The Bank of America’s $4 billion purchase of Countrywide Financial Corporation is now being scrutinized by just about every Wall Street analyst and financial columnist. In many cases the deal is seen as an absolute windfall for Countrywide in the midst of deteriorating circumstances and as a significant risk if not an outright error for BOA. However, a careful look suggests that Bank of America — whether its investment ultimately succeeds or fails — has done a huge favor for everyone.
“While the Countrywide acquisition is not final at this time,” says James J. Saccacio, chief executive officer of RealtyTrac.com, the nation’s leading foreclosure marketplace, “the effort by the Bank of America should be applauded. While many others have been running from the mortgage marketplace, the Bank of America is running toward it, saying in effect that financing homes remains a viable business as well as a crucial part of the national economy. You have to admire that approach.”
By The Numbers
Over a period of years Countrywide evolved into the nation’s largest mortgage lender, a company of substantial importance. At the end of the 2007, the company said it had a servicing portfolio of nearly $1.5 trillion, but it’s a portfolio in transition: Unpaid principal balances equaled .70 percent of the portfolio in December 2006, a figure which reached 1.44 percent a year later.
Countrywide not only has a mammoth mortgage servicing portfolio, it also owns a savings bank. According to The Wall Street Journal, “as of Sept. 30, Countrywide’s savings bank held about $79.5 billion of loans as investments. Three-quarters of these loans were second-lien home-equity loans — where Countrywide doesn’t have first crack at the collateral in case of default — or option adjustable-rate mortgages, which let borrowers make minimal initial payments and face sharply higher ones later. Overdue payments by Countrywide borrowers are surging as house prices drop and loans reset to higher payments.”
Marketwatch says the Countrywide portfolio includes option ARMs worth $27 billion as well as second liens worth $32 billion.
In effect, Countrywide has been a major player in the “non-traditional” mortgage marketplace, the marketplace which during the past few years abandoned long-standing underwriting and financing practices.
Assets or Anchors?
To date much of the concern regarding toxic mortgages has centered on 2/28 and 3/37 ARMs as well as interest-only financing — loans with low-level starter rates for two or three years and then far-higher rates when loans re-set.
However, option ARMs may be an even bigger financial worry. With an option ARM a borrower typically has four payment choices each month during a five-year start period:
Monthly payments large enough so the loan is paid off (amortized) over 30 years, just like a conventional loan;
Bigger monthly payments so the loan is repaid in 15 years;
Interest-only payments large enough to pay monthly interest costs but not large enough to reduce the loan balance; or
Minimal monthly payments — the real “option” payment — which are insufficient to even pay-off the interest cost. Any interest not paid is added to the loan balance, a process called "negative amortization.”
To avoid a growing mortgage balance option ARM borrowers must at least pay the interest cost of their loan each month. But since many borrowers obtained an option ARM for the specific purpose of borrowing more money than would otherwise be possible, it follows that many of those borrowers will opt for the minimum payment each month.
The end result can look like this: Imagine that buyer Wilson purchases a home for $515,000 with 3 percent down. The mortgage amount is $499,550. The fully-indexed rate is 6.25 percent but the option start rate — the absolute minimum payment — is far lower.
In this example, each month during the first five years Wilson can make a minimum payment of $1,635.59. However, by making a minimum payment Wilson is not paying all interest due on the loan — $966.23 in unpaid interest during just the first month.
What happens with this loan after the five-year start period ends? The new minimum payment for principal and interest will be $3,921.85 — assuming the interest level is not changed. Property taxes and insurance are extra. As to the loan balance, it’s reached $566,905.97. (To run your own examples, go to Mortgage-X.com.)
In this scenario, the required monthly payment increased 140 percent over five years and almost $67,000 in negative amortization was added to the loan balance. These numbers assume, of course, that after five years interest rates have not risen. If they increase, then monthly costs will be even larger than those demonstrated here.
In the example with borrower Wilson we see that the loan balance has risen significantly. At first this may seem like good news for a lender, but a closer look at the example shows why option ARMs are fraught with danger: Simply put, the lender may not collect.
The higher monthly cost faced by Wilson is not an issue if his income is sufficient to pay the bill. But how many people have seen incomes rise 140 percent in five years? The Census Bureau reports that mean household incomes reached $48,201 in 2006 — a figure which compares with $48,091 in 2001.
The bigger loan balance is also not a concern if Wilson can sell the property for enough money to pay off the mortgage. But home values are stalled or falling in many markets.
In October, for example, the S&P/Case-Shiller 20-city composite index recorded an annual decline of 6.1 percent. The National Association of Realtors reported that in November home prices reached $210,000 — 3.3 percent less than a year earlier.
“No matter how you look at these data, it is obvious that the current state of the single-family housing market remains grim,” says Robert J. Shiller, Chief Economist at MacroMarkets LLC. Schiller also noted that “eleven of the 20 MSAs, in addition to the two composites, recorded their single largest monthly decline on record in October.”
In fact, reported price declines actually understate the problem.
Why? When real estate markets are rising owners have no reason to offer discounts. When values are falling, sales may only be possible if owners include “seller contributions” and other concessions. Many loan programs allow seller contributions that equal 3 to 6 percent of the sale prices, discounts not deducted from reported sale values.
In the example above the mortgage debt grew by $67,000, a principal increase of 13.4 percent. Many ARMs allow negative amortization — but also say that when the loan balance grows to a certain level — say 110 percent or 115 percent or 125 percent of the original loan balance — then the lender has the right to call the mortgage unless the loan balance can be reduced with a cash infusion from the borrower.
Combine option ARMs with stable incomes and declining home values and the result is not likely to be good. As the New York Times explains, “while it is widely known that a wave of subprime adjustable-rate mortgages, or ARM’s, will reset this summer — raising the specter of further foreclosures — an even more troublesome mess involving pay-option adjustable-rate loans lies well beyond that. These are the kooky loans that allowed borrowers to make payments that were a fraction of the interest owed, without paying back any principal.
“Only when the loan balloons to 15 percent larger than its original size — a nifty development that results from a multi-syllabic quagmire known as ‘negative amortization’ — do lenders demand that borrowers pay down principal. In many cases, this will cause borrowers’ monthly payments to double, according to analysts.
“When do analysts say borrowers will have to start coughing up this extra cash?” asks the Times? “In 2009, or later.” (See: “Cruel Jokes, and No One Is Laughing,” January 13, 2008)
Why Buy Countrywide?
As this is written Countrywide faces what Time magazine calls a “swamp of lawsuits” as well as additional losses of unknown size. What, then, is the attraction of Countrywide to Bank of America?
Countrywide says it’s “America’s No.1 home loan lender.” In fact, the company has 900 offices, it’s the largest originator of loans in the U.S. and the second-largest servicer. In December, says Countrywide, it funded loans worth $24 billion and had a $35 billion mortgage loan pipeline at year end.
Bank of America
What we now call the Bank of America is the by-product of numerous acquisitions over a period of many years. It paid $21 billion to acquire ABN Amro North America, LaSalle Bank Corporation and LaSalle Corporate Finance in 2007; $3.3 billion to buy The United States Trust Company in 2006 and $35 billion to acquire MBNA in 2005.
In the first nine months of 2007 the Bank of America generated profits of more than $14.5 billion. It has not, however, escaped the guilt-by-association fever which has impacted the entire financial sector: It recently traded at $38.04 per share, down from a 52-week high of $54.21. Given that the company has 4.44 billion shares outstanding, it means that shareholders have shed equity worth nearly $72 billion in the past year.
The Bank of America invested $2 billion for convertible preferred Countrywide stock at a time when shares in the company were selling for about $18. The convertible shares paid a 7.25 percent dividend. In January, Bank of America said it would buy all of Countrywide in a purchase valued at roughly $4 billion. At the time of the announcement, Countrywide stock was valued at about $5.12 a share.
Having lost two-thirds of it’s initial investment, having lost more than a billion dollars, will the Bank of America lose still more money?
No one knows how the final chapter of the Countrywide story will read, but for the Bank of America there could be some interesting plot lines. For instance:
Some of those 900 Countrywide offices could be used to augment the Bank of America footprint in markets which it does not now serve.
The acquisition of the Countrywide Savings Bank may allow the Bank of America to significantly expand its asset and depositor base without violating the rule which limits individual banks to not more than 10 percent of all bank deposits nationwide. The reason? The Countrywide property is a “savings bank” and not a “bank,” a somewhat different entity.
The Bank of America will be able to offset its profits with losses from Countrywide, thereby reducing its tax bill. In effect, whatever price paid for Countrywide will actually be discounted by tax write-offs.
The Bank of America will be able to integrate its mortgage operations with Countrywide’s. This will likely mean force reductions, office closings, reduced duplication and less reliance on mortgage bankers and mortgage brokers — meaning more quality control and lower costs to originate loans.
One caveat, of course, is that the Countrywide purchase is not a done deal. It could fail because of regulatory issues, losses of unexpected size or substantial changes in share valuations, among other reasons. Whatever happens, the Bank of America should at least be credited with putting some confidence back into the marketplace at a time when such an effort is both risky and important.
Columnist Peter G. Miller is the author of The Common-Sense Mortgage and is syndicated in more than 100 newspapers.