Countrywide's (CFC) surprising announcement on Friday that they expect to be profitable in 4Q and CY 2008 pushed the stock market higher and allowed financial bonds to tighten modestly. I'm of two minds on this development. It's not that I can't imagine how Countrywide could turn things around, it's just predicated on a couple very big ifs.
First, it's not that hard to imagine a scenario where mortgage lending profitability improves suddenly. This probably sounds hard to swallow for many readers, so remember... I'm saying it's possible. What mortgage lenders have going for them is improved margins and decreased competition. Lenders with capacity to lend can pick what loans they want to underwrite, and can name their rate. I think it's also safe to say that mortgage lenders will assume weak home price appreciation [HPA] when making new loans, insist on larger down payments, and be more weary of any kind of adjustable rate loan.
All this adds up to 2H 2007 and 2008 vintage loans being much more profitable than 2005-1H2007 vintage loans, assuming both were merely held on balance sheet. In other words, investing in mortgage loans should become more profitable. It is also likely that the Fed will steepen the yield curve in 2008, which should decrease the cost of funds for most banks and other finance companies, and improve lending profitability.
Of course, Countrywide has been doing more mortgage originating and less mortgage investing in recent years. It is less clear that the origination for securitization game will improve in profitability. Securitizing through the GSEs will remain perfectly viable, but not necessarily more profitable. If mortgage underwriting spreads widen, it's unclear how much of that would be realized by the underwriter and how much by the GSE in the case of an Agency securitization. We can all agree that Freddie Mac (FRE) and Fannie Mae's (FNM) guarantee is more valuable today than in 2006, and I expect both will command a higher price for that guarantee. Plus we know that fewer mortgage loans overall will close in coming years as opposed to the recent past. So even if the profit per loan is marginally higher when securitizing via Fannie Mae or Freddie Mac, volume will be way down.
In non-agency space, there will be similar issues. Even assuming loan margins improve in 2008, I'd expect most of that margin will be passed onto the ultimate investor. Following with my market-power theory from above, while it's true that mortgage lenders have more market power than before, investors willing to buy non-Agency MBS have the ultimate market power at the moment. And I expect that will continue for a while, especially in subprime. For many young investment analysts, the Great Subprime Collapse of 2007 represents their first serious bear market in any product. They will carry this their whole career. Don't believe me? Find an analyst whose career started in 1985 or so and ask him/her about program trading.
Anyway, the result will be that the pool of potential investors in subprime securities will be permanently smaller for a long time going forward. So based on the laws of supply and demand, the spreads on subprime bonds will have to stay wide, even if there is universal agreement that newer vintages are of better quality. Even if various improvements are made to the subordination of subprime ABS, and even if the market starts believing in AAA-rated MBS again, I still think the overall spreads on subprime deals will stay much wider than was the case in 2006.
There is another issue, and one that hasn't gotten a lot of play in the media. The highest quality subprime loans which will be underwritten in the next couple years will be mostly refinancings of ARM loans. Several lenders, including WaMu (NYSE:WM) and Countrywide, have announced programs to offer below market fixed-rate loans to subprime borrowers who won't be able to afford their reset. Far from being altruistic, this is a loan modification to avoid foreclosure disguised as a refinancing. Not that there's anything wrong with that. I mean, it would seem like the best move for the bank, similar to our discussion of loan mods the other day.
On top of that, there is the FHA Secure as well as several state-run programs, which will similarly skim off the best subprime loans. It may seem strange to describe a de facto loan mod as a strong borrower, but based on how these programs are being marketed, it sounds like only stronger borrowers will qualify, or in other words, borrowers whose only problem is the rate reset as opposed to borrowers in more dire straights.
So back to Countrywide. I don't think they are in a good position to take advantage of higher loan margins. I think actual banks with actual balance sheets and better access to emergency liquidity are in stronger position to realize new opportunities in mortgage lending. On the other hand, if we assume that Countrywide underwrites nothing other than easily securitized stuff, and has indeed written down all its assets (including both loans and servicing rights) to their true value, then there is no reason why they shouldn't be profitable to some degree in the near future.
The big IF in the previous paragraph is the true value of their assets. By that I mean not the market value, but what those assets really turn out to be worth. We are living in a world where determining the value of mortgage assets is extremely difficult. We know that there are assets currently priced at 50 cents on the dollar which will eventually pay off in full. And we know there are assets similarly priced which will turn out to be worthless. If Countrywide has written down all their risky assets to x cents on the dollar, and on average, that's what those assets eventually pay out, then everything will be fine. If they realize x-y, then it may be several quarters before they're back in the black.
Finally, the thing that I don't like about Countrywide is their access to non-market capital. A bank can go to the Fed or to the Home Loan Banks and get emergency capital. So if WaMu or Fifth Third (NASDAQ:FITB) or US Bank (NYSE:USB) or some other large retail bank were to have sudden trouble with securitization, they'd have options. Countrywide Bank is too small to consider it a realistic option to fund Countrywide's overall operation, and as we saw in August, Countrywide is subject to liquidity problems.
In terms of the market overall, both in credit and stocks, you'd hope that Countrywide delivers on their promise. If not, I think there will be a very negative reaction in both markets.
Disclosure: I own no Countrywide securities. I do own Washington Mutual and Wachovia (NASDAQ:WB) bonds in client accounts, as well as various state housing agency debt.