FBR Upgrades Countrywide Financial to Outperform

I was taken aback today by Friedman Billing's upgrade of Countrywide Financial today. I believe this upgrade was agenda driven and has no real substance behind it. Any decent analyst will take into consideration significant macro economic implications behind the mortgage industry. Analysts should consider their fiduciary duty to not only their own company but also for the welfare of the shareholders of the stocks that they recommend. In this instance, I find this to be a gross negligence on the part of Paul Miller who is the analyst who upgraded Countrywide financial today.

The part that I don't understand is that Paul Miller downgraded Countrywide Financial (CFC) on January 30, 2007 from Outperform to Market Perform. Today on March 14, 2007, just over 2 months later, he flip flopped his opinion to Outperfrom from Market Perform. The main reason behind this upgrade is that Paul Miller assumes that Countrywide Financial (CFC) will survive the subprime meltdown and will emerge as the leader in subprime lending business as a result of other "competitors" going out of business. He contends that Countrywide Financial is strong enough to weather this "storm" and emerge stronger as a result of the purge both in the subprime and prime mortgage lending business. Bottom line is that the business at CFC will grow as a result of these recent activities. I will read the research report when it is available as it is not yet published on the FBR site (Friedman Billings Ramsey).

The erroneous contention that subprime business is a viable model has been ignored by the main stream financial media and the industry. The reason for this may not be too far fetched to consider that the financial community has conflict of interest in terms of share holder welfare and obligations to the companies that they follow. This can take the form of owning shares in the company in the hedge funds or mutual funds that they control, having an investment banking relationship with the company, or having non equity stake in the company. I believe that it is this conflict of interest that misleads the vast majority of shareholders in the "retail" segment of the equity market. At this point it is mere speculation and futile attempts at mental exercise to consider all the reasons for the upgrade other than what is purported to be true by FBR.

One consideration many analysts and pundits fail to realize about the subprime meltdown is that it is not insulated. I have harped on this issue over the past few days on my prior blogs. Even a small exposure to the subprime market can have compounding negative ramifications on the company such as Countrywide Financial. In order to originate the subprime loan, the company takes tremendous risks associated with possible loan default. In exchange, the lending company is rewarded with higher application fees, restrictive clauses in the loan agreement against the borrower (such as early termination fees- which can be as high as 20% of the outstanding principal), and higher interest rates. It is the high rate of return on investment that the subprime market focused on. When it was sexy, not less than 8 months ago, many main stream banks such as HSBC sought out these risky loans to increase their bottom line. Once the subprime slime has been exposed and the "hysteria" has spread in the stock market, these loans are no longer the highly sought after investment vehicles that it once was. A leper has better chances currently. This is creating a severe liquidity crisis, because many of these subprime loans are bought by other investors, banks, and hedge funds for their returns. Right now, it is considered to be about attractive as cow dung. Angelo Mozillo publicly stated that mortgage industry will face severe liqudity crisis for this very same reason. Spillover effect of the subprime meltdown is complicated but if it can be simplified, I would state that the demand for the mortgage loans would be directly proportional to the willing and able loan applicants. The purging of the subprime market does not mean subprime applicant cannot qualify for a loan. It means that the industry must have quantifiable accountability for the loans. Additionally, as the industry cracks down on its lending practices, even prime applicants will have problems obtaining the mortgage that they need because the ristrictions and guidlines will become stricter. Additionally, the same prime applicants who financed their houses are over extended in terms of what they can afford and many have resorted to 5/1 ARMS or its derivatives or have bought houses with interest only loans. It is also purported that many subprime loans were made to illegal aliens and foreign nationals. If these contingents, probably small in sheer percentage amount, are removed from the applicant pool, that will also add to the liqudity crisis.

The other issue is PMI (Private Mortgage Insurance) companies. These companies have been all but forgotten in the current subprime meltdown fiasco. They will also begin to suffer as loan defaults will eat into their bottom line and many companies will either go out of business or stop offering such insurances. This will reduce further abilities of population in the US to obtain loans for real estate due to down payment requirements. I believe that the days of 0 down home loans will go by the way of the do do bird.

One thing that struck me as interesting is the current article listing top originators of subprime loans. #1) HSBC #2) New Century (now defunct) #3) Countrywide Financial (CFC)! Yet the company continues to contend that their subprime loan exposure is small. This is another questionable aspect of CFC that needs to be scrutinized because I feel like Angelo Mozillo is not telling the whole truth. Just look at his recent spike in selling activities, as I listed on my prior blog. If the company is doing so well and does not have significant exposure to the subprime market and therefore should not suffer the same fate as Fremont General, New Century, and Accredited Home Lenders, why has the CEO and Chairman of the company's selling activity increased more than three fold over the past year, and especially during the market melt down? Sadly, if CFC ever comes under scrutiny like New Century, more dirt can be dug out at that time. I just don't trust Mozillo right now.

Speaking of trust, did anyone catch the artful double speak that he pulled off on CNBC with Maria Bartaromo? On one hand he reassured the viewers that his company was strong and that his subprime exposure was minimal (see marketwatch.com's article on this). He then turns around and says that the mortgage industry will face severe liquidity crisis and was practically beggin for the FED to cut interest rates. He contends that is the only thing that will save the mortgage industry. Oh really? And why might that be? Perhaps because even the prime lending industry is not clean and many of the loans were originated that were adjustable? Or perhaps the borrowers might have been credit worthy but bit off more than they can chew on their homes? Or is it because every prime lending institutions also have more subprime exposure than they care to admit?

And now FBR comes out with a lame upgrade that means nothing. I just don't buy it. Subprime business is not one that will be beneficial for any companies that are interested in taking over its operation via take overs, buying loans, or driving the competition out of business. The only conclusion that I can derive out of all this is that the insiders and institutions are counting on the "dumb" retail to prop up the share prices while they unload with huge profits. Because at the end of the day the only thing that matters is how much money is in the personal bank. No one really cares about retail anyways. It has always been that way on the Wall Street and the sooner we realize that the better off you are as an investor or a trader.

Lastly, shame on you Paul Miller at FBR for such weak upgrade.