You are probably aware that the SEC has accused former Countrywide CEO, Angelo Mozillo, and two of his chief lieutenants with fraud. The SEC complaint document makes for fascinating reading. It demonstrates that Mozillo and others were acutely aware and concerned with the risks they were running while steadfastly painting a different picture to investors and regulators.
Here are a few of the passages that I found captivating:
On 100% subprime loans:
Mozilo further stated that the 100% loan-to value (also known as 80/20) subprime product is “the most dangerous product in existence and there can be nothing more toxic and therefore requires that no deviation from guidelines be permitted irrespective of the circumstances.”
Then, in an April 13, 2006 email, Mozilo informed Sambol, Sieracki, and others that there were numerous issues that they must address relating to the 100% subprime second business in light of the losses associated with the HSBC buyback. One issue in particular that Mozilo identified was the fact that the loans had been originated “through our channels with disregard for process [and] compliance with guidelines.” Mozilo went on to write that he had “personally observed a serious lack of compliance within our origination system as it relates to documentation and generally a deterioration in the quality of loans originated versus the pricing of those loan [sic].” Mozilo noted that, “[i]n my conversations with Sambol he calls the 100% sub prime seconds as the ‘milk’ of the business. Frankly, I consider that product line to be the poison of ours.”
On Option ARMs:
[w]e have no way, with any reasonable certainty, to assess the real risk of holding these loans on our balance sheet. The only history we can look to is that of World Savings however their portfolio was fundamentally different than ours in that their focus was equity and our focus is fico. In my judgement, as a long time lender, I would always trade off fico for equity. The bottom line is that we are flying blind on how these loans will perform in a stressed environment of higher unemployment, reduced values and slowing home sales. (emphasis added)
Finally, on November 4, 2007, Mozi advised the president of the Bank and Sambol that “[pay options have hurt the company and the Bank badly…. World Savings culture permits them to make these loans in a sound manner) our culture does not …. fico scores are no indication of how these loans will perform.”
On Stated Income Loans:
Finally, both Mozilo and Sambol were aware as early as June 2006 that a significant percentage of borrowers who were taking out stated income loans were engaged in mortgage fraud. On June 1, 2006, Mozilo advised Sambol in an email that he had become aware that the Pay-Option ARM portfolio was largely underwritten on a reduced documentation basis and that there was evidence that borrowers were lying about their income in the application process. On June 2, 2006, Sambol received an email reporting on the results of a quality control audit at Countrywide Bank that showed that 50% of the stated income loans audited by the bank showed a variance in income from the borrowers’ IRS filings of greater than 10%. Of those, 69% had an income variance of greater than 50%. These material facts were never disclosed to investors.
A couple of things really took me back when I read this document. First off, Mozillo comes off as a guy who recognized early on that Countrywide was way too far out on the risk horizon. He talks and analyzes mortgages like a guy who has been in the business all of his life. Frankly, he sounds like one very sharp businessman. How in the world did he screw the pooch so badly?
I like the comment about trading FICO for equity. Too little has been written about this. FICO as a predictor of credit performance is, in my opinion, highly over rated. Unfortunately, we haven’t learned the lesson. Fannie (FNM), Freddie (FRE) and most egregiously FHA continue to live in the fantasy world that says you don’t need a lot of skin in the game so long as the FICO score meets certain thresholds. How much money do we have to pour down a rat hole before we learn that down payments matter?
The data on the degree of borrower fraud is staggering. We all knew that people were fudging but I had no idea that it was as widespread as Countrywide’s numbers would suggest. Furthermore, one would think that variances of 50% would have been somewhat evident simply by the application of common sense by underwriters. Evidently not or maybe they were under instructions not to bother.
Based on the dates of the various pieces of evidence contained in the complaint it’s obvious that very early on Countrywide knew that the end game was going to be a disaster. If they knew this, then so did others. Where were Fannie and Freddie? Countrywide was their biggest customer. Institutionally, they knew the mortgage business as well as Mozillo and most likely were drawing the same conclusions as he. Why didn’t they speak up?
The implosion of housing need never have occurred. The risks were evident and now we see openly discussed. Mozillo’s prosecution might with luck lead to the exposure of many others who share his culpability.