Get out your hatchets: Part 2, the wheat
[Continued from yesterday’s Part 1.]
Yesterday I started a series deconstructing a New York Times tut-tut hatchet job on Countrywide Financial, the nation’s largest independent mortgage broker, seeking to separate chaff, wheat, and just possibly, the kernels of malfeasance claims.
[Minor personal disclosure: Two years ago, as part of Rockefeller’s week-long Bellagio Housing Conference, I met and for a few days worked with Angelo Mozilo, Countrywide’s founder and chief executive. I liked him then … but of course, that proves precisely nothing when it comes to whether any part of Countrywide behaved badly.]
Yesterday’s post covered the sins of size and professionalism.
Unfortunately, not those sins
Now we move into slightly questionable territory — actions that are at least not inconsistent with the nefarious motives the Times is earnestly trying to evoke and connote.
3. Mr. Mozilo has been selling his stock
After we’ve made snide allusions about the company and its methods, what’s next on the checklist? Why, the CEO himself:
Tan and proud of it
Mr. Mozilo has ridden this remarkable wave to immense riches, thanks to generous annual stock option grants. Rarely a buyer of Countrywide shares — he has not bought a share since 1987, according to Securities and Exchange Commission filings —
What a ridiculous cheap shot. Why would he buy stock? He founded the company, so he owned it to begin with, and he sold some of it to the public years ago!
— he has been a huge seller in recent years. Since the company listed its shares on the New York Stock Exchange in 1984, he has reaped $406 million selling Countrywide stock.
Hey, New York Times, that’s a 23-year interval.
As the subprime mortgage debacle began to unfold this year, Mr. Mozilo’s selling accelerated. Filings show that he made $129 million from stock sales during the last 12 months, or almost one-third of the entire amount he has reaped over the last 23 years.
Because the stock was at its all-time high.
He still holds 1.4 million shares in Countrywide, a 0.24% stake that is worth $29.4 million.
“Mr. Mozilo has stated publicly that his current plan recognizes his personal need to diversify some of his assets as he approaches retirement,” said Rick Simon, a Countrywide spokesman.
He might want cash for charitable activities or otherwise.
“His personal wealth remains heavily weighted in Countrywide shares, and he is, by far, the leading individual shareholder in the company.”
Just in case you’re wondering, Mr. Mozilo is 69.
4. Countrywide’s compensation systems created perverse incentives
Now, finally, we get to if not the kernels then at least the grain — at least, something beyond mere ephemera. From top to bottom, Countrywide’s external partners, executives, and staff were compensated based on Countrywide’s income, which in this business can be readily measured loan by loan. Some loans are riskier than others; some cost more than others.
Some things cost more, others cost less
As I wrote in the credit conundrum some months back (before all the fits hit):
[Every] borrower pays a premium related to that borrower’s credit-worthiness, or said in a simplified equation:
Setting an Interest Rate (I)
+ C, Treasury’s cost of capital (set by the Federal Reserve)
+ R, Risk premium (lender judgment based on assessing the applicant and his collateral)
= I, Interest rate quoted for this loan
The interest rate every borrower pays is thus related to the loan’s riskiness. That varies by asset class (as loan collateral, homes are safer than restaurants, to take an extreme example), but within a particular asset class, the prime consideration is borrower quality.
The relationship between risk and yield should be self-evident, yet it comes in this story as a revelation:
As a result, former employees said, the company’s commission structure rewarded sales representatives for making risky, high-cost loans. For example, according to another mortgage sales representative affiliated with Countrywide, adding a three-year prepayment penalty to a loan would generate an extra 1% of the loan’s value in a commission.
You see, to a lender ‘risk’ isn’t just credit risk (chance of default), it’s also prepayment risk (the chance that somebody will refinance at a lower rate, cutting us out of our future rate spread). Extending the loan’s maturity makes it more profitable, and that’s what prepayment penalties do.
Many of these loans had interest rates that recently reset from low teaser levels to double digits; others carry prohibitive prepayment penalties that have made refinancing impossibly expensive, even before this month’s upheaval in the mortgage markets.
The same reasoning applies to buyers of securitized loans:
One reason these loans were so lucrative for Countrywide is that investors who bought securities backed by the mortgages were willing to pay more for (x) loans with prepayment penalties and (y) those whose interest rates were going to reset at higher levels. Investors ponied up [Can’t resist the loaded words, can she? — Ed.] because pools of subprime loans were likely to generate a larger cash flow than prime loans that carried lower fixed rates.
We’re only in it for the money
As usual with this story, the paragraph conflates two ideas that are really quite different.
Prepayment. Lending and borrowing is about renting money. In normal mortgage finance, the borrower takes out a fixed-rate loan, and has the right to prepay it after some period of time. If interest rates rise, the borrower hangs on to the loan, chortling at how cheap the payments are. If interest rates fall, the borrower refinances, and gains the savings. Said in finance-speak, a fixed-rate borrower who can prepay has all the optionality, and optionality has value. Prepayment penalties thus are a legitimate means of balancing the optionality; they translate into higher or lower interest rates for borrowers, and higher or lower values for loans.
One former employee provided documents indicating Countrywide’s minimum profit margins on subprime loans of different sizes. These ranged from 5% on small loans of $100,000 to $200,000 to 3% on loans of $350,000 to $500,000. But on subprime loans that imposed heavy burdens on borrowers, like high prepayment penalties that persisted for three years, Countrywide’s margins could reach 15% of the loan, the former employee said.
‘Could’. Conditional verb. Not ‘would.’ For a loan, not a portfolio. As I put it in the credit conundrum:
Risk premium is applied not just to the defaulting borrower, but to everybody with similar credit characteristics. It’s a simple pooling: if I (a lender) want to make a profit of (say) 100 basis points per loan per year, I have to charge more than that to reflect the risk that some borrowers will default and when they do, I’ll lose money.
In short, I have to be compensated for the risk.
The bigger the risk, the more compensation I need.
Prepayment penalties and late fees are thus means of reducing cost given event occurrence (prepayment or default, as the case may be).
When borrowers tried to reduce their mortgage debt, Countrywide cashed in: prepayment penalties generated significant revenue for the company — $268 million last year, up from $212 million in 2005. When borrowers had difficulty making payments, Countrywide cashed in again: late charges produced even more in 2006 — some $285 million.
Late charges are a knife edge. If they pay, all well and good; if not, you waive ‘em to protect your loan. Late charges also serve the useful purpose of getting the borrowers attention in a way that crabby late notices do not.
Rate resets. These are more nasty. The borrower’s income eligibility was probably figured using the low introductory rate, and if the rate ratchets up, the borrower may be unable to pay it. The borrower may be counting on something good happening — a raise, home appreciation, a new lender offering a refinancing — and quite often, it does.
“Something will always turn up”
In a variable-payment loan, the borrower surrenders lots of optionality. Yet optionality isn’t zero-sum — the lender’s given up optionality as well. Both sides are at the mercy of market forces, and the wind blows where it will.
While mortgage brokers’ commissions would vary on loans that reset after a short period with a low teaser rate, the higher the rate at reset, the greater the commission earned, these people said.
Well, of course — again, it’s all about the loan’s expected present value. Note that, among the lender dramatis personae, now the originating broker and the borrower have a shared interest in not looking too closely at the borrower’s ability to pay. Who’s at risk here? Why, the investing lenders, and they’re not in the room.
The company’s incentive system also encouraged brokers and sales representatives to move borrowers into the subprime category, even if their financial position meant that they belonged higher up the loan spectrum. Brokers who peddled subprime loans received commissions of 0.50% of the loan’s value, versus 0.20% on loans one step up the quality ladder, known as Alternate-A, former brokers said.
More sophist construction — correlation does not imply causation, and imputing evil as the sole motive from among a long motive menu.
Stipulate that subprime loans earn a higher commission rate. Why might that be? Here’s four reasons off the top of my head:
- More care required in credit evaluation.
- Harder to place.
- Generally smaller than Alt-A loans (because they go to poorer people, who can afford less home).
- Incentive to swindle customers.
You gotta admit, it makes better copy
[Concluded tomorrow in Part 3.]
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