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The Government’s Role
The United States government had noble intentions in creating Fannie Mae, Ginnie Mae and Freddie Mac. They wanted to ensure that more citizens could afford a home, and thus promote the “American Dream”. The first of these programmes was Fannie Mae.
It ensured there was a secondary market where mortgage loans insured by the government under the Federal Housing Administration could be traded. The creation of a secondary market reduced the holding period of loans greatly. Originators of loans no longer had to wait up to ten years to recover their principal and interest. They could easily transfer them to interested third parties on the secondary market.
This option served its purpose well. The companies risk appetite was increased and they advanced riskier loans. After all, they could always sell these loans to someone on the secondary market, thus transferring the risk of default to them. More Americans purchased homes under this scheme, and the government was pleased.
The downside is that nobody considered the final brunt of these risky loans. Eventually, someone had to bear the burden in case borrowers defaulted. If it were not the originator companies, or the government that insured these loans, then the secondary market investors would suffer. Ginnie Mae helped to achieve Fannie Mae’s goals, thus expanding home ownership in America in its time.
The Government created Freddie Mac to deal with the problem of conventional conforming loans. This refers to those loans not guaranteed by the government. This means that in the event of borrower default, the secondary investors in Freddie Mac would definitely suffer loss. This programme enabled borrowers with higher risk profile than under Fannie Mae to obtain loans from originator companies while transferring the risk of default to third parties. Thus, the US government looked good in the eyes of its citizens.
There were two positive outcomes of these government initiatives. More Americans became homeowners and the underwriting procedures countrywide were standardized. However, the question remains whether the price paid was worth it. This increased risk and demand for homes aided in the creation of a housing bubble.
The government enacted several laws to support its aim. The first was the Community Reinvestment Act, which addressed issues of discrimination in issuing of home ownership loans. People had begun to complain that the increased home ownership did not benefit the poor neighbourhoods. Lenders were accused of both racial and geographical discrimination. In their defence, loan originators explained this trend by pointing out the high unemployment and crime rates associated with the mentioned regions.
To counter these risks, the government enacted the Depository Institution Deregulation and Monetary Control Act. This allowed originators to create subprime loans for high-risk borrowers. This law increased the access to homes while simultaneously increasing the risk portfolio of the originators.
These laws created a ticking time bomb. In the event of an economic slow-down, the subprime borrowers would be the first to suffer foreclosure. The government created a short-lived honeymoon for the poor. Unfortunately, the cost of this honeymoon was too great for the people to afford.
The Clinton Administration increased the Loan to Value to all time highs of beyond 90%. They did this through the Housing and Community Development Act. Previously, the LTV was 60%. Americans who did not qualify for loans under conventional circumstances could access these loans and thus houses.
However, these subprime loans created additional risk, and since the government did not insure subprime loans, lenders and creditors bore the risk. There was inadequate disclosure regarding the true risk associated with these loans. Investors, especially in the secondary markets were deceived to believe they got a great deal.
The Housing Bubble and its Consequences
The rising prices of homes resulted in a housing bubble. Around 1994, there was a growing demand for houses, fuelled by the lax underwriting procedures. This was the beginning of the bubble, which continued to grow until around 2006. High demand compared to supply pushed the value of homes upwards.
People made quick profits from trading in houses. They also obtained refinancing loans pegged on the values of their homes. The government scheme to expand home ownership in America seemed to be a great success during 2006. Everybody was pleased with the results.
Unfortunately, this bliss was short-lived. It is usual for countries to experience trade cycles, and in 2007, America’s trade cycle was headed to a recession. Unemployment and inflation were rising and so was the cost of living. This resulted in a decline in the demand for houses, thereby making supply higher than demand.
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The consequence of this was a rapid decline in the fair market value of homes. The mortgage balance for most was higher than the fair value. Their homes were underwater. Since nobody was willing to buy houses anymore, and Americans could not afford to pay their mortgages on time, majority of the homes acquired under the scheme went into foreclosure.
This was devastating to middle-class families whose dream to own a home drove them to homelessness. Secondary investors who had purchased such mortgages turned to the government and insurance companies for compensation. However, the default rate was so high that Fannie Mae, Ginnie Mae, Freddie Mac and AIG the largest insurer combined could not cover the losses.
Homeowners lost their homes; investors suffered loss on their investment and the entire financial system lost credibility. As a result, many financial institutions had to curtail operations.
Countrywide Financial Corporation
Angelo Mozilo founded Countrywide during 1969. He wanted to grow the company’s operations to a nationwide scope. The deregulation and lax underwriting laws benefited CFC greatly. In 1993, the increase in loan originations was around 265%, an all time abnormal high. Between the year 2000 and 2005, the interest rates were quite low, and demand for housing was high. The company advanced many mortgages and increased its profits tremendously.
Government policy influence on Countrywide Financial Corporation’s strategy is evident in the trend in the mortgages originated between 1990 and 2007. Initially, CFC did not deal in conventional conforming loans. After the year 2001, the company started to deal in them, increasing their number by almost 30% up to 2006.
There was also an increase in the proportion of Subprime loans in the portfolio, reflecting the government efforts to get poor people to own homes. Since the government guaranteed subprime loans under the Federal Housing Administration, the company did not hesitate to increase the subprime loans originated. The availability of a secondary market under Fannie Mae also encouraged the origination of these loans.
Freddie Mac also encouraged the trading of Mortgage backed Securities. Credit rating agencies rated these MSB’s AAA, deceiving consumers that they were low-risk. They failed to disclose the fact that the MSB’s were anchored in high-risk subprime and conventional conforming loans.
The market for subprime loans was growing rapidly in America. In 2006, it was approximately 37% of the total mortgages. All financing companies moved to take advantage of the situation. CFC did this through its HELOC programme. This is another evidence of strategy re-alignment due to the government initiatives.
|Insurance Claims Expense||360,046||390,203||441,584||449,138||525,045|
|Stock Price at the end of period||25.28||37.01||34.19||42.45||8.94|
The table above shows part of CFC’s financial performance during the 5-year period between 2007 and 2003. There was a constant increase in revenues until 2007 when it declined. The compensation expense also increased steadily, reflecting the increase in performance pay.
However, in 2007, there was a 5% decline, reflecting the financial difficulties facing CFC. The company managed to maintain a stable ratio of compensation/ total expenses. The insurance claims increased drastically in 2007, again because of the defaulted mortgages. During the downfall, stock price suffered the most, with a 79% decline in 2007.
Ethics in Countrywide Financial Corporation
Several breaches of ethical guidelines contributed to CFC’s downfall. The greatest of these was the VIP Loan Programme. It allowed friends of CFC’s executives to obtain preferential treatment in relation to mortgage loans. These “friends “were people in positions of power who could influence CFC’s business.
By then, this practise was already outlawed in America. It was bribing in disguise. Most participants in the VIP programmes were senators and policy-makers. The problem with this scheme is that it interfered with the participant’s independence and objectivity when dealing with CFC. However, the executives proceeded knowing what the implications were.
CFC engaged in predatory lending. This means that the company convinced customers to obtain mortgages without full-disclosure of the consequences. As a result, many found themselves trapped in mortgages that they could barely afford. In issuing new mortgages, CFC disregarded its own and industry underwriting rules, thereby increasing the risk profile of its loans.
The company also failed to disclose to its insurer AIG the true nature of the risk associated with its mortgages. This dishonesty resulted in AIG taking on more risk than acceptable. Eventually, the national insurer had to turn to the government for assistance during the financial crisis. AIG sued CFC for failure to employ full-disclosure.
Compensation can be either ethical or unethical. Countrywide had a system of compensation that focused on incentive pay. At one point, incentive pay was 100% of the salary paid to employees. The incentive was based on number of new loans originated. This encouraged employees to advance loans to undeserving customers just to get the commission.
The biggest problem with this system was the failure to reduce pay due to defaults in advanced loans. This would have motivated employees to be careful in the screening process. A good payment system should be well balanced, not constituted of performance pay solely. Like most American firms, CFC compensated its executives handsomely. This ate into the profits further. Roughly, 60% of expenses at Countrywide were made up of salaries. Executive salaries were the bulk of this amount.
Salvaging Countrywide Financial Corporation
The Bank of America acquired Countrywide in 2008. Later, the bank had to pay an estimated $8.5 billion to bail CFC out of its legal tussles. In total, BofA spent around $12.5 billion on Countrywide before the end of 2008. The question is, was this investment worthwhile? The bank had to distance itself from the CFC brand, following the bad publicity surrounding it. Further, it had to retire the brand from the market place since it brought sad memories to Americans’ minds.
The strategic decisions BofA needs to make cannot be based on the $12.5 billion it spent on CFC. This money is already a sunk cost. The bank can decide to dispose of CFC now, since the economic climate has improved. It is likely that this option will result in a loss. There is a very low probability that Bank of America will find a buyer willing to pay more than $13 billion for CFC. The better option would be to retain the company, and rebuild it from ground up.
The original idea of CFC was a great one. Though the company has fallen into trouble, it is still possible to salvage its business. When the trade cycle moves to a boom, and unemployment and inflation are low, then Americans will begin to demand more houses. As it is, it is very difficult to purchase a house in cash.
Therefore, the demand for mortgages will also rise. BofA should start preparing for this period. It has taken a right step in retiring the CFC brand. Now it has to create a new brand and ensure consumers associate it with honesty. For this strategy to be successful, an aggressive marketing campaign is necessary.
BoFA must also re-think the underwriting policies of CFC. They must make more stringent and enforce them to ensure employees comply. The company needs a new and improved code of conduct. This code should have top management support. Thus, schemes like the VIP and FOA will be prevented. Finally, BofA may have to downsize CFC if it is to survive. Some employees may have to be laid off. Reorganization could also be necessary. This will aid in realigning CFC to the strategic objectives of BofA.