Countrywide Financial Corporation Analysis

Home Mortgages in America

Before the early 1930s, home mortgages in America were availed to a few households. These mortgages were not divided over the loan life; therefore, a one-off payment was to be made at the date of its expiration. During the great depression, many customers were unable to pay off the lump-sum payments hence creating defaulted loans.

The United States government decided to intervene in the market in order to salvage the affected stakeholders. It created the Federal Home loan bank to aid financial institutions by funding their working capital. This created additional funds for home mortgages and, therefore, could borrow to finance a mortgage. The National Housing Act of 1938 Act further protected lenders against default by the borrowers, ensuring that lending firms were not on the verge of collapsing.

The government then created a secondary market for investors to trade in mortgages. This association allowed the lending institutions to make a much greater number of loans. They could trade the loans in the created secondary markets. Therefore, they did not have to hold them full-term. Since loans were trading in the secondary market, new loans were made. In the late 60s, FNMA was reconstituted as Fannie Mae.

It then became a publicly sponsored government enterprise. The government excluded FM from the federal budget. Instead, the government transferred its portfolio of mortgages to another government-owned corporation, Ginnie Mae. This expanded homeownership. Around 1970, the Government created Freddie Mac as another Government Sponsored Enterprise. It pooled loans advanced to American homeowners.

These were used to create special securities, which were backed by the mortgages. The GSE then sold the loans to investors. These securities were less risky. The move was an advantage to investors as they could choose to purchase shares of a loan portfolio instead of an intact loan. This enabled them to diversify investment risk. The three GSE was assigned the task of supporting the new secondary mortgage market. This assisted low- income families to obtain funding for home loans. It also reduced the geographical discrimination in mortgage financing. Mortgage issuers standardized underwriting procedures. This made the issuing process faster and more efficient.

American Social Activists and Mortgage

American social activists accused mortgage issuers and the government of geographical discrimination. These activists used statistics to prove discrimination against those living in poor neighborhoods. These activists convinced the government to enact two laws, CRA and HMDA. The aim was to eliminate the identified injustice in the mortgage industry, therefore enabling minorities to obtain home loans. The Acts required detailed disclosure about mortgage terms from the lending institutions. They also required them to offer greater support to poor and marginalized neighborhoods.

Some lenders disclosures still revealed redlining. However, they were very quick to defend themselves. They pointed out the fact that residents of such neighborhoods were subject to high unemployment rates. This increased their risk of default greatly. Those residents who were employed were very low-income earners. Low-income earners could not afford to pay the deposit or subsequent repayments.

In response to these complaints, the government enacted a law that eliminated the limit on interest rates. Lenders were now allowed to charge higher interest rates with a higher risk of default. The Housing and Community Development Act was enacted. This enabled FHA borrowers with unstable credit records to obtain mortgage loans. It also increased the LTV ratio to approximately 91 to 96 percent.

The above legislative was an effective way of ensuring equity and fairness in mortgage loan allocations. It was not only an advantage to low-income earners in the sense that they could acquire loan mortgages but to the lenders such that they had a hedge over the feared risky loans. These measures increased homeownership tremendously. By the early 2000s, one in seven Americans owned their homes. However, the subprime mortgage loans and the high loan to value ratio posed a higher risk to both the lenders and the investors in the secondary market. As the subprime market grew, underwriting rules and standards were relaxed.

Little attention was accorded to documentation requirements and credit histories of the borrower. There was a greater risk of defaulting as demand for homeownership increased. The shoot up in demand could cause a price bubble in housing. At the burst of the bubble, unable to sell the houses at a higher price, the subprime borrowers could default.

The Subprime Mortgage

The subprime mortgage loans led to a high demand for homeownership. There was laxity in underwriting standards. Many Americans acquired homes. This, in turn, increased the prices of housing, causing housing bubbles. Homeowners discovered they could make profits quite fast by buying and selling houses. They could also take out additional loans for other users based on their homes. During this time, the US economy was at stake.

Around 2007, the economy was getting weaker, demand for housing declined to cause home prices to drop. The value of the property dropped way below their market value, implying that many homeowners were forced into foreclosure, as they could not sell their homes at a price enough to pay for their mortgage balance. Lenders had made quite a large number of originations in the subprime mortgage loans, which had a higher risk of default.

This they made without following stringent borrowing conditions. The lenders, therefore, found themselves with property acquired from foreclosures, which could not fetch the mortgage amount in the market. There was no trust in the financial system. MBSs could not sell shares price. They, therefore, found themselves holding such shares. All financial institutions were forced to mark their assets to market value. Some were forced to declare bankruptcy, and larger institutions acquired others. The American Insurance Group announced its inability to back bond ratings assigned to MBSs. The United States Treasury provided a bailout to AIG and Fannie Mae, and Freddie Mac. In essence, subprime mortgages contributed much to the 2008 financial crisis.

Countrywide Financial Corporation and Financial Services in Mortgage

CFC offered financial services in mortgage lending and other real estate businesses. CFC was managed through its five business segments. These are; Mortgage Banking, Banking, Capital markets, Insurance, and global operations. Apparently, CFC mainly majored in mortgage banking. In 1995-1996, CFC began to underwrite home equity and subprime loans.

CFC had laid its strategy targeting the origination of subprime mortgages and no- down payment loans. This was in synchrony with the Community Reinvestment Act and the Depository and Institution Deregulation and Monetary Control Act of 1980, which encouraged lending to low-income earners. The federal legislation promoted homeownership, allowing many to acquire and own homes.

The Countrywide’s financial statistics reveal a general rise in subprime loans from 1996 to 2006. This increased the number of subscribers of the subprime mortgage loans. CFC, having the largest market share of mortgages, had probably a high number of subprime loan originations approximated to 11 percent of its loan originations. Most of these originations were made during housing boom. Therefore, they were at high risk of being defaulted. Exhibit 7 of the case study shows that initially in 1996 when CFC started offering subprime loans, there were fewer originations.With time from 1996 through to 2006 the number of originations increased from 2 to 227 in 2006.

This can be attributed to encouragement from government to provide subprime loans. Exhibit 2 showing the percentage of prime versus subprime reveals that the percentage total of originations in prime mortgages decreased from 94 percent in 1994 to 63.7 percent in 2006. While the subprime percentage total increased from 6 percent in 1994 to 36.3 percent in 2006.Implying that as the number of prime loans reduced , CFC ventured in the likely risky subprime loans.

The Mortgage Loan Production for Countrywide Financial Corporation

The mortgage loan production for CFC shows a general increase in total mortgage loans from 2003 worth$ 434864 to 468, 172 in 2006. In 2007, there was a drop of revenue to 6,061,437. This was due to the then housing boom where there was an increase in demand for house therefore forcing home prices upward. The 2007 figures are lower. The housing bubble burst in 2007 pushing prices of housing way down.

Evaluation of CFC financial ratios

Return on Average Assets

This ratio measures the rate earned on each dollar amount invested in assets. It is computed by taking profit before interest and tax divided by Average Total Assets (Multiplied by 100 percent).

The rate earned on each dollar invested in CFC decreased from 2003-2.65 percent to 0.30%. This implies that as much was invested in assets its profits returns reduced.

Return on Average Equity

This ratio shows how many dollars of net income was earned for each dollar invested by the shareholders. Generally, investors expect to earn much if they invest more.

Return on Equity= Net Income –Preferred dividends

Average common stockholders’ Equity

CFC financials show a decline in ROE. That is from 34.25% in 2003, to 4.57% in 2007. The more the shareholders invested the less the returns obtained invested funds.

Dividend Payout Ratio

This measure the percentage of earnings distributed in the form of cash dividends.

It is calculated by dividing cash dividends by the net income. CFC Financial shows that there was an increase in issue of cash dividend by 10.1% in 2006. No dividend was paid in 2007. This generally implies that CFC did not put much into investments but rather issued dividends to its shareholders hence low growth rate.

Cfc Evaluation on Annual Growth

Revenues

Compound Annual Growth Rate for Revenues = (Revenues for 2007)1/4 – 1

(Revenues in 2003 )

(6,061,437)1/4 -1

(7,978,642)

=-0.8100

=-8.1% (Figs in thousands)

Expenses

Compound Annual Growth Rate for Expenses = (Expenses for 2007)1/4 – 1

(Expenses for 2003)

= (7371711/4132870)1/4 – 1

= 0.1556

=15.56%

There was an increased growth rate in expenses compared to Revenues, which posted a negative growth rates. As expenses shot up, returns in terms of revenues tremendously reduced. The overall growth rate of CFC was poor. The high expenses, which essentially could not be covered by revenues therefore, signify this.

Most of CFC loan originations were not retained for investments rather cash dividends were paid out to shareholders as indicated by high Dividend Payout Ratios. This could be one of the reasons for negative growth rate of CFC.

CFC performance from 2003- 2007 is poor. Increased expenses, reduced revenues, evidence this. In addition, there is increased DPR, Reduced ROE and ROA and more so increase in cash dividend declared by the firm, which in essence was to hide the financial position of CFC to investors.

Countrywide Financial Corporation and Predatory Lending Practices

CFC practiced predatory lending practices. These involved deception of potential and existing customers. The company employees also manipulated and deceived borrowers to agree to loan terms. This was revealed when CFC was charged with predatory lending practices in a lawsuit filed by the Department of Legal Affairs. CFC did not uphold its own stipulated underwriting procedures. It issued borrowers with loans they could not afford. Secondly, the company failed to give a full disclosure of loan terms to the borrowers. Finally, CFC and provided its underwriters with bonuses based upon volume of mortgages approved.

CFCs compensation system was based on number of loan originations made. It did not factor loan defaults into the compensation measure. Therefore risky loans expense was ignored. It was also revealed that CFC senior executives were aware of the degree of defaults that would occur but they still increased the number of subprime loans originated. The company went further to allow borrowers to select their desired monthly repayment.

These repayments did not consider the interest required. Ties were also uncovered in Angelo Mozillo’s emails. In 2009, he was charged with misrepresentation of CFC’s credit and market risk. As the CEO, Mozillo awarded himself a huge compensation in terms of salary. He also enjoyed huge expensive perquisites at expense of CFC stakeholders. This also applied to the other executives. Mozilo took stock options worth $ 121, which gave him huge returns at the sale of CFC to BoA. The VIP Program at CFC was full of corruption. It was centered mainly on friends of Angelo and it serviced friends and contacts of CFC executives.

This practice evidently portrayed discrimination and corruption. Given that CFC was a nationwide largest mortgage lender this unethical practices did not only have a negative impact to borrowers and shareholders but also the economy at large.

The Senior Management of Bank of America

The senior management of Bank of America should have a strategic plan outlining the mission, vision, objectives, core values, short term and long-term strategies of the new CFC. Having changed its brand name, they should focus on restructuring systems on which the new mortgage firm will work on. For the sake of transparency, they should come up with a fully-fledged auditing department that will ensure internal controls are in place. The department will also oversee full financial disclosures. This also will ensure that gaps are identified and worked on in time to avoid actions that could cause harm to the economy.Each department should outline its most urgent objectives in line with the overall the firm’s vision which in turn should reflect the goal of industry.

BoA managers should come up with stringent underwriting standards especially for subprime loans if they have to be offered. Revised rates should be established for risky loans to the low-income earners, and the conforming loans. BoA should also come up with strategy to hedge against risks of default. This will ensure that shareholders funds are safeguarded. If the new CFC demonstrates care for their needs, stakeholders will increase their trust in the firm.

Thereafter, a risk management department should be set up. BoA should set up systems that will ensure constant monitoring of the liquidity position of the mortgage firm. A compensation system should be able to motivate employees as well as making sure the mortgage firm’s shareholders wealth is maximized. It should come up with a platform on which remuneration is done preventing managers from taking perquisites that could drain the organization off finances. In addition, it should come up with an established code of ethics to be followed by every employee.

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