Countrywide Financial Corp. (CFC)

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rewind to 1996, Countrywide going subprime

COUNTRYWIDE MAY SOAR UP TO 50%, BUT BEWARE OF HIGH-FLYING AAMES

By JUNIUS ELLIS
November 1, 1996

(MONEY Magazine) – I should have paid closer attention when I saw TV pitchman Jim Palmer exhorting viewers to phone 1-800-LOAN-YES to latch on to one of Money Store's no-sweat home loans. As the ads ran over the past two years, shares in this Union, N.J. finance company (ticker symbol: MONE; OTC; 0.4% yield) soared from a low of $4 to today's $22, a 450% profit, in step with a 125% surge in new loans to about $5.2 billion. Two smaller, less ballyhooed finance companies also enjoyed major spurts in their loan production and share prices. And I missed them all.

If you did too, you have an extra incentive to check out my strategy for exploiting the innovation, called the subprime mortgage, that elevated these stocks to now unappealing altitudes. As I will amplify in a minute, subprimes are high-rate loans tailored to high-risk borrowers who can't qualify for conventional, grade-A mortgages. My sharp-pencil sources in the financial sector are buying Countrywide Credit (CCR; NYSE, $24; 1.3% yield) in Pasadena. This leading mortgage banker produces about $36 billion in annual loans, 6% of the $560 billion market for conventional home loans. The appeal? Countrywide has recently expanded into the immensely profitable $120 billion market for subprime mortgages and home-equity loans. If my sources' projections pan out, ccr shares could rise as much as 50% to $36 next year as superefficient Countrywide grabs more and more business from subprime pioneers, including Money Store.

Indeed, investors' concerns about growing competition and near-record consumer indebtedness have already knocked Money Store's share price down some 24% from its $29 peak in April. Still, today's $22 stock doesn't look to me like a great buy--or sell. Instead, I would sell (or short) the high-flying shares of $900 million Aames Financial (AAM; NYSE, $49; 0.4% yield), a Money Store wannabe based in Los Angeles, before investors realize how vulnerable AAM is to Countrywide's invasion. Here's what I've learned:

--Debt consolidation is still the rage. Consumers' slide down the credit-rating scale is greased by unemployment, divorce or illness. But many subprime borrowers still own houses and have taken out home-equity loans, whose 11% to 12% interest is tax deductible, to replace the much higher nondeductible rates on auto loans (21%) and credit-card balances (18% to 24%). Finance companies began flogging subprime first mortgages in 1993. Since then the market for all subprime loans has ballooned 50% to $120 billion a year and is projected to grow another 38% to $165 billion by '98. Already 65% of today's total is derived from new first mortgages. Most are made to homeowners who use them to consolidate other debts, including their old mortgage.

Fixed interest rates on 30-year subprime mortgages run 11% to 12%, as much as 50% above today's 8% average on a grade A, to compensate lenders for the greater risk of borrowers becoming deadbeats. But subprime borrowers benefit because their monthly payments are lower than the total for all the other, usually higher-rate, loans retired. Homeowners typically must have around 25% equity, vs. as little as 3% for a grade-A loan. And like conventional mortgages, subprime loans are sold to investors in the form of mortgage-backed securities, reducing lenders' credit risk.

--Subprime profit margins are sublime. Countrywide's latest quarter reveals why my sources are so smitten. Over the three months to Aug. 31, the company's 350 offices nationwide made $318 million in subprime loans, compared with a mere $59 million in the year-earlier period. True, the amount is a trifling 3.5% of the quarter's $9.2 billion in total new loans dominated by grade-A mortgages. But--get this--the $318 million generated an estimated 50% of Countrywide's $33.8 million pretax profit from all new loans. Why? Countrywide earned a razor-thin 0.2% pretax profit margin in the highly competitive market for grade-A mortgages. Last quarter's subprime lending, however, earned a juicy 5.35% margin, topping the 3.5% to 5% returns of most finance companies.

--Countrywide is gunning for No. 1. Chairman David Loeb is telling institutional shareholders that the firm is committed to becoming a leading subprime lender, cranking out $4 billion in annual production within three years. That would amount to blistering compound growth of 50% a year. Even if Loeb is being overly optimistic, his subprime push figures to give CCR's earnings a big boost that's not fully reflected in most Wall Street forecasts. Analysts' per-share estimates average $2.40 for the fiscal year that ends Feb. 28, a brisk 23% rise, and $2.70 for '98, another 13%. Some of my sources, in contrast, predict gains in the subprime sector will lift '98 profits above $3, a projected 25% jump. If their estimate is on target, Countrywide's $24 stock should command upwards of $36, or 50% more, in 12 months. And the stock would still be cheap at 12 times the next fiscal year's earnings, vs. 17 for the S&P 500 index.

Aames is destined to disappoint. Two years ago, stock in this Los Angeles finance company traded at just below $6, up a buck since coming public at $5 in late '91. Today, AAM fetches $49, down from $53 on Sept. 23, when the company announced it's selling 1.5 million new shares and issuing $150 million in debt. Still, the stock has had an amazing eightfold rise powered by a two-year, 465% spurt to $849 million subprime loans by 50 offices in 17 states. Earnings rose 242%.

What gives? Aames is riding the resurgence of California's once moribund $900 billion economy, which accounts for 34% of the firm's '96 loan production. But Countrywide is king in California, the source of 26% of its business. Until recently, Countrywide created customers for Aames as it turned down lots of Californians for grade-A mortgages. Many rejects promptly turned to subprime lenders like Aames. Now these homeowners can simply go subprime with Countrywide at competitive rates.

Aames' rising share of loans that are 30 or more days delinquent is also troubling. In fiscal '96, delinquent loans increased from 12% to nearly 16% of Aames' total. That's scary compared with Money Store's fairly steady 5.4% rate. (Countrywide's is only 3% overall.) Delinquencies historically peak in the third and fourth years of a loan. Most of Aames' are less than two years old. Are Aames execs concerned? I can tell you this: Over the past year, CEO Gary Judis has sold 900,000 shares, about 36% of his holdings. I'd follow his lead.

http://money.cnn.com/magazines/moneymag/moneymag_archive/1996/11/01/204001/index.htm