The USS Housing Market

It wasn't just the news that second quarter profits were down 33 percent at Countrywide Financial that had some investors spooked Tuesday. It was the fact that Countrywide took hundreds of millions in charges and increased its provisions for losses because prime home equity loans it originated aren't performing as well as expected (see Inman News story).

Countrywide's been talking for months about how it cut back on subprime loan production and went on a hiring jag in order to take business from weaker competitors as they fall by the wayside during the downturn. Now we hear there are worries about Countrywide's prime loans?

In a conference call with investment analysts, Countrywide CEO Angelo Mozilo said that subprime tsunami recedes, there will be just five major lenders with a major share of the mortgage lending market (compared to 10 today), and that Countrywide intends to be one of them.

Housing markets are like a "huge battleship" that will take two years to turn around, he said, but 2009, 2010 and 2011 will be "great years for the industry."

Click continue reading to hear Countrywide's explanation for the worsened expectations for its prime home equity loans, and Mozilo's take on what it will take to turn housing markets around.

Mozilo on the housing market:

"I think the first thing is that the inventory and the house supply has to reverse itself. Because as I view it, and I have been through a lot of these things in 54 years, although the market's a lot bigger now so the problems are a lot bigger, but as I try to walk through what happened here, and could a lot of this been foreseen ... should we have known, could we have seen it, as I do reflect on it, and I do a lot, that nobody saw this coming. S&P and Moody's didn't see it coming, but they just downgrade bonds. They don't take hits. Bear Stearns didn't see it coming, Merrill Lynch didn't see it coming, nobody saw this coming.

So it was the deterioration of real estate values that was the base cause of all of this. We had none of this as real estate values were going up. It's an oversimplification, admittedly, but (it was) deterioration in real estate values, as a result of the affordability issue, and an oversupply.

So I think one turning point is the supply of housing, because I think once that turns around, then psychology of the country changes, because the borrowers and potential borrowers simply say look, I'll just wait, because I'll be able to buy the house cheaper tomorrow than I can today. And that psychology has to change, and the only thing that's going to change it is supply.

The other is that the Fed, knowing that well over 50, 60, 70 percent of the loans made in 2003, 4, 5, and 6, were indexed, variable-rate loans -- indexed one way or another to the Fed funds rate -- increased the Fed funds rate 17 times, 17 consecutive times, with most of the product out there being variable rate product. And you never knew when they were going to stop increasing. But the fact they did that, had a material impact on affordability, as people went to refinance or people went to buy. Major, major impact. So for a Fed governor to say that the lending industry had this coming is unbelievable, when the Fed, to a great extent, was a contributor -- a knowing contributing factor to this. Plus they came in with the joint agency guidelines which restricted the type of loans we could make in an environment where we had limited liquidity to start with.

The other was the rapid increase in real estate values that we have faced over the last few years, caused people to stretch themselves, and their financial resources in order to get into a home. There's a high desire for people to own a home. And the mortgage product then was developed to try help them get into the home, which was known as exotic products of various kinds. But there was a secondary market for it. There was plenty of liquidity for that, and so the primary market responds to that.

And I say also the traditional underwriting standards ... were altered and (lenders) used more technology and more credit scoring as a judgmental factor in whether a loan could qualify or not, versus the traditional documentation. And you had on top of that ... speculation.

I say 2009 because my experience is it just takes a long time to turn a battleship around. And this is a huge battleship, and it's headed in the wrong direction. So first we have to get it to slow down, then stop, and then turn. And I think ... this is just a gut feeling, based upon what I've seen in the past and the size of this market, is its going to take the balance of this year to get this thing to look like it's slowing down, 2008 to get it to slow down and stop, and 2009 to head in the other direction. My feeling is by that time, we'll have reduced competition, very substantial pent up demand, because of all the people that have been closed out of housing, probably lower interest rates. I do thing that this ultimately has to have an effect on the economy. I just can't believe that this economy is totally insulated from housing, and we'll be 2009, 2010, 2011, I look to as sort of like 2003, 2004 and 2005 -- great years for the industry.

What is up with those prime HELOCs?

The 3 1/2 hour conference call also included an in-depth discussion of what's happening with the performance of Countrywide's prime home equity loans, after the company boosted loan loss provisions for loans it held for investment by $181 million, and wrote down the value of residual securities backed by such loans by $388 million. Delinquencies of 90 days or more for the company's prime home equity loans stood at 2.15 percent, compared to .75 percent last year

Some analysts wondered how Countrywide could be seeing such high delinquency rates on prime loans.

"We are experiencing home price depreciation almost like never before, with the exception of the Great Depression," Mozilo said. "And so I think using standards, or frames of reference on prime and the performance of prime in other environments may not be a fair comparison in light of what's happening to real estate values."

Mozilo said the most of the delinquencies seen Countrywide's prime home equity loans aren't driven by resets, but "traditional issues" like people losing their jobs, crumbling marriages or failing health. "The problem is, they either can't refinance, because the value of the homes have gone down, so they're underwater, or the (loan) program they used to get into the home is no longer available to them," he said.

The average FICO score on Countrywide's prime home equity loans is 730. But Countrywide's chief risk officer, John McMurray, said that's an average, and borrower's FICO scores can vary widely.

"There is a belief by many that prime FICOs stop at 620. That's not the case," McMurray said. "There are affordability programs, and Fannie Mae expanded approval is an example, that go far below 620, yet those are still considered prime. Documentation and leverage (loan-to-value ratio) are also important factors. So if you have the existence of one of these high risk factors, or the combination of several of these factors in a prime loan, its going to exhibit higher delinquencies."

McMurray said some of the prime home equity loans Countrywide is holding for investment are being subjected to a more conservative charge off standard for the first time this quarter. The loans become charge offs after they're delinquent for 180 days, instead when they go into foreclosure. That accounted for about $30 million of a $181 million charge off on prime home equity loans held for investment in the banking segment, he said.

President and Chief Operating Officer David Sambol said home equity loans with higher loan-to-value ratios and reduced documentations were "disproportionately contributing to charge offs and delinquencies" in Countrywide's prime home equity loans. Many, he said, stemmed "from the higher concentrations of piggyback financing that we did, and have in the (portfolio) stemming from what was occurring in the market. I'd point out that when we originated those loans, we were cognizant of the fact that they would perform differently than traditional home equity loans, and we attempted to price for that."

Countrywide was pricing such loans 190 basis points above the prime rate, compared to "prime flat" or "prime minus" for typical stand-alone HELOCs, Sambol said. "That was a risk premium that we added for those loans, but certainly we didn't anticipate what would happen with (home price appreciation)."

Sambol said Countrywide was "enjoying very robust earnings" on the loans, "and now we're really seeing some of that risk premium we charge or embedded in the loan being absorbed. It's another way to look at what we're seeing."

So how do we know there won't be further charge offs and write downs, nervous analysts wanted to know?

McMurray said Countrywide has a "housing price forecast embedded in the valuation that's more severe than anything we've seen in the past. I hesitate to give any comfort, because the future is uncertain. It's possible it will have to be revisited. We hope that's not the case."

Sambol said Countrywide worked with borrowers to modify the terms of about 2,000 loans in June -- double the rate of a year ago. He said the bank is willing to do workouts when its in its best economic interest and the interests of the borrower.

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