Countrywide: Thriving Despite Rate Hikes

Investopedia Advisor submits: I’ve always considered myself a keen observer of the obvious. Here’s an example: The housing market is in the doldrums.

According to data aggregated by the National Association of Realtors, existing-home sales were down 7% in the second-quarter of 2006 compared to the same quarter last year, and the National Association of Home Builders' most recent index for U.S. sales of new single-family homes fell to 32 this month, its lowest reading since February 1991.

I also consider myself a keen applicator of deductive reasoning: As the housing industry goes, so goes mortgage lending and servicing; the two are intertwined. Homebuilder stocks have been a disaster in 2006.

Deductive reasoning dictates that mortgage originator and servicer issues should be a disaster as well. And so you would think, given that mortgage applications are down 26% from the same period last year. So much for thinking and deductive reasoning.

Wells Fargo (WFC), the second-largest originator and servicer of mortgages, has recently seen its stock trade near all-time highs after reporting record second-quarter profits of $2.09 billion and a 36% increase in home-loan originations, raising its share of the market to 13.7%. Go figure.

My deductive-reasoning skills hold more water when contemplating the number one mortgage originator and servicer, Countrywide Financial (CFC), whose stock is trading at a 21% discount to its 52-week high.

Investors are concerned because profit margins for its mortgage-origination business slipped to 0.31% in the second quarter from 0.40% in the second quarter of 2005 and remain far below the 1.03% margin postings of 2003.

Nevertheless, Countrywide continues to make money – and lots of it. In the most recent quarter, the California-based lender earned $722 million, up 28% from last years $566 million. Moreover, revenues surged 30% to $3 billion (albeit because loan and securities sales rose 33% to $1.53 billion).

Countrywide is working hard to insulate itself from the vicissitudes of mortgage lending. To that end, its non-mortgage businesses, which include Countrywide Bank and Countrywide Capital Markets, comprise an ever-growing share of its top and bottom lines, accounting for 41% of total pretax profit, up from 20% in 2000.

Countrywide's banking business is showing exceptional promise as a business ballast. After five years, the segment has become one of the top 20 U.S. banks as measured by assets, which have quadrupled since 2003 and reached $84.3 billion in June. The goal is to reach $250 billion by 2010. The bank’s pretax profit for the first half of 2006 surged 43% to $666 million from last year's $467 million, and today contributes more than a quarter of the company's total pretax profit.

But, don’t write off the mortgage business just yet. As the mortgage environment improves, so should margins. In the meantime, the servicing business provides an interest-rate hedge to the production business, and the bank's decision to retain more of its shorter-duration adjustable rate mortgages and home equity loans should produce a steady, swelling stream of net-interest income.

Given Wall Street’s current antipathy toward Countrywide, long-term investors have an opportunity to acquire a well-run financial institution that’s trading at a discount to other well-run financial institutions.

CFC 1-year chart:

By Stephen Brown, Contributor - Investopedia Advisor

At the time of release Stephen Brown did not own any shares in any of the companies mentioned in this article.