Phantom Profits

There's hardly a rival in mortgage lending that Countrywide Financial (CFC ) CEO Angelo Mozilo hasn't taken a swipe at. During a January earnings call he complained that Ameriquest Mortgage Co. and New Century Financial Corp. (NEW ), among others, were giving the industry a bad name with "irresponsible" grubbing for profits and lax standards. Then, in a July call, he lambasted Lehman Brothers Inc. (LEH ) and Bear Stearns Cos. (BSC ) as neophytes in underwriting and pricing home loans. "It tightens my cheeks," Mozilo said. "They don't know anything about the mortgage business."

It seems the CEO of America's No. 1 mortgage lender would have you believe the company is above reproach. But Calabasas (Calif.)-based Countrywide has been among the most aggressive underwriters of option ARMs. As of the end of last year, the dollar amount of option ARMs on its books leaped more than fivefold, to $26.1 billion, or 38% of its total mortgages held, vs. 11% in 2004. Three-quarters of the company's option ARM borrowers chose the cheapest mortgage payment, according to its latest earnings release -- meaning these loans could reset at much higher rates. Yet accounting rules let Countrywide book the full payment as revenue on its books right now.

That has boosted Countrywide's bottom line nicely. It reported $295 million in deferred interest revenues for the 12 months ended June, 2006, vs. $5.9 million in the previous 12 months. In the second quarter those revenues represented 19% of net interest income, up from virtually zero a year earlier.

Mozilo, 67, who declined requests to be interviewed, has seen his share of real estate cycles, good and bad. But he might not have bargained for the aftermath of this latest housing bubble. "We don't see how he can be so confident," says David Hendler of CreditSights. "Later on you are going to see whether that earnings stream plays out."

In a written statement, Countrywide said the "PayOption ARM is a popular product and Countrywide takes steps to inform borrowers about the features and potential risks." The company also said in the statement that it had so far this year sent out 8,500 letters to customers "reminding them their future minimum monthly payment could increase if they continue to make the minimum monthly payments."

Early indications of the performance of Countrywide loans are troubling. Desmond Macauley, an analyst at RBS Greenwich Capital, found that of the option ARMs Countrywide originated in 2004, about 1.4% of borrowers were 60 days or more late on their payments by the loan's 24th month. For similar loans originated by Washington Mutual (WM ), the comparable number was 0.31%. Macauley noted that while the majority of borrowers are keeping up with their monthly payments so far, the results raised questions about whether Countrywide lowered standards to bolster business.

At a May conference hosted by Sanford C. Bernstein & Co., analyst Howard Mason asked about the risks of ARM portfolios in a downturn. "What might that do to your earnings?" queried Mason. Mozilo replied: "The impact on Countrywide through any of these cycles has been de minimus."

But despite the brave talk, Countrywide has begun to tone down its lending. On July 25 it reported that its option ARM volume had decreased 42% in July from a year earlier. That's vs. a 19% decrease in overall loan volume.

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