A Foretaste of the New World
Washington is Setting Up

by
William Krehm

I owe our readers a word of apology for the figure-laden report on how Washington is kidding itself that it is cleaning up the subprime economy that it has created. What is involved is one of the very largest US banks taking over the largest mortgaging organization. The reporter is Gretchen Morgenson, one of the very keenest Times reporters.

My quotations are from New York Times (08/06, “Countrywides Buyer Isnt Blinking). “Six months ago the Bank of America announced its plans to take over Countrywide Financial. Many investors have doubted that the $4 billion deal for the hobbled mortgage lender would get done. Bank of America has been strangely silent about its plans for merging the two operations, with the exception of a cryptic regulatory filing last month warning that investors should not count on it assuming all of Countrywides debt.

“But in a conference call on Monday with investors, Kenneth D. Lewis, the chief executive of the Bank of America, confirmed his commitment to the Countrywide buyout, which is expected to close by the end of September. When asked about the fact that home prices have plummeted and loan defaults have soared since the deal was announced with Mr. Lewis defending it as compelling, with a pretty nice upside. We dont have our heads in the sand.

“Investing in distressed assets, of course, can be extremely profitable. But be nervous about the deal, analysts say. As the nations largest mortgage lender, Countrywide, stands at the centre of the mortgage storm and is being buffeted by woeful financial results, but also by intense scrutiny from state and federal regulators. Bankruptcy judges have become vocal about what they consider dubious tactics taken by Countrywide against troubled borrowers.

“Its a lot to ask Bank of America shareholders to stomach, said Mike Larson, a real estate analyst at Weiss Research in Jupiter, Fla.

“Countrywide is not only one of the biggest lenders in California and Florida, states that have been hit hard by the housing crisis, he said. It also has a large portfolio of home equity lines of credit and an especially risky type of adjustable-rate mortgage known as the option ARM. It shows that the company is vulnerable to many geographies and loan types that are showing the worst performance, said Mr. Larson. It raises a real question about the logic of the deal at current terms.

“Those terms, struck on Jan. 11 call for an exchange of Countrywide stock for Bank of America shares worth $5.56 each at current price. Indicating the skepticism about the transaction, Countrywides shares trade at a 13% discount to that price.

“David Dreman, chairman of Dreman Value Management, which oversees $15 billion in assets, is a Bank of America shareholder who said had never been happy with the Countrywide deal at current terms.

“On Thursday, the Federal Reserve signed off on the transaction. Yet Countrywides ugly financial results of late show no sign of abating. In the last three quarters it has lost $2.5 billion, according to financial filings. In the first quarter of 2008, total nonperforming assets hit $6 billion almost five times that of the same period last year.

“Countrywide declined to comment for this article.

“The credit risk in its loan portfolio is immense, analysts say. At the end of the first quarter, Countrywide had $95 billion in loans held for investments on its books, many of them adjustable-rate mortgages written on properties in California, where prices are still falling. Some $34 billion of the loans held for investments are home equity lines of credit and second liens, riskier because they are more likely to generate losses when home values fall.”

Portfolio Valued from Internal Model for Lack of Market

“ Countryside also has $15.6 billion in mortgages and related securities it hopes to sell. Of these, $10.4 are so-called Level 2, and hard to value because the market for them is inactive. An additional $5.1 billion are valued on internal company models, not market prices.

“Because of the credit risk in Countrywides books, Paul Miller, managing director at Friedman, Billings, Ramsey, estimates that it will cost Bank of America an additional $10 billion to $15 billion above the $4 billion purchase price when a final accounting of losses is made.

“Countrywides role in the US housing market is hard to overestimate. In addition to being No. 1 lender, it is the nations largest loan services in the nation, administering $1.5 trillion in loans by other institutions as well as itself. The servicing and processing businesses provides years of enviable profitability, but now they, too, are vulnerable to earnings pressure. especially as delinquencies surge and regulators heighten the scrutiny of the companys practices.

“Before the days of record-setting defaults, mortgage-servicing was a low-cost enterprise, generally around 0.3 percent of the dollar amount of the loans administered each year. The value of these operations rose and fell based on interest rates. If rates fell, mortgage prepayments would increase and the value of the servicing portfolio would decline. Conversely, if rates rose, prepayments would slow and the servicing units value would rise.

“But because the servicing business is built for payment processing, default significantly increase its costs. For example, companies administering mortgages must advance monthly payments to the owners of the loan even if borrowers stop paying. While each loan is different, these advances are typically made for at least three months.

“As a result Countrywides servicing portfolio is not worth what it once was, said Thomas A. Lawler, founder of Lawler Economic and Housing Consulting. All of a sudden youve got to factor in a lot of variables that you didnt have to before.

“Foreclosures also take longer to complete. The big increase in foreclosures - some 243,000 homes were in some stage of the process in April, according to RealtyTrac, up 65% from April 2007 - has gummed up the system. Foreclosures are likely to keep rising; the delinquency rate grew to 6.35 percent in the first quarter, the highest since 1979 according to the Mortgage Bankers Association.

“Countrywides servicing unit lost $817 million before taxes in the first quarter, versus as $100 million loss in the same period of 2007.

“Countrywides role in the US housing market is hard to overestimate. In addition to being the No. 1 lender, is the largest loan servicer in the nation, administering $1.5 trillion in loans made by other institutions.

“The problems facing Countrywides servicing units go beyond a weak housing market and the credit crisis. In a number of court cases, judges are halting Countrywide foreclosures because they were based on servicing errors or improprieties.”

Countrywides Reputation Tarnished

“ Countrywides reputation as an efficient mortgage servicer has been tarnished repeatedly in recent months. Last March, the company came under blistering criticism from Jeff Bohm, a federal judge in Houston who told it to mend its broken practices. And the United States Trustee, a Justice Department units that oversees the integrity of bankruptcy courts, has sued Countrywide, contending that its tactics represent an abuse of the bankruptcy system.

“The final wild card in the Countrywide deck relates to shareholder lawsuits against it and continuing investigations into its practices. The Securities and Exchange Commission is examining its accounting and insider stock transaction. The Federal Trade Commission is investigating Countrywide as part of a broad inquiry into practices of lender and loan servicers. The FBI is looking for possible loan fraud, and regulators in Illinois and California are also investigating the company; its interest to the two states is whether it discriminated against minority borrowers.”

At a time when the public is asking how investment banks “too big to be allowed to fail” got themselves in such a problem-ridden, boom-turned-to-bust-business, only one conclusion is possible: banks in the Federal Reserve System should be prohibited from acquiring interests in the other financial pillars - stock brokerages, insurance and mortgages.

For doing so puts within their acrobatic reach the cash reserves these other pillars need for their business. That not only places them in the privileged category of being too big to be allowed to fail, but that becomes their main capital asset, as they use the cash reserves of the “other financial pillars” as the legal tender base to hasten the exponential increase of the strictly computer-entry money they lend into existence. “Too big to be allowed to fail” under such circumstances guarantees that the central banks of the world are headed for the status of subprime institutions. There are too many public resources at risk since the deregulated large investment banks have their hands in the public purse.