Chapter 3: Risk Assessment Using Countrywide Financial
Corporation as an Example
Years 2002-2006
Note: my presentation was created in early 2009 based largely on a complaint filed in the private securities
class action (first filed in 2007) in early 2009, which is extremely (400 plus pages) long. The SEC complaint
was filed a year and a half later. It is substantively somewhat similar and has the advantage of being only a
little over 50 pages long. You can reach the SEC complaint via a hyperlink on the SEC AAER which is
hyperlinked into the course schedule or assignments. So when I refer to pages of a complaint, I am referring
to that 400 page document that you do not have access to.
Prof. Fuerman: Auditing Class
Countrywide %Origination of Structurally Risky Loans (p. 34 of Complaint)
Countrywide Allowance for Loan Loss % (p. 106 of Complaint)
Countrywide Allowance for Loan Loss %: Minumum ALL that Countrywide should have had (based on
tracking the increased origination of higher risk (structure type) mortgages)
Types of Structurally Risky Loans
Nonprime mortgage loans (also called subprime mortgage loans): FICO scores of borrower
less than 660
ƒ The CEO of Countrywide stated that nearly all of the securitized mortgage loans were
prime, when actually in 2004, 2005 and 2006 approximately 25%-35% of them were with
FICO scores of less than 660
ARM loans: Adjustable Rate Mortgage loans (variable rate loans). After a 2 year low
interest rate "teaser" period, they would reset at a higher interest rate.
Pay option ARM loans: ARM loan that allows the borrower to pay less than the amount of
interest accruing each month, causing negative amortization. After a stipulated amount of
negative amortization a cap is hit, causing the borrower to have the interest rate reset and
have to immediately pay off some of the principal.
ƒ Countrywide stated in its SEC filings that the borrowers of pay option ARM loans had very
high FICO scores (over 700), when in fact many of them were below 620
HELOC loans (Home Equity Line of Credit Loans): A type of second mortgage loan that is
secured only by the equity unmortgaged by the first mortgage loan.
ƒ Countrywide routinely made HELOC loans where the equity unmortgaged by the first
mortgage loan was trivial or nonexistent.
How Countrywide Underwrote its Mortgages
Many mortgages were made based on a borrower’s bare representations about his or her
ability to repay, with little or no documentation to support those representations.
Many mortgages were made with a loan equal to 100% of the appraised value of the
house, while waiving the normal PMI (Private Mortgage Insurance) requirement
ƒ Normally, PMI is required when a mortgage loan equal to more than 80% of the appraised
value of the house is extended.
Minimal FICO scores were often ignored
Needless to say, none of this was fully disclosed in the footnotes to the financials of the
corporation
How Countrywide was able to get away with making so many bad mortgage
loans for so long
Countrywide held some of the mortgages (Loans Held for Investment) it
underwrote, but got rid of 95% of them
Countrywide securitized and sold 95% of its loans through its affiliates
CWALT, Inc. (Pay Option ARMs), CWMBS, Inc. (fixed-rate and ARM loans),
CWABS, Inc. (subprime loans), and CWHEQ, Inc. (HELOCs). These entities
acquired loans originated by Countrywide pursuant to pooling and servicing
agreements, and then issued securities backed by those loans, with
Countrywide acting as the “sponsor” of the offerings. During the Class Period,
CWALT, CWMBS, CWABS, and CWHEQ and their affiliates disseminated
more than 1,000 prospectus supplements for offerings of mortgage-backed
securities.
ƒ The truth of the poor underwriting practices was not fully disclosed
ƒ The underwriters made huge fees selling these securities and were not
interested in possibly losing those fees by making Countrywide tell the truth
about its underwriting practices
Underwriters that got fees by selling Countrywide mortgage backed
securities to the investing public
ABN AMRO Incorporated, A.G. Edwards & Sons, Inc., Banc of America
Securities LLC, Barclays Capital Inc., BNP Paribas Securities Corp., BNY
Capital Markets, Inc., Citigroup Global Markets Inc., Countrywide Securities
Corporation, Deutsche Bank Securities Inc., Goldman, Sachs & Co.,
Greenwich Capital Markets, Inc., HSBC Securities (USA) Inc., J.P. Morgan
Securities Inc., Merrill, Lynch, Pierce, Fenner & Smith Inc., Morgan Stanley &
Co. Incorporated, RBC DainRauscher Inc., RBC Dominion Securities Inc.,
Scotia Capital Inc., TD Securities Inc., UBS Securities LLC, and Wachovia
Capital Markets, LLC.
ƒ Many of these companies are being “bailed out” by the federal government or
have been forced into mergers (Merrill Lynch)