Chapter 3: Risk Assessment Using Countrywide Financial Corporation as an Example

Years 2002-2006Note: my presentation was created in early 2009 based largely on a complaint filed in the private securities class action (first filed in 2007) in early 2009, which is extremely (400 plus pages) long. The SEC complaint was filed a year and a half later. It is substantively somewhat similar and has the advantage of being only a

little over 50 pages long. You can reach the SEC complaint via a hyperlink on the SEC AAER which is hyperlinked into the course schedule or assignments. So when I refer to pages of a complaint, I am referring

to that 400 page document that you do not have access to.

Prof. Fuerman: Auditing Class

Countrywide %Origination of Structurally Risky Loans (p. 34 of Complaint)

Countrywide Allowance for Loan Loss % (p. 106 of Complaint)

Countrywide Allowance for Loan Loss %: Minumum ALL that Countrywide should have had (based on tracking the increased origination of higher risk (structure type) mortgages)

Types of Structurally Risky Loans

Nonprime mortgage loans (also called subprime mortgage loans): FICO scores of borrower less than 660

ƒ The CEO of Countrywide stated that nearly all of the securitized mortgage loans were prime, when actually in 2004, 2005 and 2006 approximately 25%-35% of them were with FICO scores of less than 660

ARM loans: Adjustable Rate Mortgage loans (variable rate loans). After a 2 year low interest rate "teaser" period, they would reset at a higher interest rate.

Pay option ARM loans: ARM loan that allows the borrower to pay less than the amount of interest accruing each month, causing negative amortization. After a stipulated amount of negative amortization a cap is hit, causing the borrower to have the interest rate reset and have to immediately pay off some of the principal.

ƒ Countrywide stated in its SEC filings that the borrowers of pay option ARM loans had very high FICO scores (over 700), when in fact many of them were below 620

HELOC loans (Home Equity Line of Credit Loans): A type of second mortgage loan that is secured only by the equity unmortgaged by the first mortgage loan.

ƒ Countrywide routinely made HELOC loans where the equity unmortgaged by the first mortgage loan was trivial or nonexistent.

How Countrywide Underwrote its Mortgages

Many mortgages were made based on a borrower’s bare representations about his or her ability to repay, with little or no documentation to support those representations.

Many mortgages were made with a loan equal to 100% of the appraised value of the house, while waiving the normal PMI (Private Mortgage Insurance) requirement

ƒ Normally, PMI is required when a mortgage loan equal to more than 80% of the appraised value of the house is extended.

Minimal FICO scores were often ignored Needless to say, none of this was fully disclosed in the footnotes to the financials of the corporation

How Countrywide was able to get away with making so many bad mortgage loans for so long

Countrywide held some of the mortgages (Loans Held for Investment) it underwrote, but got rid of 95% of them

Countrywide securitized and sold 95% of its loans through its affiliates CWALT, Inc. (Pay Option ARMs), CWMBS, Inc. (fixed-rate and ARM loans), CWABS, Inc. (subprime loans), and CWHEQ, Inc. (HELOCs). These entities acquired loans originated by Countrywide pursuant to pooling and servicing agreements, and then issued securities backed by those loans, with Countrywide acting as the “sponsor” of the offerings. During the Class Period, CWALT, CWMBS, CWABS, and CWHEQ and their affiliates disseminated more than 1,000 prospectus supplements for offerings of mortgage-backed securities.ƒ The truth of the poor underwriting practices was not fully disclosedƒ The underwriters made huge fees selling these securities and were not

interested in possibly losing those fees by making Countrywide tell the truth about its underwriting practices

Underwriters that got fees by selling Countrywide mortgage backed securities to the investing public

ABN AMRO Incorporated, A.G. Edwards & Sons, Inc., Banc of America Securities LLC, Barclays Capital Inc., BNP Paribas Securities Corp., BNY Capital Markets, Inc., Citigroup Global Markets Inc., Countrywide Securities Corporation, Deutsche Bank Securities Inc., Goldman, Sachs & Co., Greenwich Capital Markets, Inc., HSBC Securities (USA) Inc., J.P. Morgan Securities Inc., Merrill, Lynch, Pierce, Fenner & Smith Inc., Morgan Stanley & Co. Incorporated, RBC DainRauscher Inc., RBC Dominion Securities Inc., Scotia Capital Inc., TD Securities Inc., UBS Securities LLC, and Wachovia Capital Markets, LLC.ƒ Many of these companies are being “bailed out” by the federal government or

have been forced into mergers (Merrill Lynch)