COUNTRYWIDE FINANCIAL CORPORATION AND THE SUBPRIME MORTGAGE DEBACLE
Business Policy and Strategy - CASE STUDY
NIVASEN GOVENDER
The financial meltdown of 2008 proved that actions in the market place do not occur in isolation. When these actions are aggregated, the consequences can be devastating. Many lessons can be gleaned but the question is whether people are able to learn from them or continue along the same course of action due to situations of financial leverage that many possess over others.
A solid understanding of the history of the mortgage industry is crucial in contextualizing the financial crisis of 2008. An analysis of the practices and scope of operations of one of the largest players in the mortgage industry, Countrywide Financial, can shed further light on the events leading up to 2008. To help achieve this, Porter’s Five Forces Model will also be used. Upon drawing a conclusion as to the causes of the financial crises, the Political, Economic, Social and Technological Impacts on the financial industry will be evaluated. Lastly, a set of recommendations will be made to companies like Bank of America to ensure long-term financial prosperity for all parties involved.
Overview of Mortgage Lending In the United States
The policies or pieces of regulation passed by government with regard to the mortgage industry can be considered as individual blocks of wood that helped slowly fuel a fire that would eventually burn uncontrollably.
Before the year 1929, loans were limited to a select number of clients and loan terms ranged between 3 to 10 years. It is also interesting to note that loan- to- value ratios were average, approximately 60%1. This means that lenders would only provide roughly 60% of the money necessary to purchase a home. The remainder would have needed to be financed by the buyer’s own savings. Due to the fact that loans were non- amortizing, only interest payments would be made monthly, while the principal amount would be due at the end of the loan term in the form of a lump sum. As a result, homeowners would have needed to take steps to ensure that they have enough money at the loan maturity date to settle their obligations. The pressure to meet these terms would have made this form of lending risky. The Great Depression further compounded this risk and many people failed to make their payments.
The US government responded by creating:
· The Federal Home Loan Bank to provide short term funding to financial institutions so they could have more money to lend for home mortgages
· The National Housing Act, which insured loans made by lenders in the event borrowers defaulted
· The Federal Housing Administration, which compensated lenders for losses associated with defaults
· The Federal National Mortgage Association to provide a secondary market for mortgages; this means that once a loan is made it can be repackaged by the bank and sold to investors
· Fannie Mae which was the old Federal National Mortgage Association was now a government enterprise
· Freddie Mac which combined conforming loans with Mortgage Backed Securities and sold shares to those portfolios
After the savings and loans crisis in 1970, (financial institutions were not receiving enough interest from the mortgages they held to pay savings account holders), mortgage originations and loan servicing become different functions. Institutions could now sell Mortgage Backed Securities to investors and not have to hold these loans for 25 or 30 years. As a result, more institutions sprung up making mortgage loans and then selling them to investors. In 1987, there were 7000 of these loan originators1. By 2006, there were 530001.
In an effort to expand home ownership after 1970 the government:
· Created the Community Reinvestment Act to provide financing to minorities in low income areas
· Created the Depository Institution Deregulation and Monetary Control Act in 1980 which lowered standards for qualifying borrowers
Elements of subprime (below the prime lending rate) mortgages were evident in the above-mentioned regulations but it only became prominent in the early 1990’s.
This series of regulation or lack thereof enabled 70% of Americans to own a home by the year 2004.
See Appendix 1 (US Ownership Rate, 1930-2004)
This expansion in home ownership pushed home values higher, which in turn caused people to make renovations and other big purchases because of this increase in equity they could realize should they decide to sell their homes. But as the US economy began to weaken with inflation and interest rate hikes people began to default on mortgages, financial institutions lost value on mortgage backed securities and credit was scarce. Thus, the entire financial system was heading for disaster.
To gain a deeper insight into the effects of the financial collapse, it would make sense to analyze one of the biggest players in mortgage lending at that time, Countrywide Financial Corporation.
Countrywide Financial Corporation
Countrywide was a financial services provider founded in 1969 with a core business of mortgage banking. Its key strength early on was the ability to expand throughout the country. It took the company only 11 years to create a presence in eight states with 40 offices1. By 2006, the company was valued at 24 billion dollars with assets exceeding 200 million dollars1.
The company had several business segments:
· Mortgage Banking - Includes the origination, purchase, sale of non-commercial mortgage loans; In 2006, this core business generated 48% of their pretax profits
· Banking – Collected retail deposits (savings) which it used to invest in mortgage loans and home equity credit
· Capital Markets – Broker trading which excelled in underwriting and selling mortgage backed securities
· Insurance – For property, life and underwriting disability insurance
· Global Operations – The licensing of proprietary technology to other mortgage lenders and outsourcing some administration functions to India
Even before the subprime mortgage crisis, the company was in the spotlight for a number of incidents. Employees complained about being overworked, racial bias was demonstrated towards minority borrowers and friends of the CEO were given special concessions2.
A reduction in lending regulation by government provided Countrywide with the opportunity to extend as much credit as they could even thou borrowers were unqualified to meet those obligations. They also discovered that the demand for mortgage-backed securities by investors was increasing and this presented the prospect to shift the liability away from its books and onto investment banks. The profits realized in the short run were staggering and they chose to be ignorant about future consequences. It is to be noted that Countrywide was just one of the institutions partaking in this activity. Thousands of brokers as well as other banks were doing exactly the same.
With regard to employee compensation, incentives were paid based on the amount of loan originations, with loan defaults not factored into the equation. This system was set up to encourage the wrong type of behavior. The CEO, Mozilo exercised 121 million dollars stock options in 2007 and received between 80 and 115 million dollars after the sale to Bank of America1.
By using the conventional Value Chain Structure below, we can integrate and analyze some of Countrywide’s activities.
Supply Management:
· Gathering savings which would be used to fund mortgage lending
· Searching and inspecting potential borrowers who required loans, but with the “inspecting” part fairly non-existent
Operations:
· Securing mortgage deals, extending lines of credit
· Obtaining ratings on loans from outside agencies
· Insurance underwriting
Sales/Marketing:
· 321 million dollars was spent by Countrywide in 2007 for advertising and promotion1
· Promotions included the “bait and switch” which advertised initial low interest rates without warning borrowers about later fluctuations
See Appendix 2 (Online article from attorneygeneral.gov)
Distribution:
· Individual mortgages were bundled together as mortgage-backed securities and collateralized debt obligations, and sold to investment banks.
· These securities and derivatives were traded on capital markets
Services:
· These included various administrative and legal functions related to mortgage bonds and their other financial products like insurance
Profit:
· Massive short- term profits were realized because Countrywide and other lenders did not need to hold these mortgages for long periods of time
To further characterize Countrywide Financial, we can consider the microenvironment of the company. To accomplish this we can turn to Porter’ Five Forces Model.
Porter’s Five Forces Model for Countrywide Financial
Substitute Products:
Few alternatives exist for obtaining money to finance large purchases like homes. Some individuals will access their reserves or savings. Others will look to make use of regular interest payments received from their investments in shares or bonds to cover monthly installments for their homes/vehicles.
A few fortunate people will have access to trusts or foundations to acquire funds. However, the majority of people will turn to the conventional means for financing in the form of loans through financial institutions like Countrywide. With regard to these loans, an alternative is also refinancing through more than one institution should interest rates become unmanageable.
Buyers:
A weak bargaining power on the part of borrowers stems from a few factors. Firstly, there was a lack of knowledge on the part of borrowers in terms of contract/loan provisions. As a result, buyers were partially at fault for signing and agreeing to terms that they did not fully understand.
Institutions were aware of this and leveraged the situation in their favor by manipulating borrowers and engaging in predatory lending practices. The asymmetry of information also played a part. In other words, some borrowers were not aware that their loans were being sold to investment banks and that the banks were not the ones holding the title deeds to their homes anymore. This makes a difference when defaults caused homes to be repossessed because the banks no longer had the right to sell people’s home’s as they no longer had ownership of those titles.
Buyers did have some bargaining power in the form of multiple mortgage brokers to choose from, especially when re-financing became necessary.
Suppliers:
The large supply of private and corporate savings held by financial institutions, made lending money for mortgages simple. These huge reserves of cash were used to finance homes for buyers. However, the loans held by banks would soon be dumped to investors.
Government agencies like the FHA, tipped the scales in favor of banks by insuring loans that went into default. This incentivized reckless loan originations by banks with little concern for anyone else.
New Entrants:
The threat of new entrants (suppliers) of mortgages was very high. This is due to the amazing short- term profit potential. The lack of proper regulation surrounding mortgage companies and issuing loans also made it easier for potential entrants to penetrate the market. From 1987 to 2006, the number of loan originators had increased by 657% to reach approximately 53 0001.
Rivalry:
With the demand for mortgage-backed securities on the rise in the early 2000’s, the banks aggressively pursued loan originations and competed heavily with other institutions. As means to competing, they indulged in employee incentives, deceptive marketing and predatory lending amongst other factors. These non-ethical competitive methods formed the basis of their activities in the pursuit of profit.
See Appendix 3 A (Employee Incentives from 1992 – 2007)
AND
Appendix 3 B (Online article from TIME Magazine, “25 People to blame for the Financial Crisis”)
The financial crisis caused partly by these irresponsible actions would temporarily cripple a large portion of the US and the world. It would take time and intervention before nations could get back on their feet. Nevertheless, before we draw a conclusion, what does a Political, Economic, Social and Technological analysis of the financial crisis reveal?
PEST Analysis
Political Factors:
The Great Depression from 1929 to the early 1940’s had proved the risks associated with non-amortizing mortgages. As part of the “New Deal” legislation, President Franklin Roosevelt sought to provide Relief, Recovery and Reform to remedy the situation. Relief came in the form of The FHA, FHLB and other agencies to promote homeownership during these tough times. One type of Reform was protection for loan makers against defaults.
Firstly, this type of reform instituted does not promote long-term economic progress. It incentivizes behavior that is counterproductive to financial prosperity. Secondly, not enough significant reform materialized to ensure that institutions act in the best interest of all parties involved and that un-creditworthy applicants are denied credit. Instead of using money to insure losses or extend additional credit to banks, which was bound to be lost, the government could have better used that money. The government could have implemented programs to build homes for the people using those funds. Immediately, jobs would be created. Then those who wanted homes would now pay the government monthly installments at a very favorable rate, with the goal not being to exploit. In this way the government could better serve the people and the money spent, would be recovered over time as opposed to being put in the hands of greedy investors.
As the 1970’s approached, social activists raised concerns about minorities’ lack of opportunity to acquire funds. Under pressure from the people, the government created the Community Reinvestment Act and the FHA adopted 95% loan-to-value ratios1.
It appears that throughout time, more reactive strategies were established as opposed to proactive reformative ones. However, a possible concealed viewpoint of the government could have been that stricter controls would limit a lot of people from acquiring financing. These people would then see the government as not creating enough opportunities and as a result, affect popularity polls and re-election.
Economic Factors:
Home ownership in the US rapidly increased. However, this increase was primarily due to home financing becoming easier to obtain as well as tax credits and not because the wealth/income of the nation was rising. Therefore, this can be considered artificial increases in the prices of homes.
Buyers were also leveraged to make profits given that no down payment needed to be placed to buy a home. For example, someone buys a house for $ 1 000 000 and places a down payment of $ 400 000. They then sell it for $ 1 200 000. The return on investment is 50% (200 000 profit over 400 000 initial investment).