By Julian Delasantellis
November 27, 2007
http://www.atimes.com/atimes/Global_Economy/IK27Dj12.html
In the past few months, I've elaborated on many of the proposed
solutions to the ever-more threatening subprime mortgage crisis, from
the private sector's proposed M-LEC derivative "superfund", the
various proposals to greater involve the government's housing finance
agencies, to my prediction that the ultimate resolution of the crisis
will come from foreign sovereign wealth funds.
California-based Countrywide Financial Corporation, which led the
United States in home mortgage finance in 2005 and 2006, has come up
with a simpler idea. When all else fails, you can always try to get
lucky with just abject begging and groveling. It might just work - it
has so far for Countrywide.
If you're interested in ringside seats to watch the titanic prizefight
as to whether in the near future America will still have a fully
functioning financial system, otherwise known as the subprime crisis,
there are few better places than to be following the continuing action
at Countrywide, as every day it falls ever farther behind on the
judges' scorecards in its fight to keep being an independent,
operating commercial entity.
Back in the heady days of America's long-departed (although it was
only last year, how the mighty have fallen!) housing bubble,
Countrywide was the darling of the day, a hero of both the political
right and left. The Wall Street right loved it for it was a highly
profitable enterprise, with an almost 38% operating margin generating
US$11 billion in profit in 2006. The free marketers also found it
appealing since, in its endeavors to extend housing finance to areas
and demographics that had been effectively abandoned by both the
markets and conservative governments, Countrywide seemed to be an
effective example of the free market successfully assuming, and making
good money from, its status as a wholly private sector housing
program.
Countrywide also found favor with the political left for the same
reason: if the US Federal Government, starting with Ronald Reagan,
continuing with both George HW Bush, and, to a slightly lesser extent
Bill Clinton, then starting up again with a vengeance under George W
Bush, was abandoning its New Deal era mandate to house the less
fortunate, at least Countrywide was picking up a bit of the slack.
Countrywide's web site quotes chairman and chief executive Angelo
Mozilo that "Nobody works harder to deliver the American dream,"
although, with Mozilo last year earning over US$140 million as the
nation's seventh-most lucratively paid corporate chief executive, and
with the company now planning to lay off 12,000 of its employees, and
with the Securities and Exchange Commission now investigating Mozilo
for insider trading violations in the sale of US$140 million of
personal stock, what is a dream for Mozilo may very well be being seen
as many other's nightmare.
We now know just how much of what we knew of Countrywide in 2006 was a
lie. Countrywide was serving the poor, and those with poor credit
histories (essentially, these two groups were mostly populated by the
same people) in the same manner a slaughterhouse serves livestock; in
reality, it was earning a whole lot of that fat margin through
collecting originating and servicing fees through the writing of
inappropriate low initial floating rate mortgages for clients it knew
could never pay back the loans. The only real hope these borrowers
ever really had to stay in their homes for the long term was to be
able to refinance into sounder, floating rate mortgages before the
higher rates buried them, and with real estate values no longer
rising, the poor borrowers are finding that escape hatch firmly shut.
Mortgage delinquencies, defaults, and repossessions are up
multiple-fold over last year, and, as a result, Countrywide's stock
has fallen about 80% this year, from over $45 in February to just
below $10 this last week.
The stock is now trading at around a remarkable 48% of book value,
meaning that, for every dollar of loans the company is carrying on its
books as an asset, Wall Street now only sees 48 cents of real value.
A couple of weeks ago, yet another dour story crossed the wires
regarding poor Countrywide. No matter from what side you look at this
news, the picture for the company, and for the American financial
system as a whole, just continues to look grimmer and grimmer.
On November 9, Countrywide, in essence, dropped to its knees. In a
regulatory filing with the US Securities and Exchange Commission, the
company pleaded with the corporate financial ratings agencies,
primarily Standard & Poors, Moody's and Fitch, that the sword of
Damocles hovering above the company's head must not fall from out of
their grasp:
To retain access to the public debt markets it is critical for us to
maintain investment-grade credit ratings. Among other things,
maintenance of our current investment-grade ratings requires that we
have high levels of liquidity, including access to alternative sources
of funding such as deposits and committed lines of credit provided by
highly rated banks. We must also maintain adequate capital that
exceeds current rating agency requirements. While we retain our
investment grade ratings, all three rating agencies have placed our
ratings on some form of negative outlook.
In the event our credit ratings were to drop below "investment grade",
our access to the public corporate debt markets could be severely
limited. The cutoff for investment grade is generally considered a
long-term rating of "BBB-" (or Baa3 Moody's Investors Service), which
is equal to our lowest current rating. Furthermore, we expect that
renegotiation or replacement of our existing financing arrangements
beyond their current maturity dates will involve more restrictive
terms and higher relative rates than those presently in place. Our
ability to place custodial deposit accounts on deposit with our bank
subsidiary could be affected if our credit ratings were reduced below
investment grade. As of September 30, 2007, up to $5.5 billion of our
custodial deposits may be subject to placement with another bank if
our credit ratings were reduced below investment grade. We also expect
that a reduction in our ratings below investment grade would have a
negative effect on our ability to retain our commercial deposits. In
addition, our broker-dealer may experience difficulty in conducting
its trading operations if its parent is unable to maintain its
investment grade credit ratings.
In real person language, this is somewhat comparable to if you see a
town's worst, odiferous, pimple-faced rotund, still living with his
parents at age 45, unemployed loser approaching the most pristine
local Vestal Virgin asking for some romance.
One of two things would be happening here. Either the loser (yes, that
would be Countrywide) has become incredibly desperate, or, maybe the
town's pure and pristine Vestal Virgin (the ratings agencies) aren't
really that wholesome, chaste and unsullied after all.
In this case, it's probably more than a little of both.
Countrywide is not bluffing here; another ratings downgrade would
definitely hurt. The company, its stock, debt, and other financial
investments, have been repeatedly downgraded this year, although on
January 25, and April 23 brokerage firm A G Edwards actually issued
and re-issued buy recommendations on the stock. In the case of the
January recommendation, investors who trusted and followed their
broker's advice are now sitting on an 80% loss. If the company's paper
did get downgraded below investment grade, many investment
organizations and vehicles charged to act with maximum fiduciary
prudence, among them various college endowments and pension funds,
would be prohibited by charter from investing in it.
This would set up a classic vicious circle. Denied access to this pool
of investment capital, Countrywide would have to pay higher interest
rates to attract its share of the market that could still place funds
with it.
On October 26, the company reported its first quarterly loss in 25
years, $1.25 billion of bright red ink. The absolute last thing this
company needs now is to pay more to borrow capital; like steel and
rubber for a car company, borrowed capital is a financial company's
raw material from which it makes its final product, loans.
If the market sees Countrywide groaning and staggering under its
burden of higher interest rates its confidence in the company's
continued financial viability would grow ever weaker. More money,
whether diminishing large deposits, or through lack of sales of the
company's commercial paper, would slip away, and the company's
operational funding requirements would grow ever more challenging.
Eventually, the company's prospects would grow so dire that it would
be unable to continue as an independent entity; it would either have
to be taken over by another company - one with absolutely great big
deep pockets and a stellar credit rating in order to eat losses this
big - or close its doors.
The last thing the United States economy in general, and the real
estate sector in particular, needs now is the bankruptcy of a major
mortgage finance lender such as Countrywide. More serious than
Countrywide's vicious circle is the one the entire US real estate
sector, and it now appears, the entire economy is in as well. If
Countrywide pulls out of the market they'll be commensurately less
mortgage finance available in the US real estate market.
Monetarists such as former Fed chief Alan Greenspan always talked of
inflation as a money supply problem, in that prices of things rise
along with expansions in the supply of money, but the tautology works
just as well in reverse. Prices of things, such as real estate, can
just as easily fall if there's not sufficient mortgage capital in the
system to support them. So far, price declines outside the superhot
markets of southern California and southern Florida have been
relatively modest, but if mortgage capital does dry up the price
declines could turn into a rout. A rout could start to feed on itself
in that declining prices could make it impossible for homeowners to
re-finance out of newly reset higher floating rates into long-term
fixed rates they could manage.
If they can't re-finance, and they can't make the payments, these
homeowners will also lose their homes. Their properties will be
repossessed and move into foreclosure auctions. That's increased
supply in a market careening and faltering under the weight of what it
already can't sell; that's another level down towards what, if left
unchecked by outside forces, could be a fairly hellacious ground
floor.
Countrywide's pleading plight illustrates what is becoming one of the
most frightening facts about the subprimes. As things get worse, the
conditions get set up for things to get even worse still. No wonder
the company is begging. But what about those Vestal Virgins, the
ratings agencies? Companies are supposed to earn good ratings not
through begging and beseeching, but through sound business practices
and results. These Countrywide did not have, so it tried begging.
That is not how the system is supposed to work; the fact that
Countrywide felt brazen enough to give it a shot says a lot about how
we got here today. Ratings agencies, whether they be rating bonds,
stocks, or derivative instruments, are supposed to be working for the
benefit of the consumers of these products, the investors. Almost like
a newspaper or TV restaurant or movie reviewer, they research out the
consumer choices, in this case investment choices, and give a thumbs
up or thumbs down as to what's worthwhile.
From the Moody's web site.
Moody's Investors Service is among the world's most respected and
widely utilized sources for credit ratings, research and risk
analysis. Moody's commitment and expertise contribute to stable,
transparent and integrated financial markets, protecting the integrity
of credit ... Moody's independence and integrity have earned us the
trust of capital market participants worldwide ... Credit ratings and
research help investors analyze the credit risks associated with
fixed-income securities.
Steven Joynt, president and CEO of Fitch Ratings, says his
responsibilities fall along these lines:
The role of a rating agency is to gather and analyze a variety of
financial, industry, market and economic information, synthesize that
information, and publish independent, credible assessments of the
creditworthiness of securities and issuers, thereby providing a
convenient way for investors to judge the credit quality of various
alternative investment options. Simply put, ratings are a credit
opinion. Building confidence in an opinion, and in a rating agency, is
difficult to win, and easy to lose. Confidence in Fitch arises from
our commitment to provide the world's securities markets with
objective, timely, independent and forward-looking credit opinions.
The foundation of meeting that commitment is rooted in several core
principles - objectivity, independence, integrity and transparency.
Of course, nowhere in these probity packed protestations is there any
indication that the ratings agencies can be swayed by the type of
groveling and pleading undertaken by Countrywide.
Why then would the company try it? Why would the loser take a chance
with the Vestal Virgin?
Of all the financial actors now having accusing fingers wagged in
their faces, charged with sharing a piece of the guilt over the
subprime meltdown, more should be pointed at the ratings agencies.
Long after the subprime problems came front and center to the market's
attention last spring, the credit ratings agencies were still giving
their gold medal blessings to just about all of the derivative
instruments emerging from out of Wall Street's money foundries that
had utilized subprime mortgages as the raw material. This included the
subprime mortgage loans themselves, the collateralized debt
obligations (CDOs) , asset-based securities (ABSs) and structured
investment vehicles (SIVs) that were created out of the basic subprime
paper, as well as the big Wall Street financial institutions
themselves.
This should not have been all that surprising, since, at its core,
there is a huge difference between ratings agencies and movie and
restaurant reviewers. Movie and restaurant reviewers work for the
newspaper, and operate under strict rules of ethics that forbid any
profiting from favorable treatments they may proffer to one they
review.
It's precisely the opposite with ratings agencies. They are paid by
those they review and rate, the companies such as Countrywide. The
situation is not hidden and furtive, but well above board and known to
all. The ratings agencies know that, while it may all well and good to
provide credible and reliable ratings to some retired Palm Beach
dentist in Bermuda shorts trading his $50,000 bond portfolio from the
dial-up connection at the Senior Center, in the long run, it's the
lucre from the companies being rated that gas up the Ferrari and keep
the kids in Harvard.
Countrywide must have known this too. For, in actuality, the company
has suffered no ratings downgrade since its November 9 entreaty.
Earlier in that week, Fitch held steady the ratings of subprime
burdened mortgage insurers MBIA and Ambac, stating that "Fitch
recognizes that financial guarantors view maintenance of their 'AAA'
ratings as a core part of their business strategies, and management
teams will take any reasonable actions to avoid a downgrade." Well, it
looks like the loser had a chance with the Vestal Virgin after all.
Good for him-bad for the rest of us.
There's one other recent subprime-related story that deserved more
attention than it got.
Of the roughly 100,000 layoffs this year in the US banking and
financial systems, none (with the exception of Citigroup's Charles
Prince) has been as high profile as Merrill Lynch's Stanley O'Neil,
fired at the end of October after Merrill reported $8 billion in
capital writedowns and a quarterly loss of $2.3 billion. Multiple
media sources had reported that Merrill's first choice to take
O'Neil's place was Laurence "Larry" Fink, the founder and CEO of the
fixed income trading and advisory firm Blackrock.
Charles Gasparino of CNBC reported that Fink's interview for the
Merrill job was going fine until right at the end. That was when Fink,
like most American job interviewees these days, was asked if he had
any questions for the interview team. What you're supposed to do in
this situation is to stick out your tongue and lick the collected
hindquarters of the interview team until they're just ever so shiny,
bright and pristine-something on the order of "Gee, is it ever hard to
be such important, handsome senior management for a company so
wonderfully generous, sagacious and magnanimous in its business
practices?"
Fink broke form on this one. He said he would take the Merrill job
only if he was provided with a rock solid, take-it-to-the-bank,
absolutely reliable bottom line number as to what the brokerage
house's total exposure to subprime and related products was. At that,
Merrill called up the number 2 guy on the list, the New York Stock
Exchange's CEO, John Thain, and gave him the job.
Taken together, the travails of both Countrywide and Merrill
illustrate one of the most disturbing aspects of the subprime crisis,
one that is barely grasped by the media and not in the least
understood by the politicians. Their understanding of what's going on
is still stuck back at where the problem was in the spring, back when
this was primarily an issue with the subprime borrowers, back before
we realized just how lustily Wall Street, as exemplified by Merrill's
refusal to spill the beans to Larry Fink, and the rest of the American
and world's financial system had drunk from subprime's poisoned
chalice.
As I displayed with my speculations as to the negative ramifications
of a bankruptcy by Countrywide, until the entire subprime problem,
both with the mortgages and the Wall Street derivatives that emerged
out of them, is comprehensively addressed, the problem will continue
to get worse. The nature of the problem today guarantees that it will
be worse tomorrow, worse still the day after that. Waiting for the
application of the traditional laissez-faire tonic for financial
panics, allowing prices to fall so far so as to tempt demand back into
the market, is a prescription for a whole lot of pain in these
interconnected, over-leveraged markets.
It makes little or no sense to attempt to speculate as to the total
dollar size of the crisis right now because no one is now even close
to proposing a realistic solution to the problem; by the time
realistic solutions are proposed, maybe next year, maybe with a new US
president in 2009, the problem will be much worse. The US national
tendency not to address crises until they become actual full blown
Extinction Level Event (ELE) emergencies is an enormous impediment to
progress here; I doubt if there will be a serious American political
effort to address global warming prior to thermal atmospheric
conditions causing the floats of the annual New Year's Day Rose Parade
in Pasadena, California to spontaneously burst into flame.
Well, look at the bright side. Maybe in the near future a lot more of
us will be able to get lucky with society's self professed moral
sentinels, its Vestal Virgins. The experience with Countrywide proves
that they are more than willing to barter their morality for your
money; if things get really bad, well, even Vestal Virgins have to
eat.
Julian Delasantellis is a management consultant, private investor and
educator in international business in the US state of Washington. He
can be reached at juliandelasantel...@yahoo.com.
