A closer look at Countrywide (CFC)

Last Week I noted the $2 billion injection from Bank of America (BAC) into Countrywide Financial (CFC). In return BAC is to receive preferred stock with an annual coupon of 7.25% and the right to convert their stake into CFC common stock at $18 per share. Well apparently not. According to a story released after market last Friday on the Dow Jones news service:

BOA Can't Convert Countrywide Secs Into Common Stock August 23, 2007: 05:58 PM EST

By Damian Paletta

Of DOW JONES NEWSWIRES

WASHINGTON -(Dow Jones)- Bank of America Corp. (BAC) can't convert its $2 billion investment in Countrywide Financial Corp. (CFC) into common stock, the Office of the Comptroller of the Currency said in its letter approving the investment.

"Our conclusion is subject to the condition that (Bank of America) will not exercise the right granted to holders of the Securities to convert the Securities into common stock of (Countrywide) so long as the Securities are held by (Bank of America) or any subsidiary" of Bank of America, OCC chief counsel Julie Williams wrote Wednesday in a letter obtained by Dow Jones Newswires.

Williams said this condition was enforceable under the law. The letter was addressed to Bank of America general counsel Timothy J. Mayopoulos.

Bank of America "represents it will not at any time exercise its right as holder of the Securities to convert them into (Countrywide) common stock," Williams wrote.

The $2 billion investment was approved quickly, as Bank of America approached the OCC about the investment within a week of receiving regulatory approval.

Williams also said that Bank of America's investment would not "confer voting rights" as long as the "yield is current and the issuer is not attempting to alter the holders' rights under the instrument."

Efforts to reach spokesmen at Countrywide and Bank of America weren't immediately successful.

Bank of America's $2 billion investment in the newly issued preferred securities was interpreted by Wall Street Thursday as a major vote of confidence in the huge mortgage originator, with Countrywide stock opening up more than 10% before eventually closing up just 0.92%, or $0.20 a share.

When Bank of America announced its investment, though, little was known about the conditional approval of the investment.

The OCC said that despite the investment being labeled as a purchase of preferred securities, the agency would treat it as a purchase of debt instruments.

"In numerous other instances, the OCC has looked to the nature of an instrument instead of its label to assess whether it is a debt obligation or equity," Williams wrote. "Consistent with the OCC precedent discussed above, the securities at issue here possess characteristics typically associated with debt instruments, rather than common stock."

Williams also said that Bank of America would only have limited voting rights as a result of the investment.

So much for B of A's bargain. Last week I also expressed some doubt that $18 a share for CFC stock was actually a good deal. However I didn't back that up with any kind of analysis. So below is a cursory glance at CFC's financial condition and a look at what we might expect over the next 6 - 12 months.

Firstly let's take a look at CFC's bottom line. As can be seen from the graph below the company's earnings started to tank in 1Q07. Earnings for the first half of this year have totaled $919 million a 35% fall from the $1.406 billion posted in 1H06.


Consider that Countrywide has now closed down their 'non'-prime mortgage origination business. Also at the end of 2Q07 the company was sitting on $34 billion worth of loans for sale. Since the market for MBS has basically dried up I suspect they'll be sitting on most of those for a while yet.

Next take a look at CFC's provision for loan losses. Firstly on an annual basis. As you can see the provision for loan losses doubled in 2006 to $233m from $115 in 2005.

However that's just where the fun begins. Take a look at loan loss provisions on a quarterly basis. Basically they've gone exponential. Last quarter in fact they provided more for loan losses ($293 million) than for the whole of 2006 ($233m) which if you remember from the first graph was double the amount in 2005.

Now of the $444m in provisions for loan losses in the first 6 months of this financial year there have only been 193m, of charge-offs. However what do you think is going to happen as the number of adjustable rate mortgage resets ratchet up in the coming months?

According to this very informative article 45% of Countrywide’s loans carried adjustable rates in 2006. Even if loan loss provisions flatten from the 2Q07 level CFC is looking at $1 billion in loan loss provisions this year alone.

Countrywide's earnings are coming under attack on multiple fronts. Firstly origination revenues will take a hit as mortgage lending standards tighten and CFC stop making riskier loans. The riskier sub-prime loans by the way are the most profitable so expect margins to shrink.

Then there is the problem of having to sit on loans now that the market for mortgage backed securities has dried up impacting fee and service revenues and as we saw recently when CFC announced a 'tap' of their $11.5 billion credit line, impedes their funding ability.

Then there is the little matter of impaired loans which has been rising exponentially this financial year and don't forget the extra $145m in interest expense Countrywide now has to pay B of A each year. All this adds up to a deteriorating earnings picture for 2H07.

In trying to put a value on CFC I have assumed earnings of approximately $780 million for 2H07. That number is before any write-downs and is in line with the earnings decline in the first half. If anything, a 36% forecast decline for FY2007 earnings could prove to be optimistic.

For the sake of simplicity I have also assumed that the dividend will be kept constant as it has been over the past 2 quarters. Based on a FY07 estimate of $1.7 billion CFC's Return on Equity will decline significantly to around 12%

Discounting earnings at my standard required rate of return of 15% gives $17.66 per CFC share. CFC closed on Friday at $21 so it hardly seems attractive even at the B of A conversion price of $18 which as we know now doesn't exist.

More interesting will be in what shape CFC emerges in the next 6 - 12 months. CEO Mozillo believes that because the consolidation in the mortgage origination marketplace there is significant opportunity for Countrywide to gain market share in the prime mortgage space.

There also seems to be an assumption that sooner or later the market for MBS will return to normal. However what is normal? The total disregard for risk and the criminal ratings given by the ratings agencies over the past few years is not a normal state of affairs. It is an aberration. When the MBS market comes back it will be much subdued and the incentive to pump out billions of dollars of junk will just not be there.

Also given that the general consensus that a recovery in housing is 12 - 18 months away CFC is going to get smaller before it gets bigger. Undoubtedly there are other financials out there that are looking at shrinking operations and shrinking earnings.

The penny has not yet dropped on Wall Street that we have reached or are on the brink of the peak in the earnings cycle and are staring down the barrel of downgrades and reduced earnings.

The financial sector is large enough to drag the overall market into negative earnings territory however it will get some help from most things housing related and is sure to a include a fair share of retailers.