CFC’s loan portfolio.
Investigation of Countrywide’s business
practices disclosed how the real estate market supported by U.S. federal legislative and
regulatory decisions fostered an environment
that resulted in the collapse of Fannie Mae and
Freddie Mac, major banking institutions, Wall
Street investment firms, and mortgage brokerage firms. The financial crisis of 2008 had at its
foundation subprime mortgages, mortgagebacked securities, and capital markets activity,
and as the nation’s largest mortgage lender, CFC
was a significant contributor to the subprime
527
Gamble−Thompson:
Essentials of Strategic
Management: The Quest
for Competitive Advantage,
Second Edition
528
Part Two:
II. Cases in Crafting and
Executing Strategy
15. Countrywide Financial
Corporation and the
Subprime Mortgage
Debacle
© The McGraw−Hill
Companies, 2011
Section D: Business Ethics and Social Responsibility
mortgage debacle. As the financial and credit
crisis continued to play out into 2009, BoA executives would need to ensure that lending practices at all of its subsidiaries would promote
homeownership in a manner that was in the
best interest of borrowers, investors in the secondary mortgage market, and the company’s
own long-term financial interests.
History of Mortgage Lending
in the United States
Before the Great Depression, home mortgage
instruments in the United States were typically
of short term (3–10 years) with loan-to-value
(LTV) ratios of about 60 percent. Loans at the
time were nonamortizing and required a balloon payment at the expiration of the term.
Mortgages were available to a limited client
base, with home ownership representing about
40 percent of U.S. households. Many of these
short-term mortgages went into default during
the Great Depression as homeowners became
unable to make regular payments or find new
financing to pay off balloon payments that
became due.
The United States government intervened in
the housing market in 1932 with the creation
of the Federal Home Loan Bank (FHLB). The
FHLB provided short-term lending to financial
institutions (primarily Savings and Loans) to
create additional funds for home mortgages.
Congress passed the National Housing Act of
1934 to further promote homeownership by
providing a system of insured loans that protected lenders against default by borrowers.
The mortgage insurance program established
by the National Housing Act and administered
by the Federal Housing Administration (FHA)
reimbursed lenders for any loss associated with
a foreclosure up to 80 percent of the appraised
value of the home. With the risk associated
with default on FHA-backed mortgage loans
reduced, lenders extended mortgage loan terms
to as long as 20 years and LTVs of 80 percent.
In 1938, Federal National Mortgage Association (FNMA) was established as a government
corporation to facilitate a secondary market for
mortgages issued under FHA program guidelines. FNMA allowed private lenders to make
a greater number of FHA loans since loans
could be sold in the secondary market and did
not have to be held for the duration of the loan
term. New loans could be generated each time
the lender sold large bundles of loans to investors in the secondary market. The FNMA also
purchased conventional conforming mortgages
from lenders. Conventional conforming loans,
unlike FHA mortgages, were neither guaranteed nor insured by the federal government.
In 1968, FNMA was reconstituted as Fannie
Mae and became a publicly traded government sponsored enterprise (GSE). This move
allowed the financial activity of Fannie Mae to
be excluded from the U.S. federal budget and
transferred its portfolio of government insured
FHA mortgages to a wholly owned government corporation, Government National Mortgage Association (Ginnie Mae). Fannie Mae’s
portfolio of conforming loans remained on its
balance sheet.
In 1970, the Federal Home Loan Mortgage
Corporation (Freddie Mac) was chartered as a
GSE and operated in a manner similar to Fannie Mae (although its shares were not traded
until 1989). Freddie Mac pooled conforming
loans and created mortgage-backed securities
(MBSs) which were sold as shares of the pooled
loans to investors. The interest yield for these
agency securities was between AAA corporate
and U.S. treasury obligations, reflecting the
low risk of the securities. The development of
MBS vastly expanded the secondary market for
mortgage loans since investors could purchase
shares of a loan portfolio rather than purchase
an entire portfolio of intact loans.
The value of Freddie Mac and Fannie Mae
to the capital market was related to the implicit
U.S. government guarantee of their debt and
MBS obligations. Their federal charter required
them to support the secondary market for residential mortgages, to assist mortgage funding
for low-and moderate-income families, and to
consider the geographic distribution of mortgage funding, including mortgage finance for
Gamble−Thompson:
Essentials of Strategic
Management: The Quest
for Competitive Advantage,
Second Edition
II. Cases in Crafting and
Executing Strategy
© The McGraw−Hill
Companies, 2011
15. Countrywide Financial
Corporation and the
Subprime Mortgage
Debacle
Case 15 Countrywide Financial Corporation and the Subprime Mortgage Debacle
underserved geographic sectors. An ancillary
benefit of the MBS product required national
standardization of underwriting procedures:
appraisals, borrower credit histories, and
guidelines for determining borrowers’ financial capacity to meet debt obligations. This
provided the foundation for real growth in the
mortgage market. The mortgage market in the
United States was also bolstered by the VA loan
program, which provided zero down payment
and low interest rates to veterans.
Mortgage Loan Originators
Prior to 1980, the vast majority of residential
home mortgage loans were made by savings
and loans institutions (S&Ls). These institutions
originated, serviced (collected payments and
managed escrow accounts for insurance and
property taxes), and retained the loans in their
own portfolios. S&Ls used the interest earned
from their portfolios of 30-year fixed rate home
mortgages to pay interest to savings account
holders—the yield spread between interest
earned on mortgages and interest paid on savings allowed S&Ls to earn consistent profits for
decades. The business model used by S&Ls collapsed when the Federal Reserve began to raise
short-term rates in the late 1970s to combat
inflation pressures, with interest paid on savings accounts now being greater than interest
earned on the low-rate mortgages originated
in the 1960s and early 1970s. The inverted
yield curve led to the failure of S&Ls across the
United States and an ensuing government bailout under the auspices of the Resolution Trust
Corporation (RTC).
The S&L crisis also led to the unbundling of
the mortgage business. Mortgage originations
and loan servicing became separate functions,
which pushed most new mortgage originations
into the secondary market as MBSs or collateralized debt obligations (CDOs). The ability for
mortgage originators to sell newly recorded
mortgages as MBSs and keep balance sheets
uncluttered with large loan portfolios allowed
the number of mortgage originators to increase
from 7,000 in 1987 to nearly 53,000 in 2006. The
529
Exhibit 1
Originations and Market Shares for the
Largest U.S. Mortgage Loan Originators,
2007 (dollar amounts in billions)
RANK ORIGINATOR
1
2
3
4
5
Countrywide
CitiMortgage
Wells Fargo
Mortgage
Chase Mortgage
Bank of America
Others
Total
2007
ORIGINATIONS MARKET
(IN BILLIONS)
SHARE
$408
272
15.5%
10.3
210
198
190
1,278
$2,628
7.9
7.5
7.2
48.6
100.0%
Source: As estimated by Countrywide Financial Corporation in
its 2007 10-K.
largest mortgage loan originators and their relative shares in 2007 are presented in Exhibit 1.
Expanding Home Ownership and
the American Dream
Beginning in the 1970s, social activist groups
began to point to statistics that indicated lenders
and the FHA were engaged in systematic racial
discrimination against minority consumers living in low-income neighborhoods (a practice
called “redlining”). Such activists mobilized
the U.S. Congress and the Carter Administration to enact the Community Reinvestment Act
(CRA) and the Home Mortgage Disclosure Act
(HMDA) to remedy social injustices in housing
and lending. In part, these acts required financial institutions to provide greater support to
low-income areas and provide more detailed
disclosures regarding mortgage terms.
Lenders whose disclosures uncovered redlining of low-income neighborhoods defended
their practices by pointing to the added risk
associated with making loans to those with
lower incomes, unstable employment histories,
high debt to income levels, or inadequate funds
for down payments. The Depository Institution
Deregulation and Monetary Control Act of 1980
addressed such concerns by eliminating interest
rate caps and allowing lenders to charge higher
Gamble−Thompson:
Essentials of Strategic
Management: The Quest
for Competitive Advantage,
Second Edition
530
Part Two:
II. Cases in Crafting and
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© The McGraw−Hill
Companies, 2011
15. Countrywide Financial
Corporation and the
Subprime Mortgage
Debacle
Section D: Business Ethics and Social Responsibility
or subprime rates to higher risk borrowers.
The Housing and Community Development
Act of 1981 created targets for lenders serving
low-income borrowers and allowed FHA borrowers with imperfect credit records to obtain
mortgage loans with LTVs of 90 to 95 percent.
In 1995 the Clinton Administration expanded
high LTV subprime loans under the CRA to
further expand homeownership for Americans
who were unable to qualify for mortgage loans
using conventional underwriting criteria.
The Residential Mortgage
Market in the United States in
the 2000s
The effects of the 60 years of federal legislation
promoting homeownership allowed nearly
70 percent of Americans to own a home by
2004. The value of new loan originations had
increased from $733 billion in 1994 to an all-time
high of $3.12 trillion in 2005, with large spikes
in loan origination values occurring in 2001
and 2003 before declining in 2004. Mortgage
originations had declined again in 2006 to $2.98
trillion. Exhibit 2 presents the value of total
U.S. mortgage originations and the percentage
of prime and subprime mortgage loan originations for 1994–2006. A graph representing the
percentage of American families owning their
own homes for the years 1944 through 2007 is
presented in Exhibit 3.
The Subprime Mortgage Market
A subprime mortgage was generally classified
as a mortgage loan to a borrower with a low
credit score, with a small down payment, or a
high debt-to-income ratio. In 1994 the subprime
market in the United States was approximately
$40 billion and represented approximately
6 percent of total mortgage loans originated.
The market for subprime mortgages grew rapidly and by year-end 2005 reached 37.6 percent
of total mortgage originations.
At the core of the growth of the subprime
market were relaxed underwriting standards.
As the appetite for MBSs on Wall Street rose,
mortgage brokers widened their sales net to
include relaxed documentation requirements
and impaired or limited credit histories. Many
loans were provided as “stated income loans,”
whereby the borrower did not have to prove
income (such loans became known among
mortgage underwriters as “liar loans”). The
Exhibit 2
Value of U.S. Home Mortgage Originations and Percentage of Prime versus
Subprime Mortgage Originations, 1994–2006 (dollar amounts in billions)
YEAR
TOTAL US ORIGINATIONS
(IN BILLIONS)
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
$ 773
639
785
859
1,450
1,310
1,048
2,215
2,885
3,945
2,920
3,120
2,980
PRIME MORTGAGE
ORIGINATIONS
(PERCENT OF TOTAL)
SUBPRIME MORTGAGE
ORIGINATIONS
(PERCENT OF TOTAL)
94.0%
86.9
83.2
78.3
84.0
83.2
81.5
87.9
88.4
86.5
68.1
62.4
63.7
Source: The 2007 Mortgage Market Statistical Annual, Inside Mortgage Finance.
6.0%
13.1
16.8
21.7
15.0
16.8
18.5
12.1
11.6
13.5
31.9
37.6
36.3
Gamble−Thompson:
Essentials of Strategic
Management: The Quest
for Competitive Advantage,
Second Edition
II. Cases in Crafting and
Executing Strategy
© The McGraw−Hill
Companies, 2011
15. Countrywide Financial
Corporation and the
Subprime Mortgage
Debacle
Case 15 Countrywide Financial Corporation and the Subprime Mortgage Debacle
EXHIBIT 3
531
Rate of Home Ownership in the United States, 1944–2007
80%
70
60
50
2007
2004
2001
1998
1995
1992
1989
1986
1983
1980
1977
1974
1971
1968
1965
1962
1959
1956
1953
1950
1947
1944
40
HOMEOWNERSHIP RATE
Source: U.S. Census Data 2007.
most popular mortgage products with consumers tended to be ARMs, which often included
introductory below-market rates. Below-market
“teaser” rates allowed for a low monthly payment in the first few years of the loan and then
were adjusted in line with market rates thereafter. Some real estate investors and homeowners exploited teaser rates to get into a home and
flip the property for a profit before the rate was
adjusted. Even if homeowners did not purchase
a home with the intention of flipping the house
for a profit, the rapid appreciation in home values during the early and mid-2000s allowed
overleveraged homeowners to sell their homes
and get out of high mortgage payments without great difficulty. However, once the housing
market slowed, the excesses of the subprime
mortgage market were exposed with resultant
increase in delinquencies, defaults, and foreclosures. In fact, in March 2007, the Mortgage
Bankers Association reported that 13 percent of
subprime borrowers were delinquent on their
payments by 60 days or more.
The Housing Bubble of the Mid-2000s
The expansion of homeownership increased
demand for both new and existing homes and
forced prices upward, creating a housing bubble that began in 1994 and peaked in 2006. In
2006, housing values had increased on average some 16 percent over the previous year. In
addition to opportunities to make quick profits
from buying and selling houses, rapid appreciation in home prices allowed many homeowners
to refinance or take out home equity loans to
make improvements to their homes, purchase
automobiles, or make other general purchases.
The housing bubble burst in 2007 when the
U.S. economy began to weaken, with declining demand for housing causing home prices to
plummet. With appreciation in home prices coming to an end, many consumers found their properties underwater (a negative equity position
caused by the mortgage balance being greater
than the fair market value of the property). Such
homeowners who had lost jobs or income during the recession or who had seen their payments on adjustable-rate mortgages rise were
faced with foreclosure since they had no hope
of selling their home at a price great enough to
pay off their mortgage balance. It was estimated
that 10 percent to 14 percent of all single-family
homes in the United States in 2007, regardless of
when they were purchased, had negative equity,
making one in seven single-family homes in the
Gamble−Thompson:
Essentials of Strategic
Management: The Quest
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Part Two:
Percent change from prior year
EXHIBIT 4
II. Cases in Crafting and
Executing Strategy
15. Countrywide Financial
Corporation and the
Subprime Mortgage
Debacle
© The McGraw−Hill
Companies, 2011
Section D: Business Ethics and Social Responsibility
S&P/Case-Shiller Home Price Indices for Major U.S Cities, January 1988–May 2008
24%
21%
18%
15%
12%
9%
6%
3%
0%
–3%
–6%
–9%
–12%
–15%
–18%
–21%
10-City Composite
20-City Composite
24%
21%
18%
15%
12%
9%
6%
3%
0%
–3%
–6%
–9%
–12%
–15%
–18%
–21%
1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Source: Standard & Poor’s and Fiserv.
U.S. underwater.2 Exhibit 4 presents a graph
of percentage increases and decreases in home
prices as measured across major U.S. cities for
January 1988 through May 2008.
The U.S. Financial Crisis of 2008
With record numbers of mortgages in default,
a general liquidity crisis began to unfold which
led to an overall loss of confidence in the U.S.
financial system. The system unraveled in 2008
when losses at Fannie Mae and Freddie Mac
began to mount and American Insurance Group
(AIG) announced it was unable to back the
insurance guarantees that had supported the
Aaa to B bond ratings assigned to MBSs. Wall
Street firms had been packaging loans for sale
to investors across the world and now found
themselves holding securities with little value.
As financial institutions were forced to mark
their assets to market value, many, including
Bear Stearns, Lehman Brothers, Merrill Lynch,
Washington Mutual, and Wachovia, were either
forced to declare bankruptcy or be acquired by
stronger institutions. In September 2008, the
United States Treasury provided a bailout to
AIG3 and placed Freddie Mac and Fannie Mae
into conservatorships.
Countrywide Financial
Corporation
Countrywide Financial Corporation (CFC) was
founded in 1969 and on July 2, 2008, was sold
to Bank of America for $4 billion in an all-stock
transaction. Countrywide’s market value in late
2006 was $24 billion, but mounting mortgage
defaults and rumors of impending bankruptcy
had slashed the company’s market value by the
time it negotiated its buyout by BoA in January
2008. Angelo Mozilo, the founder and chairman
of Countrywide Financial, retired and received
a substantial severance package reported at $80
million to $115 million. In June 2009 the Securities and Exchange (SEC) indicted Mozilo for
fraudulent misrepresentation of credit and market risk inherent in the Countrywide mortgage
portfolio. Exhibit 5 provides key milestones
and events in Countrywide Financial’s corporate history.
Countrywide’s Business Segments
Countrywide was a diversified financial service provider engaged in mortgage lending and
other real estate finance–related businesses.
At its apex in 2006, Countrywide had $2.6 billion
Gamble−Thompson:
Essentials of Strategic
Management: The Quest
for Competitive Advantage,
Second Edition
II. Cases in Crafting and
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15. Countrywide Financial
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Subprime Mortgage
Debacle
© The McGraw−Hill
Companies, 2011
Case 15 Countrywide Financial Corporation and the Subprime Mortgage Debacle
533
Exhibit 5
Key Milestones and Events in Countrywide Financial Corporation’s History
1969
1974
1980
1981
1985
1984
1986
1987
1993
1996
1998
1999
2000–2005
2001
2002
2006
2007–Jan. 31
2007–April 26
2007–July 24
2007–Aug. 16
2007–Aug. 22
2007–Sept. 9
2007–Sept. 18
2007–Oct. 23
2007–Oct. 26
2007–Nov. 20
2008–Jan. 11
July 2, 2008
Angelo Mozilo and David Loeb launch Countrywide Credit Industries in New York with the
aim to one day provide home loans nationwide. Countrywide goes public in September,
trading at less than $1 per share. Mozilo and Loeb relocate Countrywide to Los Angeles.
Countrywide opens first retail office in Whittier, Califiornia.
Countrywide has 40 retail offices across eight states.
Mozilo and Loeb launch subsidiary Countrywide Securities Corp. to sell mortgage-backed
securities.
Countrywide’s ticker symbol, CCR, opens on the New York Stock Exchange on October 7.
Stock closes at $2 a share.
The value of loans serviced by Countrywide hits $1 billion. The company begins using
computers to originate home loans.
Loan production tops $1 billion.
Loan production soars to $3.1 billion. Countrywide begins servicing loans originated
by mortgage lenders.
Countrywide’s mortgage-lending reach grows amid a housing and mortgage refinancing
boom. Originations increase by 265 percent from 1992.
Company launches business units focused on home equity loans (HELOC) and home
loans to borrowers with weak credit histories (subprime).
Mozilo named chief executive in February.
Mozilo named chairman in March.
Countrywide benefits from another housing and refinancing boom coupled with
historically low interest rates.
Countrywide acquires Treasury Bank N.A. It goes on to become Countrywide Bank FSB.
Company becomes Countrywide Financial Corp. on November 13, with new stock ticker:
CFC.
CFC reports fourth-quarter earnings soar 73 percent to $638.9 million on January 31,
as profits climb 29 percent to $2.59 billion.
CFCs fourth-quarter profits fall 2.7 percent and revenue slips 6 percent. The lender blames
falling home prices and fewer home sales for a drop in new mortgage loans.
CFC first-quarter profits tumble 37 percent; revenue shrinks by 15 percent. Mounting
mortgage defaults force CFC to increase loan reserve $81 million and take a $119 million
write-down for declining value of some loans on its books. Mozilo blames deteriorating
credit in the subprime mortgage market.
CFC second-quarter profit declines by nearly a third and revenue dips 15 percent.
A worsening credit crisis sparked by the collapse of the subprime mortgage market and
ongoing housing woes force CFC to draw down $11.5 billion from its credit lines.
CFC raises $2 billion by selling a 16 percent stake to Bank of America.
Under pressure to reduce costs, CFC reports it will cut as many as 12,000 jobs.
Management takes steps to shift lending activity through its banking arm and stop selling
subprime loans.
Speaking at an investor conference, Mozilo declares the company will “come out stronger
in the long run, just as we have often done in the past.”
Countrywide outlines stepped-up efforts to help borrowers in trouble avoid foreclosures.
Countrywide reports a third-quarter $1.2 billion loss, the first quarterly loss for the
company in 25 years. Still, Mozilo says he’s “bullish” about the long-term prospects of the
company and says it expects to be profitable in the fourth quarter and in 2008.
Rumors surface that CFC may seek bankruptcy protection. CFC issues statement declaring
it has ample capital, access to cash and is well positioned to benefit from the financial
turmoil rocking the mortgage sector.
BofA announces acquisition of CFC, subject to shareholder and government approvals,
for $4 billion in an all stock transaction.
Countrywide officially became a wholly owned subsidiary of Bank of America.
Source: Countrywide Financial Corporation SEC Filings. Annual Reports and press releases.
Gamble−Thompson:
Essentials of Strategic
Management: The Quest
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15. Countrywide Financial
Corporation and the
Subprime Mortgage
Debacle
© The McGraw−Hill
Companies, 2011
Section D: Business Ethics and Social Responsibility
in net earnings and $200 billion in total assets.
The business was managed through five business segments: mortgage banking, banking, capital markets, insurance, and global operations.
•
Mortgage banking. The origination, purchase, sale, and servicing of noncommercial
mortgage loans nationwide.
•
Banking. Gathered retail deposits used to
invest in mortgage loans and home equity
lines of credit, sourced primarily through
the mortgage banking operation as well as
through purchases from nonaffiliates.
•
Capital markets. The institutional brokerdealer business which specialized in trading and underwriting mortgage-backed
securities. The business unit also traded
derivative products and U.S. Treasury securities, provided asset management services,
and originated loans secured by commercial real estate. Within this segment CFC
managed the acquisition and disposition of
mortgage loans on behalf of the Mortgage
Banking Segment.
•
Insurance. The property, casualty, life, and
disability insurance underwriting provider.
The business unit also included reinsurance
coverage to primary mortgage insurers.
•
Global operations. Licensed proprietary
technology to mortgage lenders in the
United Kingdom and handled some of
the company’s administrative and loan
servicing functions through operations
in India.
Mortgage banking was Countrywide’s core
business, generating 48 percent of its 2006 pretax earnings. A summary of CFC’s mortgage
loan production for 2003 through 2007 is presented in Exhibit 6.
Countrywide Loan Originations and
Market Share
CFC held the largest market share among U.S.
mortgage originators in 2007 with 15.5 percent
of all originations, up considerably from
2001 when CFC held a 6.6 percent share. As
shown Exhibit 7, CFC originated 35,000 loans
in 1990, which were more or less evenly split
between conventional and VHA/VA loans. It
was not until the 1995–1996 period that CFC
began to underwrite home equity and subprime loans. The company’s loan originations
peaked in 2003 with over 2.5 million loans
being originated. In 2005, approximately 11
percent of Countrywide’s loan originations
were subprime and CFC home equity line
of credit loans (HELOCs) reached a peak in
2006. Many of Countrywide’s HELOCs were
part of so-called 80/20 purchase loans that
provided borrowers with 100 percent financing. Countrywide’s no-down-payment loans
allowed borrowers to piggyback a 20 percent
LTV home equity line of credit loan on top
of a conventional nonconforming 80 percent
LTV mortgage. CFC’s originations of conventional nonconforming loans began in 2002
and closely matched the company’s origination of HELOCs. A significant portion of
Countrywide’s mortgage loan originations
were sold into the secondary mortgage markets as MBSs.
Countrywide’s Financial and
Strategic Performance
Between 2002 and 2007, Countrywide’s assets
grew from $58 million to $211 million, and its
revenues rose from $4.3 billion to $11.4 billion.
The mortgage firm’s operating earnings grew
from $1.3 million in 2002 to $4.3 million in
2006. After recording record breaking financial
results for five consecutive years, CFC reported
its first-ever loss in 2007. The dramatic reversal in CFC’s financial performance was largely
a result of its strategy keyed to the origination
of subprime mortgages and no-down-payment
loans. The hidden risk of default, foreclosures,
and downgrades of such high-risk loans was
masked while real estate values rose through
2006. Exhibit 8 presents selected financial data
for Countrywide Financial Corporation for
2003 through 2007.
Gamble−Thompson:
Essentials of Strategic
Management: The Quest
for Competitive Advantage,
Second Edition
II. Cases in Crafting and
Executing Strategy
© The McGraw−Hill
Companies, 2011
15. Countrywide Financial
Corporation and the
Subprime Mortgage
Debacle
Case 15 Countrywide Financial Corporation and the Subprime Mortgage Debacle
535
Exhibit 6
Countrywide Financial Corporation’s Loan Production by Segment and Product, 2003–
2007 (in millions)
MORTGAGE LOAN PRODUCTION
YEARS ENDED DECEMBER 31,
2007
Segment:
Mortgage Banking
Banking Operations
Capital Markets—
conduit acquisitions
from nonaffiliates
Total Residential
Mortgage Loans
Commercial Real
Estate
Total mortgage loans
Product:
Prime Mortgage
Prime Home Equity
Nonprime Mortgage*
Commercial Real
Estate
Total mortgage loans
2006
2005
2004
2003
$ 385,141
18,090
$ 421,084
23,759
$ 427,916
46,432
$ 317,811
27,116
$ 398,310
14,354
5,003
17,658
21,028
18,079
22,200
408,234
462,501
495,376
363,006
434,864
7,400
5,671
3,925
358
—
$ 415,634
$ 468,172
$ 499,301
$ 363,364
$ 434,864
$ 356,842
34,399
16,993
$ 374,029
47,876
40,596
$ 405,889
44,850
44,637
$ 292,672
30,893
39,441
$ 396,934
18,103
19,827
7,400
5,671
3,925
358
—
$ 415,634
$ 468,172
$ 499,301
$ 363,364
$ 434,864
* Countrywide Financial did not use the term “subprime.” The term “nonprime” was used to categorize subprime mortgages in the
company’s financial filings.
Source: Countrywide Financial Corporation 2007 10-K.
Incentive Compensation at
Countrywide Financial
Executive Compensation at
Countrywide Financial Corporation
Compensation expense represented approximately 55–60 percent of total expenses between
2003 and 2007. Compensation included employees’ base salary, benefits expense, payroll taxes,
and incentive pay. Countrywide’s compensation system based incentive pay on loan originations and did not include loan defaults as a
performance compensation metric. Many lending institutions frowned upon incentive plans
linked only to loan originations since loan performance ultimately determined the strength of
a loan portfolio. Exhibit 9 provides a graph of
incentive pay as a percentage of base pay for all
CFC employees during 1992 through 2007.
The compensation for Mozilo for 2006 and 2007
is shown in Exhibit 10. Mozilo’s compensation
listed in the table does not include perquisites
that amounted to approximately $108,000 per
year and included company cars, country club
memberships, the personal use of corporate aircraft, insurance, and a financial planning program. Mozilo also exercised $121 million of stock
options in 2007 and reportedly stood to collect a
reported windfall of $80 million to $115 million
on the $4 billion sale of the company to BofA, as
part of his severance package. However, after facing heavy criticism from lawmakers, Mozilo said
he would forfeit $37.5 million tied to the deal.
Gamble−Thompson:
Essentials of Strategic
Management: The Quest
for Competitive Advantage,
Second Edition
536
Part Two:
II. Cases in Crafting and
Executing Strategy
© The McGraw−Hill
Companies, 2011
15. Countrywide Financial
Corporation and the
Subprime Mortgage
Debacle
Section D: Business Ethics and Social Responsibility
Exhibit 7
Countrywide Financial Corporation Loan Originations, 1990–2007 (in thousands)
YEAR
CONVENTIONAL
CONFORMING
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
19
23
64
192
316
176
192
190
232
529
359
327
994
1510
822
767
709
1088
CONVENTIONAL
NONCONFORMING
FHA/VA
266
493
430
712
649
313
16
17
24
42
67
72
125
144
162
191
132
119
157
196
102
80
90
138
HELOC
2
8
20
41
54
91
119
290
292
392
493
581
330
SUBPRIME
TOTAL LOAN
ORIGINATIONS
2
9
16
25
43
52
44
95
219
254
227
85
35
40
88
234
383
250
327
363
451
799
625
617
1751
2586
1965
2306
2256
1954
Source: Countrywide Financial Corporation 10-Ks, various years.
Exhibit 8
Selected Consolidated Financial Data for Countrywide Financial Corporation, 2003–2007
(in thousands, except per share data)
YEARS ENDED DECEMBER 31,
2007
Statement of Operations
Data:
Revenues:
Gain on sale of loans
and securities
Net interest income after
provision for loan losses
Net loan servicing fees
and other income (loss)
from MSRs and retained
interests
Net insurance premiums
earned
Other
Total revenues
Expenses:
Compensation
Occupancy and other
office
2006
2005
2004
2003
$2,434,723
$5,681,847
$4,861,780
$4,842,082
$5,887,436
587,882
2,688,514
2,237,935
1,965,541
1,359,390
909,749
1,523,534
1,300,655
1,171,433
1,493,167
953,647
465,650
782,685
(463,050)
732,816
605,549
574,679
470,179
510,669
462,050
6,061,437
11,417,128
10,016,708
8,566,627
7,978,642
4,165,023
4,373,985
3,615,483
3,137,045
2,590,936
1,126,226
1,030,164
879,680
643,378
525,192
Gamble−Thompson:
Essentials of Strategic
Management: The Quest
for Competitive Advantage,
Second Edition
II. Cases in Crafting and
Executing Strategy
© The McGraw−Hill
Companies, 2011
15. Countrywide Financial
Corporation and the
Subprime Mortgage
Debacle
Case 15 Countrywide Financial Corporation and the Subprime Mortgage Debacle
Exhibit 8
537
(continued)
2007
2006
2005
2004
2003
Insurance claims
Advertising and
promotion
Other
525,045
449,138
441,584
390,203
360,046
321,766
1,233,651
260,652
969,054
229,183
703,012
171,585
628,543
103,902
552,794
Total expenses
7,371,711
7,082,993
5,868,942
4,970,754
4,132,870
(1,310,274)
4,334,135
4,147,766
3,595,873
3,845,772
(606,736)
1,659,289
1,619,676
1,398,299
1,472,822
$ (703,538)
$2,674,846
$2,528,090
$2,197,574
$2,372,950
$(2.03)
$(2.03)
$0.60
$4.42
$4.30
$0.60
$4.28
$4.11
$0.59
$3.90
$3.63
$0.37
$4.44
$4.18
$0.15
$8.94
$42.45
$34.19
$37.01
$25.28
(0.30%)
(4.57%)
N/M
1.28%
18.81%
13.49%
1.46%
22.67%
13.81%
1.80%
23.53%
9.53%
2.65%
34.25%
3.39%
$1,476,203
$1,298,394
$1,111,090
$838,322
$644,855
$415,634
$468,172
$499,301
$363,364
$434,864
$375,937
$403,035
$411,848
$326,313
$374,245
(Loss) earnings before
income taxes
(Benefit) provision for
income taxes
Net (loss) earnings
Per Share Data:
(Loss) earnings
Basic
Diluted
Cash dividends declared
Stock price at end of
period
Selected Financial Ratios:
Return on average assets
Return on average equity
Dividend payout ratio
Selected Operating Data
(in millions):
Loan servicing portfolio(1)
Volume of loans
originated
Volume of Mortgage
Banking loans sold
(1) Includes warehoused loans and loans under subservicing agreements.
DECEMBER 31,
Selected Balance Sheet
Data at End of Period:
Loans:
Held for sale
Held for investment
Securities purchased
under agreements to
resell, securities
borrowed and federal
funds sold
Investments in other
financial instruments
Mortgage servicing rights,
at fair value
2007
2006
2005
2004
2003
$ 11,681,274
98,000,713
$ 31,272,630
78,019,994
$ 36,808,185
69,865,447
$37,347,326
39,661,191
$24,103,625
26,375,958
109,681,987
109,292,624
106,673,632
77,008,517
50,479,583
9,640,879
27,269,897
23,317,361
13,456,448
10,448,102
28,173,281
12,769,451
11,260,725
9,834,214
12,647,213
18,958,180
16,172,064
—
—
—
continued
Gamble−Thompson:
Essentials of Strategic
Management: The Quest
for Competitive Advantage,
Second Edition
538
Part Two:
Exhibit 8
II. Cases in Crafting and
Executing Strategy
© The McGraw−Hill
Companies, 2011
15. Countrywide Financial
Corporation and the
Subprime Mortgage
Debacle
Section D: Business Ethics and Social Responsibility
(continued)
2007
Mortgage servicing
rights, net
Other assets
2006
—
Total assets
Deposit liabilities
Securities sold under
agreements to repurchase
Notes payable
Other liabilities
Shareholders’ equity
Total liabilities and
shareholders’ equity
2005
—
12,610,839
2004
8,729,929
2003
6,863,625
45,275,734
34,442,194
21,222,813
19,466,597
17,539,150
$211,730,061
$199,946,230
$175,085,370
$128,495,705
$97,977,673
$60,200,599
$55,578,682
$39,438,916
$20,013,208
$9,327,671
18,218,162
97,227,413
21,428,016
14,655,871
42,113,501
71,487,584
16,448,617
14,317,846
34,153,205
76,187,886
12,489,503
12,815,860
20,465,123
66,613,671
11,093,627
10,310,076
32,013,412
39,948,461
8,603,413
8,084,716
$211,730,061
$199,946,230
$175,085,370
$128,495,705
$97,977,673
The 2007 capital ratios reflect the conversion of Countrywide Bank’s charter from a national bank to a federal savings bank. Accordingly, the ratios for 2007 are for Countrywide Bank calculated using OTS guidelines and the ratios for the prior periods are calculated
for Countrywide Financial Corporation in compliance with the guidelines of the Board of Governors of the Federal Reserve Bank.
Source: Countrywide Financial Corporation 2007 10-K.
Charges of Predatory Lending
Practices at Countrywide
Predatory loans were generally considered to be
any loan that a borrower would have rejected
with full knowledge and understanding of the
terms of the loan and the terms of alternatives
EXHIBIT 9
available to them. Predatory lenders typically
relied on a range of practices including deception, fraud, and manipulation to convince borrowers to agree to loan terms that were unethical
or illegal. Countrywide Financial was charged
with engaging in predatory lending practices
in the case Department of Legal Affairs (Florida) v.
Incentive Pay as Percentage of Base Pay for All Employees of Countrywide Financial Corporation, 1992–2007
Incentive as % base
120%
100%
80%
60%
40%
20%
0%
1990 1992 1994 1996 1998 2000 2002 2004 2006
Source: Countrywide Financial Corporation 10-Ks, various years.
Gamble−Thompson:
Essentials of Strategic
Management: The Quest
for Competitive Advantage,
Second Edition
II. Cases in Crafting and
Executing Strategy
© The McGraw−Hill
Companies, 2011
15. Countrywide Financial
Corporation and the
Subprime Mortgage
Debacle
Case 15 Countrywide Financial Corporation and the Subprime Mortgage Debacle
539
Exhibit 10
Angelo Mozilo’s Comensation at Countrywide Financial Corporation,
2006–2007
COMPENSATION COMPONENTS
Base salary
Annual incentive
Equity awards
Total
Exercised options
2006
2007
$ 2,900,000
20,461,473
19,012,000
$ 42,373,473
—
$
1,900,000
0
10,000,036
$ 11,900,036
$121,502,318
% CHANGE
(34%)
(100%)
(47%)
(72%)
n/a
Note: n/a ⫽ not applicable.
Source: Countrywide Financial Corporation 2007 10-K.
Countrywide Financial Corp. et al., filed June 30,
2008). Specific illegal practices alleged in the
case included:
1. CFC did not follow its own underwriting
standards.
2. CFC did not follow industry underwriting
standards.
3. CFC placed borrowers into loans they
knew they could not afford.
4. CFC failed to properly disclose loan terms
including
a. Misrepresenting duration of “teaser
rates.”
b. Misrepresenting adjustable rates as fixed
rates.
c. Misrepresenting the manner and degree
of payment increases after initial fixed
rate period.
d. Not disclosing that low teaser rates
would expire and dramatically increase
resulting payments that might be far
beyond borrower’s means.
5. CFC knowingly placed borrowers in inappropriate mortgages.
6. CFC provided underwriters with bonuses
based upon volume of mortgages
approved.
Countrywide portrayed itself as underwriting mainly prime quality mortgages using rigorous underwriting standards. Concealed from
shareholders was the true Countrywide, an
increasingly reckless lender assuming greater
and greater risk. From 2005 to 2007, Countrywide engaged in an unprecedented expansion
of its underwriting guidelines and was writing riskier and riskier loans, according to the
SEC. A series of internal e-mails confirmed that
senior executives knew that defaults and delinquencies would rise. In particular, the Securities and Exchange Commission (SEC) pointed
to Countrywide’s increased origination of payoption mortgages, which allow borrowers to
choose their monthly payments even if they
did not cover the entire interest amount. While
CFC maintained these loans were prudently
underwritten, the SEC stated that Mozilo wrote
in an e-mail that there was evidence that borrowers were lying on their applications and
many would be unable to handle the eventual
higher payments.
Angelo Mozilo’s Internal E-mails at
Countrywide Financial Corporation
In June 2009, the SEC filed civil-fraud charges
against three former Countrywide executives,
including Angelo Mozilo. The complaint cited
e-mails sent by Mozilo as evidence of fraudulent behavior at Countrywide Financial. The
statements below are from excerpts of Mozilo
e-mails released by the SEC.
April 13, 2006: To Sambol (Countrywide Financial Corporation President)
Gamble−Thompson:
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Management: The Quest
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Part Two:
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15. Countrywide Financial
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© The McGraw−Hill
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Section D: Business Ethics and Social Responsibility
and others to address issues relating to
100 percentage financed loans, after Countrywide had to buy back mortgages sold to
HSBC because HSBC contended they were
defective:
Loans had been originated . . . throughout
channels with disregard for process and
compliance with guidelines.
April 17, 2006: To Sambol concerning
Countrywide’s subprime 100 percent
financing 80/20 loans. (The term “FICO”
refers to credit scores used to assess borrower’s creditworthiness.)
In all my years in business I have never seen
a more toxic product. It’s not only subordinated to the first, but the first is subprime.
In addition, the FICOs are below 600, below
500 and some below 400. With real estate
values coming down . . . the product will
become increasingly worse. There has to
be major changes in this program, including substantial increases in the minimum
FICO. . . . Whether you consider the business milk or not, I am prepared to go without milk irrespective of the consequences to
our production.
Sept. 26, 2006: Following a meeting with
Sambol the previous day about Pay-Option
ARM loan portfolio:
We have no way, with any reasonable certainty, to assess the real risk of holding these
loans on our balance sheet. . . . The bottom
line is that we are flying blind on how these
loans will perform in a stressed environment of high unemployment, reduced values and slowing home sales . . . timing is
right . . . to . . . sell all newly originated pay
option and begin rolling off the bank balance sheet, in an orderly manner.
Countrywide’s VIP Loan Program
Countrywide maintained a VIP program that
waived points, lender fees, and company borrowing rules for “FOAs”—Friends of Angelo,
a reference to CFC’s Chief executive Angelo
Mozilo. While the VIP program also serviced
friends and contacts of other CFC executives, it
is believed the FOAs made up the biggest subset.
Some FOAs were individuals who might have
been in position to aid the company through
regulatory and compliance matters or who may
have been able to keep the subprime market
viable through favorable legislation. Countrywide’s ethics code barred directors, officers, and
employees from “improperly influencing the
decisions of government employees or contractors by offering or promising to give money,
gifts, loans, rewards, favors, or anything else
of value.” Also, federal employees were prohibited from receiving gifts offered because of
their official position, including loans on terms
not generally available to the public. Senate
rules prohibit members from knowingly receiving gifts worth $100 or more in a calendar year
from private entities that, like CFC, employed a
registered lobbyist.
Among the most noteworthy recipients of
Countrywide VIP loans were two prominent
U.S. Senators, two former Cabinet members, and
a former Ambassador to the United Nations. In
2003 and 2004, Senators Christopher Dodd, a
Democrat from Connecticut and chairman of
the Senate Banking Committee,4 and Kent Conrad, a Democrat from North Dakota, chairman
of the Senate Budget Committee and a member
of the Senate Finance Committee, refinanced
properties through CFC’s VIP program.
Other participants in the VIP program
included former Secretary of Housing and
Urban Development (HUD) Alphonso Jackson,
former Secretary of Health and Human Services
Donna Shalala, and former U.N. ambassador
and Assistant Secretary of State Richard Holbrooke. Jackson was deputy HUD secretary in
the Bush administration when he received the
loans in 2003. Shalala, who received two loans
in 2002, had by then left the Clinton Administration for her current position as president of
the University of Miami. Holbrooke, whose
stint as U.N. ambassador ended in 2001, was
also working in the private sector when he and
his family received VIP loans. Mr. Holbrooke
was an adviser to Hillary Clinton’s presidential 2008 campaign. James Johnson, who had
been advising presidential candidate Barack
Obama on the selection of a running mate in
Gamble−Thompson:
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Management: The Quest
for Competitive Advantage,
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II. Cases in Crafting and
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15. Countrywide Financial
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Subprime Mortgage
Debacle
© The McGraw−Hill
Companies, 2011
Case 15 Countrywide Financial Corporation and the Subprime Mortgage Debacle
2008, resigned from the Obama campaign after
The Wall Street Journal reported that he received
CFC loans at below-market rates.
Bank of America’s Attempts
to Salvage Its Acquisition
of Countrywide Financial
Corporation
Almost as soon as the acquisition closed, BofA
entered into an $8.7 billion settlement agreement with a group of state attorneys general
over CFC’s lending practices. BofA also agreed
to modify the loans of certain CFC borrowers
with subprime and pay-option mortgages. In
the first four months following the settlement
agreement, BofA contacted more than 100,000
potentially eligible borrowers, twice the
requirement in the agreement, and completed
modifications for more than 50,000 of them.
The settlement was the largest predatory lending settlement in U.S. history as of 2009.
541
In March 2009, American International
Insurance Group (AIG) sued BoA over Countrywide’s business practices, alleging the company misrepresented the risk associated with
the sale of mortgages totaling over $1 billion.
AIG claimed that CFC had falsely represented
that its mortgages were in compliance with its
AIG underwriting standards.
BofA retired the Countrywide brand name
in 2009 as it worked to distance itself from the
brand and CFC’s business practices. According
to California Attorney General Edmund Brown,
“CFC lending practices turned the American
dream into a nightmare for tens of thousands of
families by putting them into loans they could
not understand or ultimately could not afford.”5
Going forward, Bank of America senior managers would need to develop a strategic approach
to ensure that its mortgage lending practices
promoted homeownership in a manner that
was in the best interest of borrowers, investors in the secondary mortgage market, and the
company’s own long-term financial interests.
Endnotes
1
These products were developed following the Savings and Loan
(S&L) crisis of the 1980s and converted the actual mortgage into pools
of mortgages, which enabled institutions to invest and trade a marketable security. MBSs were also known as collateralized debt obligations.
2
3
Moody’s Economy.com.
AIG’s core business as the world’s largest general insurer was sound.
However, AIG’s CDO insurance business, while a very small part of
their overall business, has brought the firm close to bankruptcy. As for
AIG’s global reach, it was far too extensive and a default would have
brought down other financial institutions across the world markets.
4
CFC had contributed a total of $21,000 to Dodd’s campaigns
since 1997.
5
As quoted in Frank D. Russo, “Attorney General Brown Announces
Largest Predatory Lending Settlement in History,” California Progress
Report, accessed at http://www.californiaprogressreport.com/2008/10/
attorney_genera_3.html (accessed September 5, 2009).