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Staring into Countrywide's abyss
Giant mortgage lender's third-quarter results will offer a view into the depth of the problems facing lenders, housing industry and the economy as a whole.
By Chris Isidore, senior writer
October 23 2007: 3:26 PM EDT

NEW YORK ( -- Everyone knows the mortgage market has been very bad for the last few months.

On Friday, when Countrywide Financial reports its third quarter earnings, Wall Street and economists will get their best look yet at just how bad.

Leading mortgage lender Countrywide Financial is expected to report a loss in a Friday report that will offer a window on the future of the already battered real estate market.

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Countrywide Financial (Charts, Fortune 500), for years the nation's leader in just about every type of housing loan available, is a proxy for the nation's housing crisis.

Its report, which could have important ramifications for the nation's financial sector, will offer a window on the depths of the real estate and home-building downturn.

Analysts surveyed by earnings tracker First Call forecast that the company will report a loss of $1.26 a share - a dramatic turn from the $1.03 per share profit it made a year earlier. Loss estimates range as high as $3.47 a share.

The company has already disclosed some of the bad news. It will take a charge of between $125 million and $150 million in order to cut staff and close offices as it scales back the business. The number of mortgage loans and their value during the quarter are both down by more that 40 percent.

Countrywide's subprime bailout
Countrywide, while a leading indicator of the housing slump, clearly isn't the only financial company reporting problems in the period. Within the last week, Bank of America (Charts, Fortune 500), the nation's No. 2 bank, reported that net income fell 32 percent. It set aside an additional $865 million for credit losses and announced a nearly $1 billion increase in loans that have gone bad.

In addition, Washington Mutual (Charts, Fortune 500), the nation's largest thrift, reported a steeper-than-expected decline in earnings and warned that it is bracing for more difficulties ahead in the housing market.

And Wachovia (Charts, Fortune 500), the nation's No. 4 bank, said profit fell 10 percent and was hurt by $1.3 billion in losses and writedowns related to turmoil in the credit markets. Wells Fargo (Charts, Fortune 500) reported it was hiking reserves for loan losses 46 percent to $892 million, while at the same time writing down $490 million related to the declining value of mortgages.

But all of those banks are far more diversified than Countrywide. None had the exposure to the mortgage business of Countrywide - none will have to overhaul their business model as much as Countrywide will.

"For a while, this is going to be a bumpy ride," said Stuart Plesser, an equity analyst for Standard & Poor's. "The expenses they have to pare down are huge, and getting it right will take a quarter or two. They've been operating in just-survival mode. All these margins are going to be way out of whack."

Countrywide, which is in a quiet period ahead of its earnings report, did not return calls for comment.

On top of that, Countrywide's third-quarter cutbacks won't be the end of the problem, partly because the company was almost one-third of the way through the quarter before the meltdown in the mortgage security market really hit.

The lender's downturn is stunning nonetheless. The drop in loans is the equivalent of General Motors selling 40 percent fewer autos or American Airlines carrying 40 percent fewer passengers. Even in the difficult periods that both of those companies went through earlier this decade, neither approached that kind of downturn.

Given Countrywide's dominance in the mortgage industry, and the sector's role in fueling the crucial home building and real estate markets, Friday's report will be a look at a shock to the overall economy that goes far beyond a single company's problems.

"To some extent Countrywide is the mortgage market," said Guy Cacala, publisher of the trade publication Inside Mortgage Finance. "In everything we track - subprime, Alt. A., jumbo loans - they really didn't have a rival. It's hard to think of anything in their third quarter statement that is going to be positive. And it's not going to be a one-time writedown of losses. You have to question when it's likely to return to any semblance of profitability."

Deliquency risk rising
The seize-up of the market for mortgage-backed securities has cost Countrywide its typical source of financing. Instead, the company has been forced to tap into bank lines of credit and offer above-market rates on CDs to attract deposits. It has also retreated to making less risky but less profitable loans that conform to the underwriting standards of the two major government-sponsored mortgage firms, Freddie Mac (Charts, Fortune 500) and Fannie Mae (Charts).

But a focus on such a fiercely competitive part of the business with very thin margins portends a much smaller and less profitable Countrywide, as well as a much tighter source of financing for those wanting to buy homes.

And that means higher hurdles for potential home buyers who don't have top credit ratings or a large amount of cash to use as down payments. In turn, it will be harder for homeowners to sell their homes, at least at the price they've come to expect.

If mortgage delinquencies and defaults continue to rise, and home values continue to fall, Countrywide could find itself owning a lot of homes that it has been forced to foreclose on, many of them in particularly depressed markets. To try to ward off such a flood of foreclosures, the company announced a program Tuesday to refinance or modify up to 80,000 loans worth $16 billion due to reset at higher payments through the end of next year.

The housing crisis has hurt the entire banking sector, but it has devastated Countrywide shares. In the last three months, the KBW Bank Stock index has lost about 10 percent of its value, while Countrywide shares are down more than 50 percent.

Still, some analysts believe Friday's report could reveal some signs that a recovery at Countrywide has begun.

"I do think they've moved to stabilize the organization since the crisis in August," said Frederick Cannon, analyst with KBW, which specializes in serving the financial sector. "I was never in the camp that thought they wouldn't make it through. We have them moving back to basically break even in the the fourth quarter. I hope to learn a lot more about the state of the company on Friday."

But Countrywide must contend with more than just market problems. Published reports last week said that the Securities and Exchange Commission is probing $130 million in stock sales made earlier this year by CEO Angelo Mozilo.

The American Federation of State, County and Municipal Employees sent a letter to the Countrywide board this week calling for it to dismiss Mozilo. The public sector union says that various pension plans that benefit its members own about 3.5 percent of Countrywide shares between them, and that those plans have lost an estimated $500 million on the company's drop in value.

But that's just the tip of the spear hanging over Countrywide - that's why Friday's earnings report is likely to be so heavily scrutinized.

The company's second-quarter conference call with analysts in July lasted for three hours before questions were cut off. What Countrywide executives have to say about their third-quarter performance will speak volumes not only about the company but also the broader market and the economy.

"There's no question the mortgage business is driving the home price declines," said S&P's Plesser. "And the way things are looking, things aren't going away after the third quarter."
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