Countrywide Financial (CFC) reported a huge quarterly loss yesterday, amounting to $2.85 per share. Most of this was a noncash charge to write down asset values – both of performing loans that are simply now worth less in the marketplace today as well as securitization residuals, on which there is not likely to be a recovery of value. CFC also added meanginfully to its loan loss reserves as delinquencies rose during the quarter. With respect to residuals, there is still $900 million on the balance sheet. On the other hand, there are between $900 million and $2.7 billion of mortgage servicing rights not reflected on the balance sheet, according to management. The conservative thing to assume is that both are $900 million and thus offset each other, having no effect on book value.
After today’s write-down and the 32% stock price rally, the stock still trades below its diluted book value of over $20. Now, in the near-term, book value is tough to get the arms around. Is it too high? While you may not be able to liquidate the company for that, as long as CFC has the ability to hold the loans they can wait for more favorable pricing. In this case, the economic value of the loans on its balance sheet could be even higher. While GAAP encourages write-downs of assets deemed permanently impaired, it does now allow “write-ups.” So if asset values are significantly written down due to higher loss assumptions that do not materialize, the balance sheet values will actually understate the economic value. Despite this possibility, I assume things will get worse.
In a more normal environment, Countrywide can earn returns on equity of 15% or greater. In this case, the company should be worth in excess of $30 per share versus its current price of around $17. In my view, that is a big enough discount to offer a solid margin of safety. Management, while surprised by the depth with which the credit market disruptions affected their access to the capital markets, is now stronger. Loan underwriting standards have already improved. During their conference call Friday management offered a slide I would call their "oops" slide showing the past business they would underwrite now versus under their old underwriting guidelines. On $170 billion of business underwritten 2006 and before, only less than $60 billion would have been accepted under the new guidelines. That is an admission of how lax their standards became and explains why loans on 2005 and 2006 vintages are performing as poorly as they are currently. Loan performance from those years certainly would be a lot better now had the company (and most of its competitors) not been as aggressive in pursuing market share while ignoring prudent underwriting principles.
While the company is not out of the woods, it seems they are dealing well with the current market realities. Access to capital has improved and the company is working to virtually eliminate its reliance on the commercial paper market, formerly its largest source of short-term financing. Having migrated its primary financing to the bank, near-term growth will slow as the company either sells loans to GSEs or holds them on its balance sheet. Given its exit from certain lines of business and elimination of 10,000 to 12,000 employees, Countrywide from here will grow from a much smaller base. But the company is poised to take share in a smaller, more rational market and be a meaningfully more profitable company in future periods than it is today.
The credit market turmoil is not over. The housing market is far from recovery, having not yet bottomed. There is still substantial excess housing inventory that must be lapped up. In some areas, prices went up far too much for far too long to not have a longer “payback” period where the excesses are wringed out and prices move more into alignment with income levels. There are more shoes to drop, but this news from Countrywide is reassuring to investors who have watched the stock freefall amid panic selling the last few months. Yet for a value investor, the bigger the discount to underlying business value, the greater is the implied future return on the stock.
Full disclosure: Long CFC shares and call options.