Item 1.
Business
Overview
Countrywide Financial Corporation is a diversified financial services holding company engaged primarily in residential mortgage banking and related businesses.
We manage our business through five operating segments - Mortgage Banking, Capital Markets, Insurance, Banking and Global Operations. We primarily conduct the following operations in these segments:
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Mortgage Banking - We originate, purchase, securitize and service mortgage loans nationwide.
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Capital Markets - We operate an institutional broker-dealer that primarily specializes in trading and underwriting mortgage-backed securities.
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Banking - We operate a federally-chartered bank that primarily invests in mortgage loans and home equity lines of credit sourced through our mortgage banking operation. We also provide short-term secured financing to mortgage lenders through a non-depository lending company.
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Insurance - We offer property, casualty, life and credit insurance as an underwriter and as an independent agent. We also provide reinsurance coverage to primary mortgage insurers.
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Global Operations - We provide mortgage loan application processing and servicing on behalf of a financial institution in the United Kingdom. Currently, we provide these services through a majority-owned joint venture with Barclays plc.
Mortgage banking continues to be our core business, generating 77% of our pre-tax earnings in 2003. The other segments generated the following percentages of our pre-tax earnings: Capital Markets - 11%; Banking - 7%; Insurance - 4%; and Global Operations - 1%. In recent years, however, we have expanded our operations beyond Mortgage Banking. We have pursued this diversification to capitalize on meaningful opportunities to leverage our core Mortgage Banking business and to provide sources of earnings that are less cyclical than the mortgage banking business. For financial information about our segments, see the “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Operating Segment Results” section of this report.
As used in this report, references to “we,” “our,” “the Company” or “Countrywide” refer to Countrywide Financial Corporation and its consolidated subsidiaries unless otherwise indicated.
Available Information
We have a website located at www.countrywide.com and make our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all exhibits and amendments to these reports available, free of charge, on that website, as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission. Our Corporate Governance Guidelines, our Code of Business Ethics, and the charters of the committees of our Board of Directors are also available on our website and available in print upon request.
Loan Production
The following table summarizes our loan production by business segment and by loan type:
For additional information about our loan production statistics, see the section in this Report entitled “Business - Loan Production Tables.”
Mortgage Banking Segment
Our Mortgage Banking Segment produces mortgage loans through a variety of channels on a national scale. Nearly all of the mortgage loans we produce in this segment are sold into the secondary mortgage market, primarily in the form of mortgage-backed securities. We generally perform the ongoing servicing functions related to the mortgage loans that we produce. We also provide various loan closing services such as title, escrow and appraisal. These activities are grouped into three business sectors - Loan Production, Loan Servicing and Loan Closing Services.
Types of Loans
We originate and purchase mortgage loans that generally fall into one of the following three categories:
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Prime Mortgage Loans - These are prime credit quality first-lien mortgage loans secured by single- (one-to-four) family residences.
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Prime Home Equity Loans - These are prime credit quality second-lien mortgage loans secured by single-(one-to-four) family residences, including home equity lines of credit.
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Subprime Mortgage Loans - These are first-and second-lien mortgage loans secured by single- (one-to-four) family residences, made to individuals with credit profiles that do not qualify for a prime loan.
The majority of our loan production consists of Prime Mortgage Loans. Prime Mortgage Loans include conventional mortgage loans, Federal Housing Administration-insured mortgage loans and Veterans Administration-guaranteed mortgage loans. The majority of the conventional loans qualify for inclusion in guaranteed mortgage securities backed by Fannie Mae or Freddie Mac. Some of the conventional loans we produce either have an original loan amount in excess of the current $333,700 Fannie Mae and Freddie Mac loan limit or otherwise do not meet Fannie Mae or Freddie Mac guidelines.
Loan Production Sector
We produce mortgage loans through three divisions of Countrywide Home Loans - Consumer Markets, Wholesale Lending and Correspondent Lending - and through our retail subprime lending subsidiary, Full Spectrum Lending, Inc.
The following table summarizes our Mortgage Banking loan production by division:
For additional production statistics, see the section in this Report entitled “Business - Loan Production Tables.”
Consumer Markets Division
Our Consumer Markets Division originates mortgage loans through three major business channels: the Branch Network channel, the Business-to-Consumer channel, and the Business-to-Business channel.
The Branch Network channel originates mortgage loans primarily through relationships with realtors and builders. As of December 31, 2003, this network consisted of 466 branch offices in 48 states and the District of Columbia.
The Business-to-Consumer channel originates mortgage loans through the Internet and through direct telemarketing. This channel focuses on customer retention by providing our mortgage customers with an efficient means to refinance their existing mortgage or obtain a mortgage on a new home. The Business-to-Consumer channel also markets Prime Home Equity loans to our existing mortgage customers. As of December 31, 2003, the Business-to-Consumer channel consisted of four call centers and five centralized processing centers.
The Business-to-Business channel originates mortgage loans through three primary marketing channels: Relocation, Affinity, and Fulfillment Services. The Relocation channel targets corporate relocation departments and relocation companies. The Affinity channel targets other corporate entities to provide loan products and services to their customers and employees. The Fulfillment Services channel provides loan sales, processing and closing services to banks, thrifts and financial planners, among others.
For 2003, our Consumer Markets Division was ranked by Inside Mortgage Finance as the third largest retail lender, in terms of volume, among residential retail mortgage lenders nationwide.
Wholesale Lending Division
Our Wholesale Lending Division originates mortgage loans through independent mortgage loan brokers and other financial intermediaries.
As of December 31, 2003, our Wholesale Lending Division operated 51 branch offices and five fulfillment centers in various parts of the United States. Through this division we service approximately 31,000 independent mortgage loan brokers nationwide.
For 2003, our Wholesale Lending Division was ranked by Inside Mortgage Finance as the largest wholesale originator, in terms of volume, among residential wholesale mortgage lenders nationwide.
Correspondent Lending Division
Our Correspondent Lending Division purchases mortgage loans from other lenders, which include mortgage bankers, commercial banks, savings and loan associations, home builders and credit unions. As of December 31, 2003, this division served approximately 1,800 approved lenders operating in all 50 states and the District of Columbia.
For 2003, our Correspondent Lending Division was ranked by Inside Mortgage Finance as the largest correspondent lender, in terms of volume, among residential correspondent mortgage lenders nationwide.
Full Spectrum Lending
Full Spectrum Lending originates primarily Subprime Mortgage Loans through a nationwide network of 97 retail branch offices located in 36 states. Full Spectrum’s mortgage production is generated primarily through referrals from our other loan production divisions, direct mailings to prospective borrowers, outbound telemarketing and affinity relationships.
Loan Quality
Our Credit Policy establishes standards for the determination of acceptable credit risks. The standards encompass borrower and collateral quality, underwriting guidelines, and loan origination standards and procedures. The standards are designed to produce high quality loans that have been underwritten to facilitate the securitization and sale of our mortgage loans in the secondary mortgage market. For a further discussion of our loan quality standards, see the section in this Report entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Credit Risk Management.”
Affordable and Emerging Markets Home Loan Programs
For more than a decade, we have pursued a variety of affordable home loan initiatives designed to increase home ownership opportunities for low- and moderate-income borrowers. Our latest initiative, known as We House America®, supports affordable housing programs undertaken by Fannie Mae and promoted by various government agencies, including the U.S. Department of Housing and Urban Development.
We have specifically designed We House America loan programs to meet the needs of low- and moderate-income borrowers. These loan programs enable more such borrowers to qualify for a home loan by allowing, for example, lower down payments, lower cash reserves, alternative income sources and more flexible underwriting criteria than on a typical loan. The mortgage loans we produce through We House America are sold and serviced on a non-recourse basis, generally through guarantee programs sponsored by Fannie Mae.
In addition, we are approved to participate in more than 900 programs offered by state, county and city agencies, municipalities and non-profit organizations that assist with down payments and closing costs.
We have made other significant commitments to affordable lending and emerging markets initiatives designed to increase homeownership opportunities among minority and immigrant communities. In early 2003, we extended our five-year “We House America” Campaign, with a goal of originating $600 billion in loans to targeted homebuyers by the end of 2010. As of December 31, 2003, we had funded $242 billion toward this new goal.
Loan Securitization
As a mortgage banker, we have historically sold substantially all the mortgage loans that we produce, generally through securitizations. We may hold as investments a small amount of the Prime Home Equity Loans produced. When we securitize our mortgage loans we retain a certain amount of credit risk. This credit risk arises through representations and warranties that we make in conjunction with all of our securitization activities, as well as through retention of limited recourse for credit losses in the case of certain securitizations. For a further discussion of our exposure to credit risk and how we manage this risk, see the section in this
Report entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Credit Risk Management.”
In addition, we typically have interest rate risk from the time a loan application is taken until the related mortgage loan is sold. For a further discussion of our interest rate risk and how this risk is managed, see the section in this Report entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Quantitative and Qualitative Disclosures About Market Risk.”
Loan Servicing Sector
Although we sell substantially all of the mortgage loans that we produce, we generally retain the rights to service these loans. We refer to these rights as mortgage servicing rights, or MSRs. We may also retain other financial interests when we securitize mortgage loans. We include the value of these retained interests on our balance sheet, and the results of the Loan Servicing Sector include the performance of these interests as well as the operational and other financial activities related to servicing mortgage loans.
In servicing mortgage loans, we collect and remit loan payments, respond to borrower inquiries, account for principal and interest, hold custodial (impound) funds for payment of property taxes and insurance premiums, counsel delinquent mortgagors, supervise foreclosures and property dispositions and generally administer the loans. In return for performing these functions we receive servicing fees and other remuneration.
Mortgage Servicing Rights
Our MSRs arise from contractual agreements between us and investors (or their agents) in mortgage-backed securities and mortgage loans. Although MSRs generally arise from the securitization of mortgage loans that we originate, we also occasionally purchase MSRs from other servicers. For a more complete description of MSRs, see “Note 9 - Securitizations” in the financial statement section of this Report.
MSRs and other retained interests, specifically interest-only securities and residual securities, are generally subject to a loss in value when mortgage rates decline. To moderate the effect on earnings of declines in value of MSRs and other retained interests, we maintain a portfolio of financial instruments, including derivative contracts, which increase in aggregate value when interest rates decline. This portfolio of financial instruments is collectively referred to herein as the “Servicing Hedge.” See “Note 10 - Financial Instruments - Risk Management Activities Related to Mortgage Servicing Rights (MSRs) and Other Retained Interests” in the financial statement section of this Report for a further discussion of our Servicing Hedge.
Loan Servicing Operations
The various functions within our loan servicing operations are briefly described in the following paragraphs. These operations are performed in three primary locations in California and Texas.
Customer Service
Our Customer Service Call Centers managed over 33 million contacts with customers in 2003. These contacts were primarily handled through our Customer Service Representatives, Automated Phone System and website (www.customers.countrywide.com).
Remittance Processing
Our Remittance Processing division processes all payments and loan payoffs. This division also provides payoff demand statements, prints monthly statements and oversees outbound customer correspondence. Approximately 31% of our customers make their monthly payments electronically using various automated payment methods. Approximately 23% of our customers have chosen to receive electronic statements, which reduces the cost and improves the timeliness of providing loan information to them.
Collections and Loss Mitigation
Our Collection and Loss Mitigation units work with delinquent borrowers to bring their mortgages back to current status and to avoid foreclosure if possible. Workout efforts are tailored to the specific borrower circumstances, as dictated by the requirements of the underlying mortgage investor.
Foreclosure and Bankruptcy
Foreclosure and bankruptcy are complex processes that are subject to federal and state laws and regulations, as well as various guidelines imposed by mortgage investors and insurers. Our workflow-based systems facilitate consistent processing of defaulted mortgage loans as well as an efficient flow of data between internal and external business partners. To minimize related costs and to increase efficiency, we utilize our own companies, such as LandSafe Title, LandSafe Appraisal, CTC Real Estate Services and Countrywide Field Services, to process foreclosures and bankruptcies.
Investor Accounting
Our Investor Accounting department reconciles custodial accounts, processes investor remittances and maintains the accounting records on behalf of our mortgage investors, including Fannie Mae, Ginnie Mae, Freddie Mac, as well as over 500 private investors.
Related Services
We perform several loan-servicing functions internally that other loan servicers commonly outsource to third parties. We believe the integration of these functions gives us a competitive advantage by lowering overall servicing costs and enabling us to provide a high level of service to our mortgage customers and mortgage investors. Our integrated services include property tax payment processing, foreclosure trustee, property inspections, and insurance tracking and premium payment processing.
The following table sets forth certain information regarding the Company’s loan servicing portfolio, including mortgage loans and securities held for sale and residential mortgage loans subserviced for others, for the periods indicated:
(1)
Runoff refers to scheduled principal repayments on loans and unscheduled prepayments (partial prepayments or total prepayments due to refinancing, modification, sale, condemnation or foreclosure).
(2)
Expressed as a percentage of the total number of loans serviced excluding subserviced loans and loans purchased at a discount due to their non-performing status.
Loan Closing Services Sector
We provide loan closing products and services such as credit reports, appraisals, title reports and flood determinations through our LandSafe, Inc. group of companies. We provide these services primarily to our loan production divisions.
Competition
In recent years, the level of complexity in the mortgage lending business has increased significantly due to several factors:
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The continuing evolution of the secondary mortgage market has resulted in a proliferation of mortgage products.
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Greater regulation imposed on the industry has resulted in increased costs and the need for higher levels of specialization.
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Increasing interest rate volatility compounded by homeowners’ increasing tendency to refinance their mortgages as the refinance process has become more efficient and cost-effective, has resulted in large swings in the volume of mortgage loans originated from year to year. These swings in mortgage origination volume have placed significant operational and financial pressures on mortgage lenders.
To compete effectively in this environment, mortgage lenders must have a very high level of operational, technological and managerial expertise. In addition, the residential mortgage business has become more capital-intensive and therefore access to capital at a competitive cost is critical. Primarily as a result of these factors, the industry has undergone rapid consolidation.
Today, large, sophisticated financial institutions dominate the residential mortgage industry. These industry leaders are primarily commercial banks operating through their mortgage banking subsidiaries. Today, the top 30 mortgage lenders combined have a 79% share of the mortgage origination market, up from 58% five years ago.
This consolidation trend has carried over to the loan servicing side of the mortgage business. Today, the top 30 mortgage servicers combined have a 64% share of the total mortgages outstanding, up from 53% five years ago.
Compared with Countrywide, the other industry leaders are less reliant on the secondary mortgage market as an outlet for adjustable-rate mortgages because they have a greater capacity to hold such mortgages in their loan portfolio. This could place us at a competitive disadvantage if the demand for adjustable-rate mortgages increases significantly, the secondary mortgage market does not provide a competitive outlet for these loans and we are unable to develop a portfolio lending capacity similar to the competition’s.
Generally, we compete by offering a wide selection of mortgage loans through a variety of marketing channels on a national scale, by providing high-quality service and by pricing our mortgage loans at competitive rates.
Capital Markets Segment
Our Capital Market Segment consists of Countrywide Securities Corporation and Countrywide Asset Management Corporation.
Countrywide Securities Corporation
Countrywide Securities Corporation is a broker-dealer that specializes in the mortgage securities market. The activities of Countrywide Securities Corporation consist of the following:
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Trading and underwriting mortgage-related fixed-income securities, including mortgage-backed securities, collateralized mortgage obligations and asset-backed securities issued by Fannie Mae, Freddie Mac, Ginnie Mae and other financial institutions, including Countrywide Home Loans
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Trading and underwriting callable debt issued by Fannie Mae, Freddie Mac, and the Federal Home Loan Bank, as well as bank certificates of deposit and corporate debt issued by Countrywide Home Loans
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Trading of securities issued by the United States Department of the Treasury
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Arranging short-term financing of fixed-income securities by institutional investors
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Acting as broker of residential mortgage loans, including subprime loans, on behalf of Countrywide Home Loans
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Managing mortgage loan securitization conduits on behalf of Countrywide Home Loans
Most of our underwriting is for Countrywide Home Loans. We trade for our own accounts and act as a broker for institutional investors, such as investment managers, pension fund companies, insurance companies, depositories and mortgage bankers, as well as regional and global broker-dealers. Countrywide Securities
Corporation is a registered broker-dealer and a member of the National Association of Securities Dealers, Inc. and the Securities Investor Protection Corporation.
Countrywide Asset Management Corporation
On behalf of Countrywide Home Loans, we manage the acquisition and disposition of loans from third parties. These are typically delinquent or otherwise illiquid residential mortgage loans which have primarily been originated under FHA and VA programs. We also manage the disposition of similar loans originated by Countrywide Home Loans. We attempt to rehabilitate the loans using the servicing operations of Countrywide Home Loans with the intent to securitize those loans that become eligible for securitization. The remaining loans are serviced through foreclosure and liquidation, which includes the collection of government insurance and guarantee proceeds due from the default and liquidation of FHA and VA program loans.
Competition
The securities industry is both highly competitive and fragmented. In the mortgage securities market, we compete with global investment banks as well as regional broker-dealers. We believe by leveraging the strengths of Countrywide Home Loans and by specializing in this market, we can offer information, products and services tailored to the unique needs of participants in the mortgage securities market. In contrast, many of our competitors offer a broad range of products and services, which may place us at a competitive disadvantage.
For 2003, according to Inside MBS & ABS, we ranked fourth in Non-Agency MBS Underwriters.
Banking Segment
Our Banking Segment consists of the following operations:
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Treasury Bank, N.A., an FDIC-insured, federally-chartered bank
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Countrywide Warehouse Lending, a non-depository lending company that provides short-term secured financing to mortgage lenders
Treasury Bank
Treasury Bank primarily originates and invests in mortgage loans and home equity lines of credit, substantially all of which are sourced through our mortgage banking subsidiary, Countrywide Home Loans. Collateralized mortgage obligations and other securities are used to supplement Treasury Bank’s loan portfolio for liquidity and asset-liability management purposes.
Through Countrywide Bank, a division of Treasury Bank, we offer deposit accounts, primarily certificates of deposit, to the retail market. We sell these products through our two-person financial centers, which are located in 31 of Countrywide Home Loan’s retail branch offices as of December 31, 2003. We also sell these deposit products on-line and through call centers. In addition, a portion of Treasury Bank’s deposit liabilities are comprised of custodial funds that relate to the loan servicing portfolio of Countrywide Home Loans. Treasury Bank borrows funds on a secured basis from the Federal Home Loan Bank of Atlanta and executes repurchase agreements to supplement its deposit liabilities.
Treasury Bank also acts as a mortgage document custodian, primarily for our mortgage banking operations. As a document custodian, we verify, maintain and release collateral for issuers, servicers, sellers and purchasers of debt securitizations. We also provide other services including safekeeping, review/certification, release requests and customer reporting.
At December 31, 2003, Treasury Bank had total assets of $19.4 billion, including $3.6 billion of investment securities and $14.7 billion of loans receivable. At December 31, 2003, Treasury Bank had deposits of $9.3 billion, including $5.9 billion of custodial balances controlled by Countrywide Home Loans.
Countrywide Warehouse Lending
We provide committed and uncommitted warehouse lines of credit to mortgage bankers to finance their mortgage loan inventories. Most of these mortgage bankers sell loans to our Correspondent Lending Division. All of these mortgage bankers are subject to the same initial and ongoing credit evaluation and monitoring applied to our correspondent lenders. We attempt to limit our credit risk under our warehouse lines of credit by securing the advances with mortgage loans that have a market value in excess of the balance of our advances.
At December 31, 2003, we had total line of credit commitments of $5.0 billion, against which we had advances outstanding of $1.9 billion.
Competition
The retail banking industry is dominated by large commercial banks with substantially more assets, significantly higher brand-name recognition and larger physical distribution networks than Treasury Bank.
We compete with other insured depository institutions, which include approximately 7,800 commercial banks and approximately 1,400 savings institutions, in the retail deposit market. The number of commercial banks and savings institutions has decreased over the past decade due to consolidation in the banking industry. As the banking industry continues to consolidate, we expect the intensity of the competition to increase, especially as we further expand our size and geographic scope.
We compete in the retail deposit market on the basis of price (i.e., interest rates offered on deposit accounts). Because of our low-cost structure, we are able to offer CD rates that are among the most competitive in the industry.
Our Banking Segment’s competitive position is significantly enhanced by its synergistic relationship with our core mortgage banking operations. For example, our mortgage banking operation is the primary source of mortgage loan and home equity line of credit customers for Treasury Bank. Treasury Bank sells retail deposit products through financial centers placed within certain of Countrywide Home Loan’s retail branch offices. This economical use of space reduces the Bank’s acquisition costs. In addition, a significant portion of Treasury Bank’s deposit liabilities consists of custodial funds controlled by Countrywide Home Loans. Treasury Bank also provides mortgage document custodial services for our mortgage banking operations.
Insurance Segment
The primary activities we conduct in our Insurance Segment include:
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Offering property, casualty, life and credit insurance as an underwriter and as an independent agent
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Providing reinsurance coverage to primary mortgage insurers
We manage these activities through two business units - Balboa Life and Casualty Operations and Balboa Reinsurance Company.
Life and Casualty Operations
Life and Casualty operations include the operations of Balboa Life and Casualty Group and Countrywide Insurance Services Group, an independent insurance agency.
Balboa Life and Casualty Group
We underwrite property, casualty, life and credit insurance in all 50 states through our Balboa Life and Casualty Group. This group operates under the following names: Balboa Insurance Company, Balboa Life Insurance Company, Balboa Life Insurance Company of New York, Balboa Lloyds Insurance Company, Meritplan Insurance Company and Newport Insurance Company.
Balboa Life and Casualty Group has the following three product lines:
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Lender-Placed Property and Auto - We offer lender-placed auto insurance, and lender-placed real-property hazard insurance. Such insurance is provided on behalf of auto and mortgage lenders when borrowers fail to have agreed-upon insurance coverage in place to protect the lender’s security interest. We also provide insurance tracking services, which alerts lenders when there is a lapse in a borrower’s insurance, for more than 11.8 million loans, including almost 4.6 million loans serviced within our mortgage banking operations.
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Homeowners - We underwrite retail homeowners’ insurance and home warranty plans for consumers.
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Life and Credit - We underwrite term life, credit life and credit disability insurance products.
Our retail insurance products are offered by select general insurance agents serving the consumer market, including our Countrywide Insurance Services Group.
The Balboa Life and Casualty Group has received an “A” rating from A.M. Best Company, an insurance company rating agency. The “A” rating is defined by the A.M. Best Company as having “an excellent ability to meet ongoing obligations to policyholders.”
Countrywide Insurance Services Group
Our Countrywide Insurance Services Group operates an independent insurance agency that provides consumers, in particular our mortgage customers, with homeowners’ insurance, life insurance, disability insurance, automobile insurance and various other insurance products.
Our Countrywide Insurance Services Group operates under the following names: Countrywide Insurance Services, Inc. (California); Countrywide Insurance Services, Inc. (Arizona); Countrywide Insurance Services of Alabama, Inc.; Countrywide Insurance Agency of Massachusetts; Countrywide Insurance Services of Texas, Inc. and Countrywide General Agency of Texas, Inc.
Balboa Reinsurance Company
We provide a mezzanine layer of non-catastrophic reinsurance coverage to the insurance companies that provide primary mortgage insurance (“PMI”) on loans in our servicing portfolio. We provide this coverage with respect to substantially all of the loans in our portfolio that are covered by PMI, which generally includes all conventional loans with an original loan amount in excess of 80 percent of the property’s appraised value. In return for providing this coverage, we earn a portion of the PMI premiums.
Competition
The lender-placed insurance market is dominated by a small number of providers, competing on policy terms and conditions, service, technological innovation, compliance capability, loan tracking ability and commissions.
The homeowners’ and credit-life and credit-disability marketplace is dominated by large, consumer brand name providers. Competition is driven by price, service, commissions and the efficiency and effectiveness of marketing and underwriting operations.
The primary mortgage reinsurance market is dominated by large mortgage originators that have extensive business relationships with the PMI industry. We compete in this market primarily through our position in the residential mortgage loan market.
We compete generally by providing high-quality service and pricing our products at competitive rates, as well as by leveraging our residential mortgage loan customer base.
Global Operations Segment
The primary activities we conduct in our Global Operations Segment include:
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Loan Processing and Sub-servicing - We provide mortgage loan application processing and servicing in the UK through a majority-owned joint venture with Barclays plc. In 2003, we processed over $28.7 billion in loans, all of which are subserviced for Barclays plc, our joint venture partner. At December 31, 2003, our subservicing portfolio was $106 billion.
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Valuation Services - We provide electronic residential property valuation services to third parties in the UK through a majority-owned joint venture.
We also develop proprietary technology for these activities. For example, we developed proprietary automated valuation technology that we believe is the first artificial intelligence property valuation system to be introduced in the UK. We manage these activities through three companies - Global Home Loans Limited, UKValuation Limited and Countrywide International Technology Holdings Limited.
Competition
Our competitors in this segment include commercial banks, multinational corporations and other financial institutions, which are entering global mortgage markets, particularly in Europe, in recognition of the opportunities presented by less mature mortgage markets outside of the United States. We compete by leveraging our experience and proprietary technology.
Financing of Operations
Uses of Financing
We have significant short-term and long-term financing needs. Our short-term financing needs arise primarily from the following:
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Warehousing of mortgage loans pending sale
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Trading activities of our broker-dealer
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Mortgage warehouse lending
Our long-term financing needs arise primarily from the following:
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Investments in mortgage loans
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Investments in MSRs and other interests that we retain when we securitize mortgage loans
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Hedging instruments associated with our investments in MSRs and other retained interests
Sources of Financing
We meet our short- and long-term financing needs primarily through the following means:
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Unsecured commercial paper and medium-term notes
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Short-term repurchase agreements
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Asset-backed commercial paper
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Deposit-gathering and other financing activities of Treasury Bank
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Retained earnings
We typically access the unsecured public corporate debt market by issuing commercial paper and medium-term notes. At times, we also issue subordinated debt, convertible debt and trust-preferred securities. Our ongoing access to the public debt markets is dependent on a high credit rating. For the last twelve years, we have consistently maintained solid investment-grade ratings. Countrywide Home Loans, our primary issuer
of public corporate debt, presently has long-term ratings of A/ A3/ A as rated by Standard & Poor’s, Moody’s Investors Service and Fitch, Inc., respectively. In order to maintain investment-grade ratings we must, among other considerations, maintain a high level of liquidity, including access to alternative sources of funding such as committed bank stand-by lines of credit, and a conservative debt-to-equity ratio.
We use short-term secured financing such as repurchase agreements and asset-backed commercial paper conduits to finance a substantial portion of our mortgage loan inventory and securities trading portfolio. Treasury Bank finances its investments in mortgage loans primarily with a combination of deposit liabilities and Federal Home Loan Bank secured advances.
Our primary source of equity capital is retained earnings. In addition, we have outstanding $1 billion in trust-preferred securities that receive varying degrees of “equity treatment” from rating agencies, bank lenders and regulators. From time to time, we issue common stock as a means of supplementing our capital base and supporting our growth.
Regulations
Regulations Applicable to Bank Holding Companies and Financial Holding Companies
General
As a registered bank holding company and a financial holding company under the Bank Holding Company Act (the “BHC Act”) and the Gramm-Leach-Bliley Act (the “GLB Act”), Countrywide Financial Corporation (“CFC”) is subject to the supervision and examination by the Federal Reserve Board (the “FRB”). The FRB has authority to issue cease and desist orders against bank holding companies if it determines that their actions represent unsafe and unsound practices or violations of law. In addition, the FRB is empowered to impose civil money penalties for violations of banking statutes and regulations. Regulation by the FRB is intended to protect depositors of the Bank, not the shareholders of CFC.
Limitation on Activities
The activities of bank holding companies are generally limited to the business of banking, managing or controlling banks, and other activities that the FRB has determined to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In addition, under the GLB Act, a bank holding company, all of whose controlled depository institutions are “well capitalized” and “well managed” (as defined in federal banking regulations) and which obtains “satisfactory” Community Reinvestment Act ratings, may declare itself to be a “financial holding company” and engage in a broader range of activities.
A financial holding company that desires to engage in activities that are financial in nature or incidental to a financial activity but not previously authorized by the FRB must obtain approval from the FRB before engaging in such activity. In addition, the BHC Act requires a bank holding company to obtain prior approval of the FRB before making certain acquisitions.
If any subsidiary bank of a financial holding company ceases to be “well-capitalized” or “well-managed,” the financial holding company will not be in compliance with the requirements of the BHC Act regarding financial holding companies. If a financial holding company is notified by the FRB of such a change in the ratings of any of its subsidiary banks, it must take certain corrective actions within specified time frames.
If any subsidiary bank of a financial holding company receives a rating under the Community Reinvestment Act of less than “satisfactory”, then the financial holding company is prohibited from engaging in new activities or acquiring companies other than bank holding companies, banks or savings associations until the rating is raised to “satisfactory” or better.
Regulatory Capital Requirements
The FRB has promulgated capital adequacy guidelines for use in its examination and supervision of bank holding companies. If a bank holding company’s capital falls below minimum required levels, then the bank
holding company must implement a plan to increase its capital, and its ability to pay dividends and make acquisitions of new bank subsidiaries may be restricted or prohibited.
The FRB’s capital adequacy guidelines require that a bank holding company maintain a Tier 1 Leverage ratio equal to at least 4.0% of its average total consolidated assets, a Tier 1 Risk-Based Capital ratio equal to 4.0% of its risk-weighted assets and a Total Risk-Based Capital ratio equal to 8.0% of its risk-weighted assets to be classified as “adequately capitalized.” To be classified as “well capitalized,” a bank holding company is required to maintain a Tier 1 Leverage ratio of 5.0% or greater, a Tier 1 Risk-Based Capital ratio of 6.0% or greater, and a Total Risk-Based Capital ratio of 10.0% or greater. On December 31, 2003, the Company was in compliance with all of the FRB’s capital adequacy guidelines. For further information regarding CFC’s capital ratios, see “Note 22 - Regulatory and Agency Capital Requirements” in the financial statement section of this Report .
Interstate Banking and Branching
Under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Riegle-Neal Act”), a bank holding company is permitted to acquire the stock or substantially all of the assets of banks located in any state regardless of whether such transaction is prohibited under the laws of any state. The FRB will not approve an interstate acquisition if as a result of the acquisition the bank holding company would control more than 10% of the total amount of insured deposits in the United States or would control more than 30% of the insured deposits in the home state of the acquired bank. The 30% of insured deposits state limit does not apply if the acquisition is the initial entry into a state by a bank holding company or if the home state waives such limit. The Riegle-Neal Act also authorizes banks to merge across state lines, thereby creating interstate branches. Banks are also permitted to acquire and to establish de novo branches in other states where authorized under the laws of those states.
Under the Riegle-Neal Act, individual states may restrict interstate acquisitions in two ways. A state may prohibit an out-of-state bank holding company from acquiring a bank located in the state unless the target bank has been in existence for a specified minimum period of time (not to exceed five years). A state may also establish limits on the total amount of insured deposits within the state which are controlled by a single bank holding company, provided that such deposit limit does not discriminate against out-of-state bank holding companies.
Source of Strength
FRB policy requires a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks. Under this “source of strength doctrine,” a bank holding company is expected to stand ready to use its available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity, and to maintain resources and the capacity to raise capital that it can commit to its subsidiary banks. Furthermore, the FRB has the right to order a bank holding company to terminate any activity that the FRB believes is a serious risk to the financial safety, soundness or stability of any subsidiary bank.
Liability of Commonly Controlled Institutions
Under cross-guaranty provisions of the Federal Deposit Insurance Act (the “FDIA”), bank subsidiaries of a bank holding company are liable for any loss incurred by the Bank Insurance Fund (the “BIF”), the federal deposit insurance fund for banks, in connection with the failure of any other bank subsidiary of the bank holding company.
Regulations Applicable to Treasury Bank
General
Treasury Bank, N.A. (the “Bank”), as a national banking association, is subject to regulation and examination by the Office of the Comptroller of the Currency (the “OCC”). The Bank is also regulated by
the Federal Deposit Insurance Corporation (the “FDIC”). The OCC is empowered to issue cease and desist orders against the Bank if it determines that activities of the Bank represent unsafe and unsound banking practices or violations of law. In addition, the OCC has the power to impose civil money penalties for violations of banking statutes and regulations. Regulation by this agency is designed to protect the depositors of the Bank, not shareholders of CFC.
Bank Regulatory Capital Requirements
The OCC has adopted minimum capital requirements applicable to national banks, which are similar to the capital adequacy guidelines established by the FRB for bank holding companies. Federal banking laws classify an insured financial institution in one of the following five categories, depending upon the amount of its regulatory capital: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. On December 31, 2003, the Bank was in compliance with the OCC’s minimum capital requirements and satisfied the requirements to be treated as well-capitalized.
The OCC conditioned its approval of CFC’s acquisition of the Bank in May 2001 on, among other things, the (i) the Bank’s Tier 1 capital being no less than $114.5 million on December 31, 2003 and (ii) the Bank maintaining a Tier 1 leverage ratio of no less than 8% until May 17, 2004. On December 31, 2003, the Bank’s leverage ratio was 8.6%, the Tier-1 risked based capital ratio was 12.8% and total-risk based capital ratio was 12.9%.
The Bank must be well-capitalized and well-managed for CFC to remain a financial holding company.
Deposit Insurance and Assessments
The deposits of the Bank are insured by the Bank Insurance Fund administered by the FDIC, in general up to a maximum of $100,000 per insured depositor. Under federal banking regulations, insured banks are required to pay semi-annual assessments to the FDIC for deposit insurance. The FDIC’s risk-based assessment system requires BIF members to pay varying assessment rates depending upon the level of the institution’s capital and the degree of supervisory concern over the institution. The FDIC’s assessment rates range from zero cents to 27 cents per $100 of insured deposits. The FDIC has authority to increase the annual assessment rate and there is no cap on the annual assessment rate which the FDIC may impose.
Limitations on Interest Rates and Loans to One Borrower
The rate of interest a bank may charge on certain classes of loans is limited by state and federal law. At certain times in the past, these limitations have resulted in reductions of net interest margins on certain classes of loans. Federal and state laws impose additional restrictions on the lending activities of banks. The maximum amount that a national bank may loan to one borrower generally is limited to 15% of the bank’s capital, plus an additional 10% for loans fully secured by readily marketable collateral.
Payment of Dividends
The Bank is subject to federal and state laws limiting the payment of dividends. Under the Federal Deposit Insurance Act (“FDIA”), an FDIC-insured institution may not pay dividends while it is undercapitalized or if payment would cause it to become undercapitalized. The OCC also generally prohibits the declaration of a dividend out of the capital and surplus of a bank.
Community Reinvestment Act
The Bank is subject to the Community Reinvestment Act (the “CRA”) and implementing regulations. CRA regulations establish the framework and criteria by which the bank regulatory agencies assess an institution’s record of helping to meet the credit needs of its community, including low and moderate income neighborhoods. CRA ratings are taken into account by regulators in reviewing certain applications made by the Company and its banking subsidiaries.
Limitations on Transactions with Affiliates
CFC and its non-bank subsidiaries are “affiliates” within the meaning of the Federal Reserve Act. The amount of loans or extensions of credit which the Bank may make to non-bank affiliates, or to third parties secured by securities or obligations of the non-bank affiliates, are substantially limited by the Federal Reserve Act and the FDIA. Such acts further restrict the range of permissible transactions between a bank and an affiliated company. A bank and subsidiaries of a bank may engage in certain transactions, including loans and purchases of assets, with an affiliated company only if the terms and conditions of the transaction, including credit standards, are substantially the same as, or at least as favorable to the bank as, those prevailing at the time for comparable transactions with non-affiliated companies or, in the absence of comparable transactions, on terms and conditions that would be offered to non-affiliated companies.
Other Banking Activities
The investments and activities of the Bank are also subject to regulation by federal banking agencies, regarding investments in subsidiaries, investments for their own account (including limitations on investments in junk bonds and equity securities), loans to officers, directors and their affiliates, security requirements, anti-tying limitations, anti-money laundering, financial privacy and customer identity verification requirements, truth-in-lending, the types of interest bearing deposit accounts which it can offer, trust department operations, brokered deposits, audit requirements, issuance of securities, branching and mergers and acquisitions.
The OCC conditioned its approval of the Company’s acquisition of the Bank in May 2001 on, among other things, the Bank obtaining the prior approval of the OCC before significantly deviating from the operating plan that the Bank had submitted to the OCC. This restriction will end on May 17, 2004.
Regulations Applicable to Non-Bank Subsidiaries
General
As discussed below, the non-bank subsidiaries of CFC are subject to the supervision of the FRB and may be subject to the supervision of other state and federal regulatory agencies. In addition, there are a number of proposed and enacted federal, state and local laws aimed at protecting a consumer’s privacy. Generally, privacy laws cover a wide range of issues including limiting a company’s ability to share information with third parties or even affiliates, providing stronger identity theft protection and victim’s assistance programs, providing the ability to avoid telemarketing solicitations through “do-not-call” lists and limiting e-mail and fax advertising. These laws also impose penalties for non-compliance.
Mortgage Banking Segment
Our mortgage banking business is subject to the rules, regulations or guidelines of, and/or examination by, the following entities with respect to the processing, originating, selling and servicing of mortgage loans:
•
The Department of Housing and Urban Development (“HUD”);
•
The Federal Housing Administration (the “FHA”);
•
The Department of Veteran Affairs;
•
Fannie Mae, Freddie Mac, Ginnie Mae;
•
The Federal Home Loan Bank (“FHLB”); and
•
State regulatory authorities.
The rules and regulations of these entities, among other things, impose licensing obligations on CFC, establish standards for processing, underwriting and servicing mortgage loans, prohibit discrimination, restrict certain loan features in some cases and fix maximum interest rates and fees.
As an FHA lender, we are required to submit to the FHA Commissioner, on an annual basis, audited financial statements. Ginnie Mae, HUD, Fannie Mae and Freddie Mac require the maintenance of specified
net worth levels (which vary among the entities). Our affairs are also subject to examination by the Federal Housing Commissioner to assure compliance with FHA regulations, policies and procedures.
Mortgage origination activities are subject to the Equal Credit Opportunity Act, Truth-in-Lending Act, Home Mortgage Disclosure Act, the Real Estate Settlement Procedures Act and the Home Ownership Equity Protection Act and the regulations promulgated thereunder, as well as to other federal laws. These laws prohibit discrimination, require the disclosure of certain basic information to mortgagors concerning credit and settlement costs, limit payment for settlement services to the reasonable value of the services rendered and require the maintenance and disclosure of information regarding the disposition of mortgage applications based on race, gender, geographical distribution and income level.
Currently, there are a number of proposed and recently enacted federal, state and local laws and regulations addressing responsible banking practices with respect to borrowers with blemished credit. In general, these laws and regulations will impose new loan disclosure requirements, restrict or prohibit certain loan terms, fees and charges such as prepayment penalties and will increase penalties for non-compliance. Due to our lending practices, we do not believe that the existence of, or compliance with, these laws and regulations will have a material adverse impact on our business.
However, there can be no assurance that more restrictive laws, rules and regulations will not be adopted in the future or that the existing laws, rules and regulations will not be applied in a manner that may adversely impact our business or make compliance more difficult or expensive.
Capital Markets Segment
Securities broker-dealer operations are subject to federal and state securities laws, as well as the rules of both the Securities and Exchange Commission and the National Association of Securities Dealers, Inc. State and federal securities laws govern many aspects of the broker-dealer’s business, including the maintenance of required levels of net capital, the establishment of segregated cash accounts for the benefit of customers, the monthly and annual reporting of operating and financial data to regulators, the approval and documentation of trading activity, the retention of records and the governance of the manner in which business may be conducted with customers.
Insurance Segment
CFC, by virtue of its affiliation with insurance companies, is a member of an insurance holding company group pursuant to the provisions of the insurance holding company acts (collectively the “Holding Company Acts”). The insurance company entities are subject to the various state insurance departments’ broad regulatory, supervisory and administrative powers. These powers relate primarily to the standards of capital and solvency which must be met and maintained, the licensing of insurers and their agents, the nature and limitation of insurer’s investments, the approval of rates, rules and form; the issuance of securities by insurers, periodic examinations of the affairs of insurers and the establishment of reserves required to be maintained for unearned premiums, losses and other purposes.
Pursuant to the Holding Company Acts, CFC must provide state insurance departments with certain financial information. In addition, certain transactions specified by the Holding Company Acts may not be effected without the prior notice and/or approval of the applicable insurance department. Examples of transactions that may require prior approval include, but are not limited to, sales, purchases, exchanges, loans and extensions of credit, dividends and investments between the insurance company entity and other entities within the holding company group.
Future Legislation
Various legislation, including proposals to change substantially the financial institution regulatory system, is from time to time introduced in Congress. This legislation may change banking statutes and the operating environment of the Company in substantial and unpredictable ways. If enacted, this legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance
among banks, savings associations, credit unions and other financial institutions. The Company cannot predict whether any of this potential legislation will be enacted and, if enacted, the effect that it, or any implementing regulations, could have on the Company’s business, results of operations or financial condition.
The references in the foregoing discussion to various aspects of statutes and regulations are summaries which do not purport to be complete and which are qualified in their entirety by reference to the actual statutes and regulations.
Employees
At December 31, 2003, we had a workforce of 34,298, including regular employees and temporary staff, engaged in the following activities:
Other than certain Global Home Loans employees who are represented by an independent trade union in the United Kingdom, none of our employees are represented by a collective bargaining agent.
Factors That May Affect Future Results
We make forward-looking statements in this report and in other reports we file with the SEC. In addition, we make forward-looking statements in press releases and our senior management might make forward-looking statements orally to analysts, investors, the media and others. Generally, forward-looking statements include:
•
Projections of our revenues, income, earnings per share, capital expenditures, dividends, capital structure or other financial items
•
Descriptions of our plans or objectives for future operations, products or services
•
Forecasts of our future economic performance
•
Descriptions of assumptions underlying or relating to any of the foregoing
Forward-looking statements give management’s expectation about the future and are not guarantees. Words like “believe,” “expect,” “anticipate,” “promise,” “plan” and other expressions or words of similar meanings, as well as future or conditional verbs such as “will,” “would,” “should,” “could,” or “may” are
generally intended to identify forward-looking statements. There are a number of factors, many of which are beyond our control that could cause actual results to differ significantly from management’s expectations.
Readers are cautioned not to place undue reliance on forward-looking statements. Forward-looking statements speak only as of the date they are made. We do not undertake to update them to reflect changes that occur after the date they are made.
For a further discussion of factors that may affect future results, see the section in this report entitled “Management’s Discussion and Analysis of Financial Conditions and Results of Operations - Factors That May Affect Future Results.”
Additional Information
Countrywide Financial Corporation was incorporated in New York on March 14, 1969 and on February 6, 1987 was reincorporated in Delaware. The Company was originally named OLM Credit Industries, Inc. and has also been known as Countrywide Credit Industries, Inc.
Loan Production Tables
The following table summarizes our consolidated loan production by loan type for the periods indicated:
(1)
Percentage of total loan production based on dollar volume.
The following table summarizes our Mortgage Banking loan production by loan type:
The following table summarizes our Consumer Markets Division mortgage loan production by loan type:
The following table summarizes Wholesale Lending Division mortgage loan production by loan type:
The following table summarizes Correspondent Lending Division mortgage loan production by loan type:
The following table summarizes FSLI mortgage loan production by loan type:
The following table sets forth the number and dollar amount of Capital Markets mortgage loan production by loan type for the periods indicated:
The following table sets forth the number and dollar amount of Treasury Bank mortgage loan production by loan type for the periods indicated:
Item 2.
Item 2.
Properties
The primary executive and administrative offices of Countrywide are located in and around Calabasas, California. The headquarters facility consists of approximately 245,000 square feet and is situated on 20.1 acres of land. Our marketing and legal departments are located in an 86,000 square foot office building in Calabasas, California, which we have leased with an option to purchase. Our executive and administrative operations of Treasury Bank are located in a 158,000 square foot office building in Thousand Oaks, California. We sublease, with an option to purchase a 215,000 square foot facility in Rosemead, California, which houses loan production and certain subsidiary operations. We lease and sublease approximately 239,000 square feet in West Hills, California, where our Correspondent Lending and Wholesale Divisions are located. In Simi Valley, California, we own four office buildings totaling approximately 796,000 square feet which currently house loan servicing operations, as well as Treasury Bank’s document custodian operations and our collateral documents and document management operations. We own a fifth building in Simi Valley that will be renovated to house loan servicing operations and other business units. We also lease 304,000 square feet in Simi Valley that house the Balboa Life & Casualty insurance tracking operations and a variety of operating subsidiaries. In Irvine, California, we lease a 136,000 square foot office building which houses the executive and administrative operations of Balboa Life & Casualty. We also own four office buildings totaling
approximately 958,000 square feet on 38.5 acres in Plano, Texas, which house additional loan servicing, loan production, data processing and subsidiary operations.
In 2003, we purchased a 79,000 square foot facility in Chandler, Arizona, which currently houses certain FSLI and loan production technology operations. In 2003, we completed tenant improvements and occupied two buildings totaling 162,000 square feet in Agoura Hills, California, housing loan production technology operations. In December 2003, we moved into a second 101,000 square foot office building in Lancaster, California, bringing our total square feet in Lancaster to 202,000, which we have an option to purchase. The Lancaster facilities currently house loan servicing operations. In September 2003, we purchased a 387,000 square foot facility in Fort Worth, Texas, which will house loan servicing operations. Additional space located in Plano, Texas as well as Woodland Hills, Calabasas Hills and Pasadena, California, is currently under lease for certain operations including: loan servicing, loan production, accounting and data processing. These leases provide an additional 235,000 square feet on varying terms. In addition, we lease space for our branch offices throughout the United States.
Item 3.
Item 3.
Legal Proceedings
We are defendants in, or parties to, a number of pending and threatened legal actions and proceedings involving matters that are generally incidental to our business. These matters include actions and proceedings involving alleged breaches of contract, violations of consumer protection and other laws and regulations, and other disputes arising out of our operations. Certain of these matters involve claims for substantial monetary damages, and others purport to be class actions.
Based on our current knowledge, we do not believe that liabilities, if any, arising from any single pending action or proceeding will have a material adverse effect on the consolidated financial position, results of operations or cash flows of the Company and its subsidiaries. We are not, however, able to predict with certainty the outcome or timing of the resolution of any of these actions or proceedings or the ultimate impact on us or our results of operations in a particular future period.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5.
Item 5.
Market for the Company’s Common Stock and Related Stockholder Matters
The Company’s common stock is listed on the New York Stock Exchange, the NASDAQ National Market and the Pacific Stock Exchange (Symbol: CFC). The following table sets forth the high and low sales prices (as reported by the New York Stock Exchange) for the Company’s common stock and the amount of cash dividends declared during the last two periods:
The Company has declared and paid cash dividends on its common stock quarterly since 1982. The Board of Directors of the Company declares dividends based on its review of the most recent quarter’s profitability along with the Company’s earnings prospects and capital requirements. Effective January 1, 2001, the Company changed its fiscal year. As a result, no dividend was declared in the quarter ended March 31, 2002 as the previous period (the month of December 31, 2001) was the short period in the transition year. In recognition of this change, the Board of Directors supplemented the dividend declared during the quarter ended June 30, 2002, to provide shareholders a return for the one-month period. During the years ended December 31, 2003 and 2002, the Company declared quarterly cash dividends totaling $0.45 and $0.27 per share, respectively.
The ability of the Company to pay dividends in the future is limited by the earnings, cash position and capital needs of the Company, general business conditions and other factors deemed relevant by the Company’s Board of Directors. The Company is prohibited under certain of its debt agreements, including its guarantee of Countrywide Home Loan’s revolving credit facility, from paying dividends on any capital stock (other than dividends payable in capital stock or stock rights) if in default, otherwise the Company may pay dividends in an aggregate amount not to exceed the greater of: (i) the after-tax net income of the Company, determined in accordance with generally accepted accounting principles, for the fiscal year to the end of the quarter to which the dividends relate, or (ii) the aggregate amount of dividends paid on common stock during the immediately preceding year. The ability of the Company to pay dividends may also be limited by the Federal Reserve Board if it determines that the payment of dividends by the Company would hinder its ability to serve as a source of strength for Treasury Bank or would otherwise be detrimental to the continued viability of Treasury Bank or the Company.
The primary source of funds for payments to stockholders by the Company is dividends received from its subsidiaries. Accordingly, such payments by the Company in the future also depend on various restrictive covenants in the debt obligations of its subsidiaries, the earnings, the cash position and the capital needs of its subsidiaries, as well as laws and regulations applicable to its subsidiaries. Unless the Company and Countrywide Home Loans each maintains specified minimum levels of net worth and certain other financial ratios, dividends cannot be paid by the Company and Countrywide Home Loans to remain in compliance with
certain of Countrywide Home Loans’ debt obligations (including its revolving credit facility). See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources.”
As of December 31, 2003 there were 1,966 shareholders of record of the Company’s common stock, with 184,490,593 common shares outstanding.
Item 6.
Item 6.
Selected Consolidated Financial Data
(1)
Certain amounts in the Consolidated Financial Statements have been reclassified to conform to current year presentation.
(2)
Adjusted to reflect subsequent stock dividends and splits.
(3)
Includes warehoused loans and loans under subservicing agreements.
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
Countrywide’s core business is residential mortgage banking. In recent years, we have expanded from our core mortgage banking business into related businesses. We have pursued this diversification to capitalize on meaningful opportunities to leverage our core mortgage banking business and to provide sources of earnings that are less cyclical than the mortgage banking business. We manage these businesses through five business segments - Mortgage Banking, Capital Markets, Banking, Insurance and Global Operations.
The mortgage banking business continues to be the primary source of our revenues and earnings. As a result, the primary influence on our operating results is the aggregate demand for mortgage loans in the U.S., which is affected by such external factors as prevailing mortgage rates and the strength of the U.S. housing market.
In 2003, total U.S. residential mortgage production reached a record level of $3.8 trillion, attributable in large part to historically low interest rates. Driven by this mortgage market, our mortgage banking operations achieved record earnings, as increased profits from loan production, enhanced by a significant increase in market share, more than offset losses attributable to the decline in value of our mortgage servicing rights. Our related businesses also benefited from low interest rates and the record level of mortgage production in 2003. As a result, our net earnings reached $2.4 billion in 2003, an increase of $1.5 billion, or 182%, from 2002.
For 2004, forecasters predict a 40% to 50% reduction in total U.S. mortgage production, due to an expected decline in mortgage refinance activity. We believe that a market within the forecasted range would still be favorable for our loan production business, although we would expect increased competitive pressures to have some impact on the profitability of that business. A reduction in mortgage refinance activity should result, however, in an increase in profitability from our investment in mortgage servicing rights. A decline in mortgage production would likely result in a reduction in mortgage securities trading and underwriting volume, which may negatively impact the profitability of our Capital Markets Segment. However, we expect earnings in our Banking Segment to increase, primarily as a result of growth in its mortgage loan portfolio.
The principal market risk we face is interest rate risk - the risk that the value of our assets or liabilities or our net interest income will change due to changes in interest rates. We manage this risk primarily through the natural counterbalance of our loan production operations and our investment in mortgage servicing rights, as well as through the use of various financial instruments including derivatives. The overall objective of our interest rate risk management activities is to reduce the variability of earnings caused by changes in interest rates.
We also face credit risk, primarily related to our residential mortgage production activities. Credit risk is the potential for financial loss resulting from the failure of a borrower or an institution to honor its contractual obligations to us. We manage mortgage credit risk principally by securitizing substantially all mortgage loans that we produce, and by only retaining high credit quality mortgages in our loan portfolio.
Our liquidity and financing requirements are significant. We meet these requirements in a variety of ways including use of the public corporate debt and equity markets, mortgage- and asset-backed securities markets, and increasingly in the future through the financing activities of our bank. The objective of our liquidity management is to ensure that adequate, diverse and reliable sources of cash are available to meet our funding needs on a cost-effective basis. Our ability to raise financing at the level and cost required to compete effectively is dependent on maintaining our high credit standing.
The mortgage industry has undergone rapid consolidation in recent years, and we expect this trend to continue in the future. Today the industry is dominated by large, sophisticated financial institutions. To compete effectively in the future, we will be required to maintain a high level of operational, technological and managerial expertise, as well as an ability to attract capital at a competitive cost. We believe that we will benefit from this consolidation through increased market share and rational price competition.
Countrywide is a diversified financial services company, with mortgage banking at its core. Our goal is to be the leader in the mortgage banking business in the future. We plan to leverage our position in mortgage banking to grow our related businesses.
As used in this report, references to “we,” “our,” “the Company” or “Countrywide” refer to Countrywide Financial Corporation and its consolidated subsidiaries unless otherwise indicated.
Critical Accounting Policies
The accounting policies with the greatest impact on our financial condition and results of operations, and which require the most judgment, pertain to our mortgage securitization activities, our investments in MSRs and other retained interests, and to our use of derivatives to manage interest rate risk. Our critical accounting policies involve the following four areas: 1) accounting for gains on sales of loans and securities; 2) accounting for MSRs and other retained interests; 3) valuation of MSRs and other retained interests, and; 4) accounting for derivatives and our related interest rate risk management activities.
Gain on Sale of Loans and Securities
Substantially all of the mortgage loans we produce are sold in the secondary mortgage market, primarily in the form of securities. When we sell loans in the secondary mortgage market we generally retain the MSRs. Depending on the type of securitization, there may be other interests we retain including interest-only securities, principal-only securities and residual securities, which we generally hold as available-for sale securities.
We determine the gain on sale of a security, or loans, by allocating the carrying value of the underlying mortgage loans between securities, or loans, sold and the interests retained, based on their relative estimated fair values. The gain on sale we report is the difference between the cash proceeds from the sale and the cost allocated to the securities, or loans, sold.
Here is an example of how this accounting concept works:
(1)
The carrying value of mortgage loans includes the outstanding principal balance of the loans net of deferred origination costs and fees and any premiums or discounts.
Accounting for MSRs and Other Retained Interests
Once MSRs and other retained interests have been recorded, they must be periodically evaluated for impairment. Impairment occurs when the current fair value of the MSRs or other retained interests falls below its carrying value.
If MSRs are impaired, the impairment is recognized in current-period earnings and the carrying value of the MSRs is adjusted through a valuation allowance. If the value of the MSRs subsequently increases, the
recovery in value is recognized in current-period earnings and the carrying value of the MSRs is adjusted through a reduction in the valuation allowance. (As of December 31, 2003, the MSR impairment valuation allowance was $1.2 billion.) If impairment is deemed to be other than temporary, the valuation allowance is applied to reduce the cost-basis of the MSRs. MSRs cannot be carried above their amortized cost-basis.
For other retained interests, which we account for as available-for-sale securities, impairment is recognized as a reduction to shareholders’ equity (net of tax). If the impairment is deemed to be other than temporary, it is recognized in current-period earnings. Once we record this impairment, we recognize subsequent increases in the value of other retained interests in earnings over the estimated remaining life of the investment through a higher effective yield.
In addition to periodic evaluation for impairment, MSRs are also subject to periodic amortization. We compute MSR amortization by applying the ratio of the net MSR cash flows projected for the current period to the estimated total remaining net MSR cash flows. The estimated total net MSR cash flows are determined at the beginning of each reporting period, using prepayment assumptions applicable at that time.
Valuation of MSRs and Other Retained Interests
Considerable judgment is required to determine the fair values of our retained interests. Unlike government securities and other highly liquid investments, the precise market value of retained interests cannot be readily determined, because these assets are not actively traded in stand-alone markets.
Our MSR valuation process combines the use of a sophisticated discounted cash flow model, extensive analysis of current market data, and senior financial management oversight to arrive at an estimate of fair value at each balance sheet date. The cash flow assumptions and prepayment assumptions used in our discounted cash flow model are based on our own empirical data drawn from the historical performance of our MSRs, which we believe are consistent with assumptions used by market participants valuing MSRs. The most critical assumptions used in the valuation of MSRs include mortgage prepayment speeds and the discount rate (projected LIBOR plus option-adjusted spread). These variables can and generally will change from quarter to quarter as market conditions and projected interest rates change. We determine the fairness of our MSR valuation quarterly by comparison to the following market data (as available): MSR trades; MSR broker valuations; prices of interest-only securities, and; peer group MSR valuation surveys.
For the other retained interests, we also estimate fair value through the use of discounted cash flow models. The key assumptions used in the valuation of our other retained interests include mortgage prepayment speeds, discount rates, and for residual interests containing credit risk, the net lifetime credit losses. (See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Credit Risk Management” section of this document for further discussion of credit risk). We have incorporated cash flow and prepayment assumptions based on our own empirical data drawn from the historical performance of the loans underlying our other residual interests, which we believe are consistent with assumptions other major market participants would use in determining the assets’ fair value.
At December 31, 2003, the Company’s investment in MSRs was as follows:
(1)
Excludes subservicing and mortgage loans held for sale or investment.
(2)
The weighted average mortgage rate.
The portfolio serviced for others has a weighted average service fee of 0.327%.
The following table shows the value sensitivity of our MSRs to the key assumptions we used to determine their fair values at December 31, 2003:
(1) option-adjusted spread over LIBOR
The following table shows the value sensitivity of our other retained interests to the key assumptions we used to determine their fair values at December 31, 2003:
These sensitivities are hypothetical and should be used with caution. This information is furnished to provide the reader with a basis for assessing the sensitivity of the values presented to changes in key assumptions. As the figures indicate, changes in fair value based on a 10% variation in individual assumptions generally cannot be extrapolated. In addition, in the above table, the effect of a variation in a particular assumption on the fair value of the retained interest is calculated without changing any other assumption. In reality, changes in one factor may result in changes in another, which could magnify or counteract the sensitivities.
Derivatives and Interest Rate Risk Management Activities
We use derivatives extensively in connection with our interest rate risk management activities. We record all derivative instruments at fair value.
We may qualify some of our interest rate risk management activities for hedge accounting. To qualify for hedge accounting we must demonstrate, on an ongoing basis, that our interest rate risk management activity is highly effective. We use standard statistical measures to determine the effectiveness of our hedging activity. If we are unable to qualify certain interest rate risk management activities for hedge accounting, then the change in fair value of the associated derivative financial instruments would be reflected in current period earnings, while the change in fair value of the related asset or liability might not, thus creating a possible earnings mismatch. This issue is potentially most significant regarding MSRs, which absent the application of hedge accounting, are required to be carried at the lower of amortized cost or market.
In connection with our mortgage loan origination activities, we issue interest rate lock commitments (“IRLCs”) to loan applicants and financial intermediaries. The IRLCs guarantee a loan’s terms, subject to credit approval, for a period of time while the loan application is in process, typically between 7 and 60 days. IRLCs are derivative instruments and, therefore, are required to be recorded at fair value, with changes in fair value reflected in current period earnings. However, unlike most other derivative instruments, there is no active market for IRLCs that can be used to determine an IRLC’s fair value. Consequently, we have developed a method for estimating the fair value of our IRLCs.
We estimate the fair value of an IRLC based on the change in estimated fair value of the underlying mortgage loan, given the probability that the loan will fund within the terms of the IRLC. The change in fair value of the underlying mortgage loan is based on quoted MBS prices. The change in fair value of the underlying mortgage loan is measured from the lock date. Therefore, at the time of issuance the estimated fair value of an IRLC is zero. (Subsequent to issuance, the value of an IRLC can be either positive or negative,
depending on the change in value of the underlying mortgage loan.) The probability that the loan will fund within the terms of the IRLC is driven by a number of factors - in particular, the change, if any, in mortgage rates subsequent to the lock date. In general, the probability of funding increases if mortgage rates rise and decreases if mortgage rates fall. This is due primarily to the relative attractiveness of current mortgage rates compared to the applicant’s committed rate. The probability that a loan will fund within the terms of the IRLC also is influenced by the source of the applications, age of the applications, purpose for the loans (purchase or refinance) and the application approval rate. We have developed closing ratio estimates using historical empirical data that take into account all of these variables, as well as renegotiations of rate and point commitments that tend to occur when mortgage rates fall. These closing ratio estimates are used to estimate the number of loans that we expect to fund within the terms of the IRLCs.
In March 2003, the SEC issued Staff Accounting Bulletin No. 105 - “Application of Accounting Principles to Loan Commitments” (“SAB No. 105”), which summarizes the views of the SEC staff regarding the application of generally accepted accounting principles to loan commitments accounted for as derivative instruments. Our current method used to estimate the fair value of IRLCs is consistent with SAB No. 105; therefore, SAB No. 105 will have no impact on the Company’s financial condition or results of operations.
Change in Fiscal Year
Effective January 1, 2001, we changed our year end from February 28 to December 31. For purposes of this Annual Report on Form 10-K, our consolidated statements of earnings, consolidated statement of common shareholders’ equity, consolidated statements of cash flows and consolidated statements of comprehensive income consist of the years ended December 31, 2003, 2002 and the ten months ended December 31, 2001. We changed our year end to conform our reporting periods to those required by the Board of Governors of the Federal Reserve for regulatory reporting purposes.
Change of Corporate Name
On November 7, 2002, we changed our corporate name from Countrywide Credit Industries, Inc. to Countrywide Financial Corporation.
We believe our new name more accurately reflects the full array of products and services we offer to consumers and financial companies.
Stock Split Effected as a Stock Dividend
In the fourth quarter of 2003, we consummated a 4-for-3 stock split effected as a stock dividend. All references in the accompanying Management’s Discussion and Analysis of Financial Condition and Results of Operations to the number of common shares and earnings per share amounts have been restated accordingly.
Comparison of Results of Operations for the Year Ended December 31, 2003 (“2003”) to the Year Ended December 31, 2002 (“2002”)
Consolidated Earnings Performance
Our diluted earnings per share for 2003 totaled $12.47, a 156% increase over diluted earnings per share for 2002. Net earnings were $2,373.0 million, a 182% increase from 2002. This earnings performance was driven by an increase in our mortgage loan production from $251.9 billion in 2002 to $434.9 billion in 2003. In addition, our non-mortgage banking businesses achieved a substantial overall increase in earnings in 2003.
Industry-wide, mortgage loan production reached a new record level of $3.8 trillion in 2003, up from $2.7 trillion during 2002 (Source: Inside Mortgage Finance). Approximately two-thirds of the mortgages produced in 2003 were refinances of existing mortgages that were triggered by historically low mortgage rates. These same low rates contributed to increased activity in the U.S. housing market, which also reached record levels in 2003.
The continued high demand for mortgages drove not only high production volumes for Countrywide, but also high production margins. The combination of high volumes and margins yielded Loan Production Sector pre-tax earnings of $4,087.9 million for 2003, an increase of $1,692.9 million from 2002.
The high levels of mortgage refinances and home purchases resulted in significant prepayments within our mortgage loan servicing portfolio during the period. This, along with the expectation of continued higher-than-normal prepayments in the future due to low mortgage rates, resulted in significant amortization and impairment of our MSRs and other retained interests in 2003. The combined amount of amortization and impairment of MSRs and other retained interests, net of Servicing Hedge gains, was $3,267.4 million, resulting in a pre-tax loss of $1,233.5 million in the Loan Servicing Sector for 2003, compared to a pre-tax loss of $1,489.8 million in 2002.
These factors combined to produce pre-tax earnings of $2,952.2 million in the Mortgage Banking Segment for 2003, an increase of $1,977.1 million, or 203%, from 2002.
Our non-mortgage banking businesses had combined pre-tax earnings of $893.6 million in 2003, an increase of 143% over 2002. Benefiting again from a favorable market environment, our Capital Markets Segment achieved pre-tax earnings of $442.3 million, up from $199.9 million in 2002. In addition, our Banking Segment increased its pre-tax earnings by $203.2 million over the prior year, driven primarily by growth in its portfolio of mortgage loans.
Operating Segment Results
Pre-tax earnings by segment are summarized below:
Mortgage loan production by segment and product is summarized below:
Mortgage Banking Segment
Our Mortgage Banking Segment includes the Loan Production, Loan Servicing and Loan Closing Sectors. The Loan Production and Loan Closing Services Sectors generally perform at their best when mortgage rates are relatively low and loan origination volume is high. Conversely, the Loan Servicing Sector generally performs well when mortgage rates are relatively high and loan prepayments are low. The natural counterbalance of these sectors reduces the impact of changes in mortgage rates on our earnings. During 2003, historically low mortgage rates drove record levels of mortgage originations and prepayments industry-wide, which contributed to record profits in the Loan Production and Loan Closing Services Sectors and near record losses in the Loan Servicing Sector.
Loan Production Sector
The Loan Production Sector produces mortgage loans through the three production divisions of Countrywide Home Loans (“CHL”) - Consumer Markets, Wholesale Lending and Correspondent Lending, as well as through Full Spectrum Lending, Inc.
The pre-tax earnings of the Loan Production Sector are summarized below:
Strong demand for residential mortgages enabled the Loan Production Sector to achieve significant growth in revenues and earnings in 2003 compared to 2002. This performance was enhanced by a significant increase in our market share during the year. Our mortgage origination market share was 11.6% in 2003, up from 9.4% in 2002 (Source: Inside Mortgage Finance). Ongoing favorable market conditions contributed to
the continued high revenues earned, while high productivity levels helped keep unit costs low. These factors combined to produce continued high profit margins (pre-tax earnings as a percentage of loan volume) for the Loan Production Sector.
The following table shows total Mortgage Banking loan production volume by division:
Mortgage Banking loan production for 2003 increased 64% in comparison to 2002. All divisions, in particular Correspondent Lending, contributed to the increase in origination volume. The increase was due primarily to a rise in non-purchase loan production of 78%. An increase in purchase production of 39% also contributed to the higher origination volume. The increase in purchase loans is significant because this is the relatively stable growth component of the mortgage market, with average annual growth of 8% over the last 10 years. (The non-purchase, or refinance, component of the mortgage market is highly volatile because it is driven almost exclusively by prevailing mortgage rates.)
The following table summarizes Mortgage Banking loan production by purpose and interest rate type:
In 2003, 82% of our loan production was fixed rate, which reflects homeowner preferences for fixed rate mortgages in a low mortgage-rate environment. Management expects that a higher percentage of homeowners would potentially choose adjustable rate mortgages in a higher interest rate environment. Such a shift in homeowner preferences may favor portfolio lenders, which have a natural preference for adjustable rate mortgages, over mortgage bankers that rely more heavily on securitization.
As shown in the following table, the volume of Mortgage Banking Prime Home Equity and Subprime Mortgage Loans produced (which is included in the total volume of loans produced) increased 59% during the current period from the prior period:
Prime Home Equity and Subprime Mortgage Loans carry higher profit margins historically, and the demand for such loans is believed to be less rate sensitive than the demand for prime home loans. Consequently, Management believes these loans will be a significant component of the sector’s future growth, in particular if mortgage rates should rise significantly.
A major source of intrinsic value derived from our MSRs is Countrywide’s ability to retain its customers when they either refinance their loans or purchase new homes. We successfully retained a significant percentage of the customers who prepaid their mortgages during 2003. Our overall retention rate for 2003 was 40% as compared to 37% for 2002. Our retention rate increased for purchase customers and remained constant for refinance customers. Our retention rate for purchase customers was 27% for 2003 as compared to 21% for 2002. Our retention rate for refinance customers was 42% for 2003 and 2002.
During 2003, the Loan Production Sector operated at approximately 110% of planned operational capacity. The primary capacity constraint in our loan origination activities is the number of loan operations personnel we have on staff. Therefore, we measure planned capacity with reference to the number of loan operations personnel we have multiplied by the number of loans we expect each available loan operations staff person to process under normal conditions. As volume decreased toward the end of 2003, we began to make reductions in operations staff. From its peak, the total number of operations personnel has been reduced by approximately 3,000. As loan production volume continues to moderate, the operations staff will be further reduced accordingly. At the same time, a reduction in productivity to more sustainable levels will likely result in higher overall unit costs. We plan to continue building our sales staff despite any potential drop in loan origination volume as a primary way to increase market share.
The following table summarizes the Loan Production Sector workforce:
The Consumer Markets Division continued to grow its commissioned sales force during the period. At December 31, 2003, its commissioned sales force numbered 3,484, an increase of 1,000 during the year. The primary focus of the commissioned sales force is to increase overall purchase market share. The commissioned
sales force contributed $25.8 billion in purchase originations in 2003, a 91% increase over 2002. The purchase production generated by the commissioned sales force represented 71% of the Consumer Markets Division’s purchase production for 2003.
Like the Consumer Markets Division, the Wholesale Lending Division and FSLI continued to grow their sales forces as a core strategy to increase market share. At December 31, 2003, the sales force in the Wholesale Lending Division numbered 886, an increase of 27% during the year. FSLI expanded its sales force by 981, or 96%, during 2003.
Loan Servicing Sector
The Loan Servicing Sector reflects the performance of the Company’s investments in MSRs and other retained interests and associated risk management activities, as well as profits from subservicing activities in the United States. The Loan Servicing Sector includes a significant processing operation, consisting of approximately six thousand employees who service the Company’s 5.1 million mortgage customers. How effectively this servicing operation manages costs and generates ancillary income from the portfolio has a significant impact on the long-term performance of this sector.
The following table summarizes the results for the Loan Servicing Sector:
The Loan Servicing Sector experienced continued losses during the recent period, driven by high amortization and impairment of the Company’s retained interests. The amortization and impairment charges reflect the loss in value of the Company’s retained interests, which was primarily due to the high level of actual and projected prepayments in the Company’s mortgage servicing portfolio. In general, the value of the retained interests is closely linked to the estimated life of the underlying loans. As prepayments increase, the estimated life of the underlying loans decreases. The combined impairment and amortization charge was $3,502.2 million and $4,682.6 million during 2003 and 2002, respectively.
During 2003, the Servicing Hedge generated a gain of $234.8 million. This gain resulted from a decline in long-term Treasury and swap rates during the first part of 2003; these indices underlie the derivatives and securities that constitute the primary component of the Servicing Hedge. The Servicing Hedge gains generated in the early part of 2003 were partly offset by Servicing Hedge losses toward the end of the year as long-term Treasury and swap rates rose. Amortization and impairment, net of the Servicing Hedge, was $3,267.4 million for 2003, an increase of $372.7 million over 2002. In a stable interest rate environment, Management would expect no significant impairment and would expect to incur expenses related to the Servicing Hedge driven primarily by the composition of the hedge, the shape of the yield curve and the level of interest rate volatility.
During 2003, we securitized a portion of our net servicing fees (“excess servicing”). Proceeds from the sale of such securities amounted to $1,043.4 million. Securities not sold were classified as trading securities and included in “Investments in other financial instruments” at December 31, 2003. We believe such securitizations enable us to more efficiently manage our capital.
Despite the high level of prepayments, we increased our servicing portfolio to $644.9 billion at December 31, 2003, a 43% increase from December 31, 2002. At the same time, the overall weighted-average note rate of loans serviced for others declined from 6.9% to 6.1%.
Loan Closing Services Sector
This sector is comprised of the LandSafe companies, which provide credit reports, flood determinations, appraisals, property valuation services and title reports primarily to the Loan Production Sector but increasingly to third parties as well. Our integration of these previously outsourced services has provided not only incremental profits but also higher overall levels of service and quality control.
The LandSafe companies produced $97.8 million in pre-tax earnings, representing an increase of 40% from the year-ago period. The increase in LandSafe’s pre-tax earnings was primarily due to the increase in our loan origination activity.
Non-Mortgage Banking Businesses
To leverage our mortgage banking platform, as well as to reduce the variability of earnings due to changes in mortgage interest rates, we have expanded into other financial services. These other businesses are grouped into the following segments: Capital Markets, Banking, Insurance and Global Operations.
Capital Markets Segment
Our Capital Markets Segment achieved pre-tax earnings of $442.3 million for 2003, an increase of $242.4 million, or 121%, from 2002. Total revenues were $676.0 million, an increase of $301.6 million, or 81% compared to 2002. Capital Markets took advantage of the highly favorable operating environment prevalent during 2003, consisting of a robust mortgage securities market, high mortgage securities price volatility, and low short-term financing costs.
The following table shows the pre-tax income of the Capital Markets segment:
During 2003, the Capital Markets Segment generated revenues totaling $269.6 million from its conduit activities, which includes brokering and managing the acquisition, sale or securitization of whole loans on behalf of CHL. Conduit revenues for 2003 increased 142% in comparison to 2002 as a result of an increase in the amount of mortgage loans sold that were acquired by the conduits. During 2003, the mortgage loans sold that were acquired by the conduits totaled $38.1 billion, an 81% increase in comparison to $21.1 billion in conduit loans sold in 2002.
Revenues from securities trading increased 43% to $199.1 million for 2003 due to a 43% increase in securities trading volume. The following table shows the composition of Countrywide Securities Corporation’s (“CSC”) securities trading volume, which includes intersegment trades with our mortgage banking operations, by instrument:
(1)
Approximately 12% and 13% of the segment’s total securities trading volume was with CHL during 2003 and 2002, respectively.
In 2003, underwriting revenues totaled $172.0 million, an increase of 83% compared to 2002. This increase was attributable to a 74% increase in underwriting volume in 2003.
Effective January 15, 2004, CSC became a primary dealer. As a primary dealer, CSC is an authorized counterparty with the Federal Reserve Bank of New York in its open market operations. Management believes that CSC’s status as a primary dealer will enhance our ability to compete in its core mortgage securities business by expanding its client base.
Banking Segment
The Banking Segment achieved pre-tax earnings of $287.2 million in 2003, as compared to $84.0 million for 2002. Following is the composition of pre-tax earnings by company:
The Bank produced pre-tax earnings of $223.0 million for 2003, an increase of $171.3 million over 2002. The overall increase was due to an increase in net interest income arising from growth in average earning assets combined with a $30.5 million increase in intersegment profits related to the Bank’s document custodian services provided to our mortgage banking operations. Average earning assets increased to $12.4 billion during 2003, an increase of $9.0 billion in comparison to 2002. Asset growth was funded primarily by the transfer of custodial balances controlled by CHL from third-party banks to the Bank, three capital contributions from CFC, Federal Home Loan Bank advances, and growth in the Bank’s retail deposit base. As of December 31, 2003, $5.9 billion of custodial balances controlled by CHL were placed as deposits in the
Bank. The Bank’s annual pre-tax return on assets for 2003 was 1.8% as compared to 1.5% for 2002. The composition of the Bank’s assets was as follows:
Our banking strategy entails holding loans in portfolio that historically would have been immediately securitized and sold in the secondary mortgage market. Management believes this strategy will increase earnings, as well as provide more stable earnings, over the long term; in the short term, reported profits will be impacted by the reduction in gains otherwise recognizable at time of sale.
CWL’s pre-tax earnings increased $45.5 million in 2003. This was primarily due to growth in average outstanding mortgage warehouse advances partially offset by a decline in the average net spread from 2.1% during 2002 to 2.0% during 2003. For 2003, average mortgage warehouse advances outstanding were $4.0 billion, an increase of $2.3 billion in comparison to 2002. The increase in warehouse advances was largely attributable to growth in the overall mortgage originations market.
Insurance Segment
The Insurance Segment pre-tax earnings increased 86% over 2002, to $138.8 million for 2003. The following table shows pre-tax earnings by business line:
(1)
Includes the Balboa Life and Casualty Group and the Countrywide Insurance Services Group.
The following table shows net earned premiums:
Our mortgage reinsurance business produced $102.1 million in pre-tax earnings, due primarily to a 55% increase in net earned premiums that was driven by growth in the Company’s loan servicing portfolio, offset by
a $31.5 million increase in insurance claims reserves. Insurance claims reserves are a function of expected remaining claims losses and premiums.
Our Life and Casualty insurance business produced pre-tax earnings of $52.0 million, an increase of $50.9 million from 2002. The growth in earnings was driven by a $125.4 million, or 26%, increase in net earned premiums during 2003 in comparison to 2002. The growth in net earned premiums was primarily attributable to growth in lender-placed insurance.
Our Life and Casualty insurance operations manage its insurance risk by reinsuring portions of its insured risk. Balboa seeks to earn profits by capitalizing on Countrywide’s customer base and institutional relationships, as well as through operating efficiencies and sound underwriting.
Pre-tax earnings from the agency operations increased in 2003 due to a restructuring of the agency in 2002 to reduce costs and focus on profitable business lines.
Global Operations Segment
For 2003, our Global Operations Segment’s pre-tax earnings totaled $25.6 million, representing an increase of $20.3 million in comparison to 2002. Results in the current period were positively impacted by growth in the portfolio of mortgage loans subserviced and the number of new mortgage loans processed on behalf of GHL’s minority joint venture partner, Barclays plc.
Detailed Discussion of Consolidated Revenue and Expense Items
Gain on Sale of Loans and Securities
Gain on sale of loans and securities is summarized below for 2003 and 2002:
Gain on sale of loans and securities increased in 2003 as compared to 2002 primarily due to higher prime mortgage loan production and sales volume combined with higher margins on prime mortgage loans. Margins on prime mortgage loans were high in both periods on a relative historical basis, due largely to the very favorable mortgage market environment that prevailed during those periods.
During 2003, we sold a small portion of Prime Home Equity Loans produced. We plan to hold the remaining prime home equity loans as investments in the form of available-for-sale securities or loans.
Re-performing loans are reinstated loans that had previously defaulted, and were consequently re-purchased from mortgage securities we issued. The increase in gain on sale of re-performing loans is due to an increase in the volume of loans sold. The note rate on these loans is typically higher than the current mortgage rate, and therefore, the margin on these loans is typically higher than margins on Prime Mortgage Loans.
Capital Markets’ revenues from its trading activities consist of gains on the sale of securities and net interest income. In a very steep yield curve environment, which existed during both periods, trading revenues will derive largely or entirely from net interest income earned during the securities’ holding period. As the yield curve flattens, the mix of revenues will shift toward gain on sale of securities. The increase in Capital Markets’ gain on sale of loans related to its conduit activities was due to increased acquisitions and sales during 2003 in comparison to 2002.
In general, gain on sale of loans and securities is affected by numerous factors, including the volume and mix of loans sold, production channel mix, the level of price competition, the slope of the yield curve and the effectiveness of our associated interest rate risk management activities.
Net Interest Income
Net interest income is summarized below for the years ended 2003 and 2002:
The increase in net interest income from mortgage loans and securities held for sale reflects an increase in the average inventory resulting from increased production during 2003 as compared to 2002.
The increase in net interest income from the Capital Markets securities trading portfolio is attributable to an increase of 61% in the average inventory of securities held, which in turn was driven by an increase in trading activity. This increase was partially offset by a decrease in the average net spread earned from 4.1% in 2002 to 3.3% in 2003. The decrease in the average net spread is the result of a flatter yield curve.
The increase in net interest income from the Banking Segment was primarily attributable to year-over-year earning asset growth in both the Bank and CWL. Average assets in the Banking Segment increased to $16.4 billion during 2003, an increase of $11.2 billion over 2002. The average net spread earned increased slightly to 2.1% in 2003 from 1.9% in 2002.
Re-performing loans are reinstated loans that had previously defaulted and were consequently re-purchased from mortgage securities issued by Countrywide or others. Such loans are subsequently securitized and re-sold.
Net interest expense from custodial balances increased in 2003 due to the substantial increase in loan payoffs over 2002. We are obligated to pass through monthly interest to security holders on paid-off loans at
the underlying security rates, which were substantially higher than the short-term rates earned by us on payoff float. The amount of such interest passed through to the security holders was $406.8 million and $218.8 million in 2003 and 2002, respectively. In addition, the earnings rate on the custodial balances, which is tied to short-term rates, declined from 1.6% during 2002 to 1.0% during 2003. Average custodial balances increased by $7.6 billion, or 68%, over 2002 due largely to the increase in loan payoffs.
Interest expense allocated to the Loan Servicing Sector decreased due primarily to a decline in short-term rates (a portion of our long-term debt is variable-rate), which was combined with a decrease in total Sector assets.
The increase in net interest income from home equity AAA asset-backed securities is due to an increase in the average inventory of securities held.
Loan Servicing Fees and Other Income from Retained Interests
Loan servicing fees and other income from retained interests are summarized below for 2003 and 2002:
The increase in servicing fees, net of guarantee fees, was principally due to a 45% increase in the average servicing portfolio, partially offset by a reduction in the overall net service fee earned from 0.38% of the average portfolio balance during 2002 to 0.35% during 2003. The reduction in the overall net service fee was largely due to the securitization of excess service fees.
The increase in income from other retained interests was due primarily to a 33% increase in investment balances during 2003, combined with an increase in the average effective yield of these investments from 20% in 2002 to 25% in 2003. These investments include interest-only and principal-only securities as well as residual interests that arise from the securitization of nonconforming mortgage loans, particularly subprime home loans.
Higher prepayment penalty income in 2003 corresponded to the increase in subprime home loan payoffs during the year.
The increase in subservicing fees earned in the Global Operations Segment was due to growth in the portfolio subserviced and to an increase in fees earned per loan. The Global Operations subservicing portfolio was $106 billion and $92 billion at December 31, 2003 and 2002, respectively.
Amortization of Mortgage Servicing Rights
We recorded amortization of MSRs of $2,069.2 million during 2003 as compared to $1,267.2 million during 2002. The increase in amortization of MSRs was primarily due to a reduction in future estimated net MSR cash flows primarily due to forecasted higher mortgage prepayments in 2003 when compared to 2002, coupled with an increase in the cost basis of the MSRs related to the larger servicing portfolio.
Impairment or Recovery of Retained Interests and Servicing Hedge Gains
Impairment of retained interests and Servicing Hedge gains are detailed below for 2003 and 2002:
During 2003 and 2002, impairment of MSRs and other retained interests resulted from a reduction in the estimated fair value of those investments, which was primarily driven by the decline in mortgage rates during these periods.
Rising mortgage rates in the future should result in an increase in the estimated fair value of the MSRs and recovery of all or a portion of the impairment reserve. The MSR amortization rate, which is tied to the expected net cash flows from the MSRs, likewise should reduce as mortgage rates rise.
During the first part of 2003, long-term Treasury and swap rates declined, resulting in a Servicing Hedge gain of $234.8 million for 2003. During 2002, the Servicing Hedge generated a gain of $1,787.9 million.
The Servicing Hedge is intended to moderate the effect on earnings caused by changes in the estimated fair value of MSRs and other retained interests that generally result from changes in mortgage rates. Rising interest rates in the future will result in Servicing Hedge losses.
Net Insurance Premiums Earned
The increase in net insurance premiums earned is primarily due to a 30% increase in policies-in-force.
Commissions and Other Income
Commissions and other income consisted of the following for 2003 and 2002:
The increase in processing fees earned in the Global Operations Segment was due to growth in the number of loans processed.
The increase in credit report, appraisal and title service fees is primarily due to the increase in our loan origination volume.
The decrease in insurance agency commissions is due to discontinuation of the agency’s home warranty and auto lines.
Compensation Expenses
Compensation expenses are summarized below for 2003 and 2002:
Compensation expenses increased $812.5 million, or 46%, during 2003 as compared to 2002.
Compensation expenses in the Mortgage Banking Segment increased primarily due to growth in the level of loan production activity. In the Loan Production Sector, compensation expenses increased $595.2 million, or 65%, reflecting a 64% increase in loan production coupled with a 55% increase in average staff. Salaries rose 55% and incentive bonus and commissions rose 79%. The relative increase in incentive bonuses and commissions reflects a shift toward a more incentive-based compensation structure within our loan production operations. In the Loan Servicing Sector, compensation expense rose $49.0 million, or 25%, as a result of an increase in average staff of 21% to support a 28% increase in the number of loans serviced and an 81% increase in the number of loan payoffs. Compensation expenses in the Loan Closing Services increased $19.7 million, or 36% as a result of an increase in average staff of 18% to support increased activity in this sector.
Incremental direct costs associated with the origination of loans are deferred when incurred. When the related loan is sold, the costs deferred are included as a component of gain on sale. See “Note 2 - Summary of Significant Accounting Policies - Financial Statement Reclassifications” in the financial statement section of this Report for a further discussion of deferred origination costs.
Compensation expenses increased in all other business segments, reflecting their growth.
In our Insurance Segment, compensation expenses increased by $4.1 million, or 4%, as a result of an increase of 11% in average staff to support growth of 30% in net earned premiums and growth in the Insurance Segment’s third-party insurance tracking operation.
In the Capital Markets Segment, incentive bonuses increased $35.1 million, or 34%, reflecting growth in revenues of 81%.
Banking Segment compensation expenses increased by $31.9 million, or 110%, to accommodate the growth of the Bank’s operations, primarily in its labor-intensive mortgage document custodian business.
Compensation expenses in our Global Operations Segment increased $26.5 million, or 47%, as a result of an increase in average staff of 31% resulting from the addition of a facility to process the additional volume of loans serviced in GHL.
Compensation expenses for Corporate Administration increased $42.6 million, or 15%, in 2003 as compared to 2002 due to an increase in average staff of 21% to support the Company’s overall growth.
Occupancy and Other Office Expenses
Occupancy and other office expenses for the year ended December 31, 2003 increased primarily to accommodate personnel growth in our loan production operations, which accounted for 67% of the increase, as well as growth in our corporate operations, which accounted for 26% of the increase in this expense.
Insurance Claims Expenses
Insurance claim expenses were $360.0 million, or 49%, of net insurance premiums earned for 2003, as compared to $277.6 million, or 49%, of net insurance premiums earned for 2002. The increase in insurance claim expenses was attributable to higher net premiums earned and an increase in insurance claims expenses of Balboa Reinsurance, of $31.5 million over 2002. Reinsurance claims expenses are a function of expected remaining losses and premiums. These increases were partially offset by improvement in the loss ratio at Balboa Life and Casualty. The loss ratio (including allocated loss adjustment expenses) of Balboa Life and Casualty was 55% and 58% for 2003 and 2002, respectively.
Other Operating Expenses
Other operating expenses for 2003 and 2002 are summarized below:
Insurance commission expense as a percentage of insurance premiums earned declined from 21% in 2002 to 19% in 2003 primarily due to reduced contingent commissions accruing to insurance agents as a result of higher than anticipated insured losses on certain lender-placed auto policies. Contingent commissions are paid only on certain lender-placed auto policies sourced through agents.
Professional fees increased from the prior period due primarily to increased legal costs and consulting services.
Bad debt expense consists primarily of losses during the period arising from unreimbursed servicing advances on defaulted loans, credit losses arising from repurchased or indemnified loans and defaulted VA-guaranteed loans. (See the “Credit Risk Management” section of this Report for a further discussion of credit risk.)
Comparison of Results of Operations for the Year Ended December 31, 2002 to the Ten Months Ended December 31, 2001
Consolidated Earnings Performance
Our diluted earnings per share for the year ended December 31, 2002 totaled $4.87, a 67% increase over diluted earnings per share for the ten months ended December 31, 2001. Net earnings increased 73% from the ten months ended December 31, 2001. This earnings performance was driven mainly by the increased level of residential mortgage loans we produced - $251.9 billion during the year ended December 31, 2002 in comparison to $124.0 billion for the ten months ended December 31, 2001. In addition, the year ended December 31, 2002 is compared to a transition period consisting of ten months.
Industry-wide, residential mortgage originations were approximately $2.7 trillion during calendar 2002, up from approximately $2.0 trillion in calendar 2001 (Source: Inside Mortgage Finance). Approximately 62% of the residential mortgages produced in calendar 2002 were refinances of existing mortgages triggered by historically low mortgage rates. The balance of mortgages produced related to home purchases.
The record demand for residential mortgages not only drove record loan production volumes for Countrywide, but also high loan production margins. The combination of record volumes and high margins increased our Loan Production Sector pre-tax earnings to $2.4 billion for the year ended December 31, 2002, an increase of 162%, or $1.5 billion from the ten months ended December 31, 2001.
The high levels of mortgage refinances and home purchases in the year ended December 31, 2002 resulted in significant prepayments within our mortgage loan servicing portfolio during the year. This, along with the expectation of continued higher-than-normal prepayments due to historically low mortgage rates, resulted in significant amortization and impairment of the Company’s MSRs and other retained interests in the year ended December 31, 2002. The combined amount of amortization and impairment of MSRs and other retained interests, net of Servicing Hedge gains, was $2.9 billion. This resulted in a pre-tax loss of $1.5 billion in the Loan Servicing Sector in the year ended December 31, 2002, $1.1 billion more than the pre-tax loss in the ten months ended December 31, 2001.
Overall, the Mortgage Banking Segment generated pre-tax earnings of $975.1 million for the year ended December 31, 2002, an increase of 58% over the ten months ended December 31, 2001.
Our non-mortgage banking businesses also were significant contributors to Countrywide’s record earnings performance in the year ended December 31, 2002. In particular, our Capital Markets Segment had pre-tax earnings of $199.9 million for the year ended December 31, 2002, as compared to $81.2 million for the ten months ended December 31, 2001. Capital Markets has grown its core franchise significantly over the last five years and is now among the leading investment banking firms in its niche, the mortgage securities market. This segment continued to benefit from robust activity in the mortgage securities market, as well as from a highly favorable interest rate environment. In total, our non-mortgage banking businesses contributed $367.9 million in pre-tax earnings for the year ended December 31, 2002, an increase of 117% from $169.6 million for the ten months ended December 31, 2001.
Operating Segment Results
Pre-tax earnings by segment are summarized below:
Mortgage loan production by segment and product is summarized below:
Mortgage Banking Segment
The Mortgage Banking Segment includes Loan Production, Loan Servicing and Loan Closing Services.
Loan Production Sector
Our Loan Production Sector produces mortgage loans through CHL’s three production divisions - Consumer Markets, Wholesale Lending and Correspondent Lending and through Full Spectrum Lending, Inc.
The pre-tax earnings of the Loan Production Sector are summarized below:
Strong demand for mortgages enabled the Loan Production Sector to achieve significant growth in revenues and earnings in the year ended December 31, 2002 in comparison to the ten months ended December 31, 2001. This performance was enhanced by a significant increase in market share during the year. Our mortgage origination market share was 9.4% in calendar 2002, up from 6.6% in calendar 2001 (Source: Inside Mortgage Finance). Favorable market conditions allowed us to increase revenues earned on prime home loans, while high productivity levels during the year ended December 31, 2002 helped keep unit costs low. These factors combined to produce record profit margins (pre-tax earnings as a percentage of loan volume) for the Loan Production Sector.
The following table shows total loan volume by division:
Our mortgage banking loan production for the year ended December 31, 2002 increased 100% in comparison to the ten months ended December 31, 2001. The increase was due to a rise in both purchase and non-purchase loan production of 86% and 109%, respectively. The increase in purchase-money loans is significant because this is the relatively stable growth component of the mortgage market, with average annual growth of 8% over the last 10 years. (The non-purchase, or refinance, component of the mortgage market is highly volatile because it is driven almost exclusively by prevailing mortgage rates.) All divisions, in particular Correspondent Lending, contributed to the increase in origination volume. The Correspondent Lending Division has benefited most from the consolidation trend in our industry. In calendar 2002, the top five correspondent lenders combined had a 58% share of the correspondent origination market, up from 37% in 1998.
The following table summarizes loan production by purpose and interest rate type:
As shown in the following table, the volume of Prime Home Equity and Subprime Mortgage Loans produced (which is included in the total volume of loans we produced) increased 94% during the year ended December 31, 2002 as compared to the ten months ended December 31, 2001:
Prime Home Equity and Subprime Mortgage Loans carry higher profit margins historically and the demand for such loans is believed to be less rate sensitive than the demand for prime home loans. Consequently, Management believes these loans will be a significant component of the sector’s future growth, in particular if mortgage rates should rise significantly.
During the year ended December 31, 2002, the Loan Production Sector operated at approximately 114% of planned operational capacity. The primary capacity constraint in our loan origination activities is the number of loan operations personnel we have on staff. Therefore, we measure planned capacity by multiplying the number of loan operations personnel we have by the number of loans we expect each available loan operations staff person to process under normal conditions. In the year ended December 31, 2002, we continued to increase the number of sales and operations staff in our loan production divisions to capitalize on the current market environment.
In recent years, our Consumer Markets Division has commenced a fundamental restructuring of its business model primarily by building a “best-in-class” sales organization. This organization consists of a dedicated commissioned sales force and the attendant management, systems and operations support. In addition, the Consumer Markets Division has begun to centralize some of its processing operations to create more flexible processing capacity to support its expanded sales organization, as well as its growing portfolio retention effort. At December 31, 2002 the commissioned sales force (external home loan consultants) numbered 2,484, an increase of 1,090 during the year. The primary focus of the external home loan consultants is to increase overall purchase market share. External home loan consultants contributed $13.5 billion in purchase originations in the year ended December 31, 2002, a 119% increase over the ten months ended December 31, 2001. The purchase production generated by the external home loan consultants represented 63% of the Consumer Market Division’s purchase production for the year ended December 31,
2002. At December 31, 2002, the Consumer Markets Division had 424 branches and 19 regional processing centers nationwide. During the year ended December 31, 2002, the regional processing centers handled 9.3% of the division’s total loan volume.
Like the Consumer Markets Division, the Wholesale Lending Division has focused on improving its sales efforts. The division has created specialized sales units that cater to individual segments of the wholesale market (e.g., large regional and national brokers). In addition, the Wholesale Lending Division continued to make improvements in its business partner website (“CWBC.com”), which was used by its business partners in 93% of the loans produced by the division in the year ended December 31, 2002. To improve efficiency and quality control, the division centralized processing of its subprime loans in the year ended December 31, 2002.
During the year ended December 31, 2002, the Correspondent Lending Division added significant capacity by adding temporary staff, moving to multiple shifts, implementing accelerated training classes and increasing the use of electronic data interfaces with customers. This strategy allowed the division to quickly adjust to changes in the origination market.
Loan Servicing Sector
Our Loan Servicing Sector reflects the performance of the Company’s investments in MSRs and other retained interests and associated risk management activities, as well as profits from subservicing activities in the United States. The Loan Servicing Sector incorporates a significant processing operation, consisting of approximately five thousand employees who service the Company’s 4.0 million mortgage customers. How effectively this servicing operation manages costs and generates ancillary income from the portfolio has a significant impact on the long-term performance of this sector.
The following table summarizes the Loan Servicing Sector pre-tax loss:
(1)
Annualized
The Loan Servicing Sector experienced significant losses during the year ended December 31, 2002. This was expected, given the increasing level of refinance activity driven by mortgage rates that reached 40-year lows. The Company’s MSRs and other retained interests represent the present value of cash flow streams that are closely linked to the expected life of the underlying servicing portfolio. The continued high level of actual and forecasted prepayment activity reduced the life of the servicing portfolio and thus the value of our MSRs and other retained interests, as reflected by the combined impairment and amortization charge of $4.7 billion incurred in the year ended December 31, 2002.
The Servicing Hedge generated a gain of $1.8 billion during the year ended December 31, 2002, which partially offset the combined impairment and amortization charge. Amortization and impairment, net of the
Servicing Hedge, was $2.9 billion for the year ended December 31, 2002, an increase of $1.5 billion over the ten months ended December 31, 2001. In a stable interest rate environment, Management would expect no significant impairment and would expect to incur expenses related to the Servicing Hedge driven primarily by the composition of the hedge, the shape of the yield curve and the level of interest rate volatility.
During the year ended December 31, 2002, we securitized a portion of our net servicing fees (“excess servicing”). Proceeds from the sale of these securities amounted to $566.6 million. Management believes such securitizations enable us to more efficiently manage our capital.
Despite the level of prepayments, we increased our servicing portfolio to $452.4 billion at December 31, 2002, representing a 34% increase compared to December 31, 2001.
Loan Closing Services Sector
Our LandSafe companies produced $70.0 million in pre-tax earnings in the year ended December 31, 2002, representing a 28% increase over the ten months ended December 31, 2001. The increase in LandSafe’s contribution to pre-tax earnings was primarily due to our increased loan production.
Non-Mortgage Banking Business
The Company’s other business segments include Capital Markets, Banking, Insurance and Global Operations. Pre-tax earnings from these businesses increased $198.3 million, or 117%, to $367.9 million in the year ended December 31, 2002 compared to the ten months ended December 31, 2001.
Capital Markets Segment
Our Capital Markets Segment achieved pre-tax earnings of $199.9 million for the year ended December 31, 2002, an increase of $118.7 million, or 146% compared to the ten months ended December 31, 2001. Total revenues were $374.4 million, an increase of $188.2 million, or 101% compared to the ten months ended December 31, 2001. Total securities trading volume increased 70% to $2.0 trillion. This performance was largely driven by a highly favorable operating environment consisting of a robust mortgage securities market, high mortgage securities price volatility and low short-term financing costs.
The following table shows the pre-tax income of the Capital Markets Segment:
The following table shows the composition of CSC’s securities trading volume, which includes intersegment trades with our mortgage banking operations, by instrument:
CSC has successfully increased its share of the mortgage securities market as evidenced by its league table rankings in industry publications. Most notably, CSC was ranked fourth in underwriting non-agency MBS in calendar 2002, up from seventh in calendar 2001 (Source: Inside MBS and ABS). The increase in market share is the result of increased sales penetration achieved through an expansion of the sales force, an increase in trading personnel, the effective use of market and product research to attract institutional customers and an increase in mortgage conduit activities during the year ended December 31, 2002. Approximately 13% of the segment’s total trading volume was with CHL in the year ended December 31, 2002.
Banking Segment
Our Banking Segment commenced operations in calendar 2001. The segment achieved pre-tax earnings of $84.0 million for the year ended December 31, 2002. The following table shows the composition of pre-tax earnings by company.
(1)
Treasury Bank was acquired in May 2001.
The Bank produced pre-tax earnings of $51.7 million for the year ended December 31, 2002. The overall increase in pre-tax earnings from the ten months ended December 31, 2001 was primarily due to an increase in net interest income arising from growth in average earning assets and approximately $18.0 million in intersegment profits resulting from document custodian services provided to our mortgage banking operation. Average earning assets increased to $3.4 billion for the year ended December 31, 2002, an increase of $2.8 billion in comparison to the ten months ended December 31, 2001. Asset growth was funded primarily by the transfer of mortgagor and investor impound accounts controlled by CHL from third-party banks to the Bank, a capital contribution from Countrywide Financial Corporation, Federal Home Loan Bank advances
and growth in the Bank’s retail deposit base. The Bank’s pre-tax return on assets for the year ended December 31, 2002 was 1.5%. The composition of the Bank’s assets was as follows:
CWL’s pre-tax earnings increased by $20.0 million during the year ended December 31, 2002 in comparison to the ten months ended December 31, 2001. This was primarily due to the growth in average outstanding mortgage warehouse advances partially offset by a decline in the average net spread from 2.3% during the ten months ended December 31, 2001 to 2.1% during the year ended December 31, 2002. For the year ended December 31, 2002, average mortgage warehouse advances outstanding were $1.8 billion, an increase of $1.0 billion in comparison to the ten months ended December 31, 2001. The growth in average advances was primarily attributable to the overall increased level of mortgage originations.
Insurance Segment
Our Insurance Segment pre-tax earnings decreased 2% from the ten months ended December 31, 2001, to $74.6 million during the year ended December 31, 2002. The decline in pre-tax earnings was attributable to a significant reduction in pre-tax earnings in the Balboa Life and Casualty Operations. Following are the pre-tax earnings by business line:
The following table show net earned premiums:
Our mortgage reinsurance business produced $84.5 million in pre-tax earnings, a 71% increase in comparison to the ten months ended December 31, 2001, driven by a 69% increase in net earned premiums. The increase in net earned premiums resulted from a 25% increase in the number of policies in force driven by growth in our loan servicing portfolio, coupled with an overall increase in the ceded premium percentage.
Our Life and Casualty insurance operations produced a pre-tax earnings of $1.1 million, a decrease in earnings of $29.5 million, or 96%, compared to the ten months ended December 31, 2001. Although the prior period included only ten months, the additional two months of earnings in the year ended December 31, 2002 was more than offset by lower investment portfolio income and higher than expected claims costs related to
certain homeowners’ reinsurance contracts that were later terminated. Additional insurance claim expenses also were recorded related to certain other lender-placed insurance contracts due to observed losses higher than expectations. These lender-placed insurance contracts were later favorably renegotiated. These amounts were partially offset by a $211.3 million, or 79%, increase in premiums earned during the year ended December 31, 2002 compared to the ten months ended December 31, 2001. Balboa Life and Casualty’s overall loss ratio was 58% and 51% in the year ended December 31, 2002 and in the ten months ended December 31, 2001, respectively.
Balboa manages its insurance risk by reinsuring portions of its insured risk. Balboa seeks to earn profits by capitalizing on Countrywide’s customer base and institutional relationships, as well as through operating efficiencies and sound underwriting.
Balboa Reinsurance historically has not realized insurance losses, owing to a generally strong economy, an even stronger housing market and the age of the underlying insured loans. During the year, we revised our reinsurance contracts, to provide additional coverage in exchange for additional ceded premiums. Management expects Balboa Reinsurance to incur insurance losses in the future as the underlying insured loans continue to age.
Global Operations Segment
For the year ended December 31, 2002, our Global Operations Segment’s pre-tax earnings totaled $5.3 million, representing an increase of $3.3 million in comparison to the ten months ended December 31, 2001. Results in the current period were positively affected by the recognition of higher technology licensing fees related to GHL’s increased processing volumes for both originations and servicing.
In the fourth quarter of 2002, Global Home Loans Limited (“GHL”) finalized an agreement with Barclays, plc, its joint venture partner, to provide origination processing, subservicing and delinquent servicing. GHL expanded its total volume of loans subserviced in the UK to over $91.8 billion, or over 1.2 million mortgage loans. In the future, GHL plans to provide its services to other financial institutions in the UK.
Detailed Discussion of Consolidated Revenue and Expense Items
Gain on Sale of Loans and Securities
Gain on sale of loans and securities is summarized below for the year ended December 31, 2002 and the ten months ended December 31, 2001:
Gain on sale of loans and securities increased in the year ended December 31, 2002 primarily due to higher production and sales volume and higher margins on Prime Mortgage Loans. Margins on Subprime Mortgage Loans and Prime Home Equity Loans declined primarily due to a change in production channel mix. WLD and CLD produced a larger percentage of these mortgages; these two divisions traditionally have lower margins than our retail channels. Margins on Prime Mortgage Loans were high in both periods on a relative historical basis, due largely to the very favorable mortgage market environment that prevailed during those periods. The market was characterized by record consumer demand for mortgages and modest price competition by historical industry standards. Management expects margins, particularly on prime home loans, to decline in the future as the level of mortgage originations subsides.
The reduction in Capital Markets’ gain on sale of securities was largely due to the impact of the steepening yield curve on the mix of its revenues. Capital Markets’ revenues from its trading activities consist of gains on the sale of securities and net interest income. In a very steep yield curve environment, trading revenues will derive largely or entirely from net interest income earned during the securities’ holding period. As the yield curve flattens, the mix of revenues will shift toward gain on sale of securities.
In general, gain on sale of loans and securities is affected by numerous factors including the volume and mix of loans sold, production channel mix, the level of price competition and the slope of the yield curve.
Net Interest Income
Net interest income is summarized below for the year ended December 31, 2002 and for the ten months ended December 31, 2001.
The increase in net interest income from mortgage loans and securities held for sale reflects the growth in mortgage production combined with a higher overall net earnings rate that was attributable to a relative decline in financing rates during the year ended December 31, 2002. We finance the major portion of our mortgage loans and securities held for sale at prevailing short-term borrowing rates, which declined relative to the rate earned on the loans and securities held for sale when compared to the ten months ended December 31, 2001.
The increase in net interest income from the Capital Markets securities trading portfolio is attributable to an increase in the average net spread earned, partially offset by a decrease in the average inventory of securities held. The increase in the average net spread was also attributable to the relative decline in short-term financing rates.
The increase in interest expense in the Loan Servicing Sector is due primarily to a full year of interest expense in the current period compared to ten months of interest expense in the prior period.
Re-performing FHA and VA loans are reinstated loans that had previously defaulted and were consequently re-purchased from mortgage securities issued by Countrywide or others. Such loans are subsequently securitized and re-sold. The increase in interest income related to this activity results from an increase in the volume of such loans purchased during the year ended December 31, 2002.
The increase in net interest income from the Banking Segment was largely attributable to year-over-year asset growth both in Treasury Bank and in our warehouse lending activities and in an increase in the average net spread from 1.80% in the ten months ended December 31, 2001 to 1.94% in the year ended December 31, 2002. Average assets in the Banking Segment increased to $5.2 billion in the year ended December 31, 2002, an increase of $3.8 billion in comparison to the ten months ended December 31, 2001.
Net interest income from custodial balances decreased due to a decline in the earnings rate, which is tied to short-term rates, from 3.2% in the ten months ended December 31, 2001 to 1.6% in the year ended December 31, 2002. The decrease in the earnings rate was partially offset by a $2.5 billion, or 28%, increase in the average custodial balances during the year ended December 31, 2002 compared to the ten months ended December 31, 2001, resulting from a larger portfolio and higher loan payoffs. (Custodial balances rise as loan payoffs increase because we hold the payoff funds for periods ranging from 2 to 45 calendar days, depending on the payoff date and the investor servicing agreement.) Net interest income from custodial balances decreased also as a result of the general requirement of loan servicers to pass through interest on paid-off loans at the underlying security rates, which were significantly higher than the short-term rates we earned. This reduced net interest income from custodial balances by $218.8 million and $133.5 million in the year ended December 31, 2002 and the ten months ended December 31, 2001, respectively.
The increase in net interest income from Prime Home Equity AAA asset-backed securities is due to an increase in the average balance of securities held.
Loan Servicing Fees and Other Income from Retained Interests
Loan servicing fees and other income from retained interests is summarized below for the year ended December 31, 2002 and the ten months ended December 31, 2001:
The increase in servicing fees, net of guarantee fees, was due to a full year of earnings in the current period compared to ten months of earnings in the prior period, combined with a 23% increase in the average servicing portfolio. This increase was partially offset by a small reduction in the overall annualized net service fee earned from 0.39% of the average portfolio balance during for the ten months ended December 31, 2001 to 0.38% during the year ended December 31, 2002. The reduction in the overall net service fee was largely due to the securitization of excess service fees during the year ended December 31, 2002.
The increase in income from other retained interests was due to a full year of earnings in the year ended December 31, 2002 compared to ten months of earnings in 2001, combined with a 20% increase in investment balances during the year ended December 31, 2002 and an increase in the yield of these investments from 16.2% in the ten months ended December 31, 2001 to 19.9% in the year ended December 31, 2002. These investments include interest-only and principal-only securities as well as residual interests that arise from the
securitization of nonconforming mortgage loans, particularly Subprime Mortgage and Prime Home Equity Loans.
Higher prepayment penalty income in the year ended December 31, 2002 corresponded to the increase in Subprime loan payoffs during the year ended December 31, 2002.
The increase in subservicing fees earned in the Global Segment was primarily due to growth in the portfolio subserviced in the year ended December 31, 2002 combined with a change in accounting for GHL from the equity method to consolidation with CFC, resulting from an increase in our ownership interest in GHL in July 2001.
Amortization of Mortgage Servicing Rights
We recorded amortization of MSRs of $1,267.2 million during the year ended December 31, 2002 as compared to $805.5 million during the ten months ended December 31, 2001. The increase in amortization of MSRs was primarily due to a reduction in future estimated net MSR cash flows, primarily because of forecasted higher mortgage prepayments when compared to the year-ago period, coupled with an increase in the cost basis of the MSRs related to the larger servicing portfolio. In addition, the current period includes one year of amortization while the prior period includes only ten months. The MSR amortization rate should decline as mortgage rates rise.
Impairment or Recovery of Retained Interests and Servicing Hedge Gains
Impairment of retained interests and Servicing Hedge gains are detailed below for the year ended December 31, 2002 and the ten months ended December 31, 2001:
Impairment of MSRs and other retained interests resulted from a reduction in the estimated fair value of those investments driven primarily by declining mortgage rates during the year ended December 31, 2002 and the ten months ended December 31, 2001. Rising mortgage rates in the future should result in an increase in the estimated fair value of the MSRs and recovery of all or a portion of the temporary impairment.
Servicing Hedge gains were driven by declining interest rates during the year ended December 31, 2002 and the ten months ended December 31, 2001. The Servicing Hedge is intended to moderate the effect on earnings caused by changes in the fair value of MSRs and other retained interests that generally result from changes in mortgage rates. Rising interest rates in the future will result in Servicing Hedge losses.
Net Insurance Premiums Earned
The increase in net insurance premiums earned is primarily due to an increase in policies in force and an overall rise in reinsurance premium rates. In addition, a full year of earnings is included in the current period compared to ten months of earnings in the prior period.
Commissions and Other Revenue
Commissions and other revenue consisted of the following in the year ended December 31, 2002 and the ten months ended December 31, 2001:
The increase in credit report, appraisal and title services fees is primarily due to an increase in our loan production.
The increase in insurance agency commission was primarily due to the increase in the policies in force combined with a full year of earnings in the current period compared to ten months of earnings in the prior period.
The increase in processing fees earned in the Global Segment was primarily due to growth in the number of loans processed combined with a change in accounting for GHL from the equity method to consolidation with CFC, resulting from an increase in our ownership interest in GHL in July 2001.
Compensation Expenses
Compensation expenses are summarized below for the year ended December 31, 2002 and the ten months ended December 31, 2001:
Compensation expense increased $803.1 million, or 83%, during the year ended December 31, 2002 in comparison to the ten months ended December 31, 2001. The increase is due to a full year of expense in the current period compared to ten months of expense in the prior period combined with growth in all areas of Countrywide, which is discussed below.
Compensation expense in the Mortgage Banking Segment increased due to growth both in the level of loan production activity and in the size of the loan servicing portfolio. In the Production Sector, compensation expense increased 95% (salaries rose by 72% and incentive bonuses rose by 100%) as a result of a 50% increase in average staff to support 100% higher loan production. The relative increase in incentive bonuses reflects a shift toward a more incentive-based compensation structure within the Production Sector. In the Loan Servicing Sector, compensation expense rose 50% as a result of an increase in average staff of 20% to support a 34% increase in the loan servicing portfolio and a 66% increase in loan payoff activity combined with a full year of expense in the current period compared to ten months in the prior period.
Compensation expense increased in all of the other business segments, reflecting their growth.
In the Insurance Segment, compensation expense increased by a combined $44.3 million, or 86%, as a result of a 41% increase in average staff to support 80% growth in written premiums and growth in the Insurance Segment’s third-party insurance tracking operation, combined with a full year of expense in the current period compared to the ten months in the prior period.
Banking Segment compensation expense increased by $23.6 million from the prior period’s start-up level of operations to accommodate the growth of the Bank’s operations, primarily in its labor-intensive mortgage document custodian business.
In the Capital Markets Segment, incentive bonuses increased $45.4 million, or 79%, reflecting growth in revenues of 101%.
The increase in compensation expense in the Global Segment of $31.6 million reflects a change in accounting for GHL from the equity method to consolidation with CFC, resulting from an increase in our ownership interest in GHL in July 2001.
Compensation expense for Corporate Administration increased $110.6 million, or 67%, due to an increase in average staff of 28% (of which approximately one-third were related to corporate technology) to support the overall growth of Countrywide and higher incentive bonuses earned based on our increased profitability.
Occupancy and Other Office Expenses
Occupancy and other office expenses for the year ended December 31, 2002 increased primarily to accommodate personnel growth in our loan production operations, which accounted for 56% of the increase, as well as in the non-mortgage banking businesses, which accounted for 30% of the increase in this expense.
Insurance Claim Expenses
Insurance claims expenses were $277.6 million, or 49% of net insurance premiums earned for the year ended December 31, 2002, as compared to $134.8 million, or 43% of net insurance premiums earned for the ten months ended December 31, 2001. The increased loss ratio was attributable to Balboa Life and Casualty, whose loss ratio (including allocated loss adjustment expenses) increased from 51% for the ten months ended December 31, 2001 to 58% for the year ended December 31, 2002, due to higher claims experience in both voluntary homeowners’ and lender-placed insurance lines. The level of losses recognized in a period depends on many factors, one being the occurrence of natural disasters.
Other Operating Expenses
Other operating expenses for the year ended December 31, 2002 and the ten months ended December 31, 2001 are summarized below:
Insurance commission expense as a percentage of insurance premiums earned declined from 27% to 21% between the ten months ended December 31, 2001 and the year ended December 31, 2002. This decline was due to reduced contingent commissions accruing to insurance brokers as a result of higher-than anticipated insured losses from policies subject to the contingent commission arrangements.
Bad debt expense consists primarily of losses during the period arising from un-reimbursed servicing advances on defaulted loans, credit losses on repurchased or indemnified loans and defaulted VA-guaranteed loans. (See the “Credit Risk” section of this Report for a further discussion.)
Quantitative and Qualitative Disclosures About Market Risk
The primary market risk we face is interest rate risk. The most predominate type of interest rate risk at Countrywide is price risk, which is the risk that the value of our assets or liabilities will change due to changes in interest rates. To a lesser extent, interest rate risk also includes the risk that the net interest income from our mortgage loan and investment portfolios will change in response to changes in interest rates. From an enterprise perspective, we manage this risk through the natural counterbalance of our loan production and servicing businesses. We also use various financial instruments, including derivatives, to manage the interest rate risk related specifically to our committed pipeline, mortgage loan inventory and MBS held for sale, MSRs, trading securities and other retained interests as well as a portion of our debt. The overall objective of our interest rate risk management activities is to reduce the variability of earnings caused by changes in interest rates. Our Corporate Asset/ Liability Management Committee (“ALCO”), which is comprised of several of the Company’s senior financial executives, maintains oversight of this risk.
Committed Pipeline and Mortgage Inventory
We are exposed to price risk such from the time an interest rate lock commitment (“IRLC”) is made to a mortgage applicant (or financial intermediary) to the time the related mortgage loan is sold. During this period, we are exposed to losses if mortgage rates rise, because the value of the IRLC or mortgage declines. To manage this price risk, we use derivatives, primarily forward sales of MBS and options to buy and sell MBS, as well as options on Treasury futures contracts.
The committed pipeline consists of loan applications in process where we have issued IRLCs to the applicants (or financial intermediaries). IRLCs guarantee the rate and points on the underlying mortgage for a specified period, generally from seven to sixty days. Managing the price risk related to the Committed Pipeline is complicated by the fact that the ultimate percentage of applications that close within the terms of the IRLC is variable. The primary factor that drives the variability of the closing percentage is changes in mortgage rates. In general, the percentage of applications in the Committed Pipeline that ultimately close within the terms of the IRLC increases if mortgage rates rise and decreases if mortgage rates fall. This is due primarily to the relative attractiveness of current mortgage rates compared to the applicants’ committed rates. The closing percentage is also influenced by the source of the applications, age of the applications, purpose for the loans (purchase or refinance) and the application approval rate. We have developed closing ratio estimates for the Committed Pipeline using empirical data taking into account all of these variables. Our closing ratio estimates also take into account renegotiations of rate and point commitments that tend to occur when mortgage rates fall. Our closing ratio estimates are revised periodically using the most current empirical data.
To manage the price risk associated with the Committed Pipeline, we use a combination of net forward sales of MBS and “put” and “call” options on MBS or Treasury Futures. As a general rule, we enter into forward sales of MBS in an amount equal to the portion of the Committed Pipeline expected to close, assuming no change in mortgage rates. We acquire put and call options to protect against the variability of loan closings caused by changes in mortgage rates, using our current closing ratio estimates to determine the amount of optional coverage required.
We manage the price risk related to our Mortgage Loan Inventory primarily by entering into forward sales of MBS. The value of these forward sales moves in opposite direction to the value of the Mortgage Loan Inventory. We review our Committed Pipeline and Mortgage Inventory risk profiles on a daily basis.
We use the following derivative instruments in our risk management activities related to the Committed Pipeline and Mortgage Loan Inventory:
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Forward Sales of MBS: represents an obligation to sell a MBS at a specific price in the future; therefore, its value increases as mortgage rates rise.
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Forward Purchases of MBS: represents an obligation to buy a MBS at a specific price in the future; therefore, its value increases as mortgage rates fall.
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Long Call Options on MBS: represents a right to buy a MBS at a specific price in the future; therefore, its value increases as mortgage rates fall.
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Long Put Options on MBS: represents a right to sell a MBS at a specific price in the future; therefore, its value increases as mortgage rates rise.
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Long Call Options on Treasury Futures: represents a right to acquire a Treasury futures contract at a specific price in the future; therefore, its value increases as the benchmark Treasury rate falls.
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Long Put Options on Treasury Futures: represents a right to sell a Treasury futures contract at a specific price in the future; therefore, its value increases as the benchmark Treasury rate rises.
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Short Eurodollar Futures Contracts: represents a standardized exchange-traded contract, the value of which is tied to spot Eurodollar rates at specified future dates; therefore, its value increases when Eurodollar rates rise.
Mortgage Servicing Rights (MSRs) and Other Retained Interests
Our MSRs and other retained interests, specifically interest-only securities and residual securities, are generally subject to loss in value when mortgage rates decline. Declining mortgage rates generally precipitate increased consumer refinancing activity. Increased refinancing activity reduces the life of the loans underlying the MSRs and other retained interests, thereby reducing their value. Reductions in the value of these assets impact earnings through impairment charges. To moderate the effect on earnings of impairment, we maintain a portfolio of financial instruments, including derivatives, which increase in aggregate value when interest rates decline (the “Servicing Hedge”).
We currently use the following financial instruments in our Servicing Hedge:
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Interest Rate Floors: represents a right to receive cash if a reference interest rate falls below a contractual strike rate; therefore, its value increases as reference interest rates fall. The reference interest rates used in the Company’s interest rate floors include mortgage rates, Treasury rates and U.S. dollar (“USD”) LIBOR.
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U.S. Treasury Securities: consists of notes and bonds with maturities ranging generally from ten to thirty years. As interest rates decrease, the values of these securities generally increase.
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Long Treasury Futures: represent the agreement to purchase a treasury security at a specific price in the future; therefore, its value increases as the benchmark Treasury rate falls.
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Long Call Options on Treasury and Eurodollar futures: represents a right to acquire a Treasury or Eurodollar futures contract at a specific price in the future; therefore, its value increases as the benchmark Treasury or Eurodollar deposit rate falls.
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Long Put Options on Treasury and Eurodollar futures: represents a right to sell a Treasury or Eurodollar futures contract at a specific price in the future; therefore, its value increases as the benchmark Treasury or Eurodollar deposit rate rises.
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Long Call Options on MBS: represents a right to buy an MBS at a specific price in the future; therefore, its value increases as mortgage rates fall.
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Forward Purchases of MBS: represents an obligation to buy a MBS at a specific price in the future; therefore, its value increases as mortgage rates fall.
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Interest Rate Swaps: represents a mutual agreement to exchange interest rate payments; one party paying a fixed-rate and another paying a floating rate tied to a reference interest rate (e.g., USD LIBOR). For use in the Servicing Hedge, we receive the fixed rate and pay the floating rate; therefore, the contract increases in value as rates fall.
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Receiver Swaptions: represents a right to enter into a predetermined Interest Rate Swap at a future date in which, upon exercise of its right, we receive the fixed rate and pay the floating rate; therefore, the contract increases in value as rates fall.
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Payor Swaptions: represents a right to enter into a predetermined Interest Rate Swap at a future date in which, upon exercise of its right, we pay the fixed rate and receive the floating rate; therefore, the contract increases in value as rates rise.
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Principal-Only Securities: consist of mortgage trust principal-only securities and Treasury principal-only securities (“Strips”). These securities have been purchased at discounts to their par value. As interest rates decrease, the values of these securities generally increase.
These instruments are used in tandem to manage the overall risk profile of the MSRs and other retained interests. We review our retained interests risk profile on a daily basis.
Trading Activities
In connection with our Capital Markets activities, we maintain a trading portfolio of fixed-income securities, primarily MBS. We are exposed to price changes in our trading portfolio arising from interest rate changes during the period we hold the securities. To manage this risk, we use the following derivative instruments:
•
Forward Sales of To-Be-Announced (“TBA”) MBS: represents an obligation to sell agency pass-through MBS that have not yet been issued at a specific price and at a specific date in the future; therefore, its value increases as mortgage rates rise.
•
Forward Purchases of TBA MBS: represents an obligation to purchase agency pass-through MBS that have not yet been issued at a specific price at a specific date in the future; therefore, its value increases as mortgage rates fall.
•
Forward Sale of U.S. Treasury Securities: represents a standardized exchange-traded agreement to sell a specific quantity of U.S. Treasury securities for a specific price at a specific date in the future; therefore, its value increases when interest rates rise.
•
Short Fed Funds and Eurodollar Futures Contracts: represents a standardized exchange-traded contract, the value of which is tied to spot Fed Funds or Eurodollar rates at specified future dates. The value of these contracts increases when Fed Funds or Eurodollar rates rise.
•
Interest Rate Swaps: represents a mutual agreement to exchange interest rate payments with one party paying a fixed-rate and another paying a floating rate tied to a reference interest rate (e.g. USD LIBOR). For use in our trading portfolio risk management activities, we generally receive the floating rate and pay the fixed rate; therefore, its value generally increases in value as rates rise.
Treasury Bank
The primary component of Treasury Bank’s earnings is net interest income derived from its mortgage loan and investment portfolios. At Treasury Bank, we invest primarily in adjustable rate and short duration residential mortgages. Our securities portfolio is comprised mostly of short-duration sequential collateralized mortgage obligations. We manage our interest rate risk primarily by investing in relatively simple, short duration assets, and matching the duration and re-pricing characteristics of our liabilities with those of our assets. Deposits are priced to encourage consumers to choose maturity terms consistent with our assets. In addition, the structure and terms of our borrowings are chosen to manage our interest rate risk.
Debt Securities
We determine the mix of fixed-rate and variable-rate debt as part of our overall interest rate risk management activities. We use Interest Rate Swaps to efficiently and cost-effectively achieve our desired mix of debt. Typically, terms of the Interest Rate Swaps match the terms of the underlying debt, resulting in an effective conversion of the debt rate.
Impact of Changes in Interest Rates on the Net Value of the Company’s Interest Rate- Sensitive Financial Instruments
We perform various sensitivity analyses that quantify the net financial impact of changes in interest rates on our interest rate-sensitive assets, liabilities and commitments. These analyses incorporate assumed changes in the interest rate environment including selected hypothetical (instantaneous) parallel shifts in the yield curve.
Various modeling techniques are employed to value the financial instruments in connection with these sensitivity analyses. For mortgage loans, MBS, MBS forward contracts, collateralized mortgage obligations and MSRs, an option-adjusted spread (“OAS”) model is used. The primary assumptions used in this model for purpose of these sensitivity analyses are the implied market volatility of interest rates and prepayment speeds. For options and interest rate floors, an option-pricing model is used. The primary assumption used in
this model is implied market volatility of interest rates. Other retained interests are valued using zero volatility discounted cash flow models incorporating all relevant cash flows associated with these instruments. The primary assumptions used in these models are prepayment rates, discount rates and credit losses.
Utilizing these modeling techniques, the following table summarizes the estimated change in fair value of our interest rate-sensitive assets, liabilities and commitments as of December 31, 2003, given several hypothetical (instantaneous) parallel shifts in the yield curve:
The following table summarizes the estimated change in fair value of the Company’s interest rate-sensitive assets, liabilities and commitments as of December 31, 2002, given several hypothetical (instantaneous) parallel shifts in the yield curve:
During 2003, we reduced our reliance on derivatives to manage the interest rate risk related to our MSRs. We took this action in light of the incremental profits we expected to generate from our loan production operations if mortgage rates continued to decline. This strategy had the benefit of reducing our potential derivative losses in the event mortgage rates increased, which did occur in the last half of 2003.
These sensitivity analyses are limited in that they were performed at a particular point in time, are subject to the accuracy of various assumptions used, including prepayment forecasts and discount rates, and do not incorporate other factors that would impact the Company’s overall financial performance in such scenarios, most significantly the impact of changes in loan production earnings that occur over time. In addition, not all of the changes in fair value would impact current period earnings. For example, MSRs are carried at the lower of cost or market; therefore, absent hedge accounting, the increase in the value of the MSRs that is recorded in current period earnings would be limited to recovery of the impairment reserve ($1.2 billion at December 31, 2003). Debt is carried at cost; therefore, absent hedge accounting, changes in the value of debt are not recorded in current period earnings. For these reasons, the preceding estimates should not be viewed as an earnings forecast.
Foreign Currency Risk
We occasionally issue medium-term notes denominated in a foreign currency. We manage the foreign currency risk associated with these medium-term notes through currency swap transactions. The terms of the currency swaps effectively translate the medium-term notes into U.S. dollar obligations, thereby eliminating the associated foreign currency. As a result, potential changes in the exchange rates of foreign currencies denominating such medium-term notes would not have a net financial impact on future earnings, fair values or cash flows.
Credit Risk Management
Credit risk is the potential for financial loss resulting from the failure of a borrower or an institution to honor its contractual obligations to us. Credit risk arises in many of our business activities including lending activities, trading activities and interest rate risk management activities. We actively manage credit risk to maintain credit losses within levels that achieve our profitability and return on capital objectives while meeting our expectations for consistent financial performance.
Our Credit Committee, which is comprised of our Chief Credit Officer and other senior executives, has primary responsibility for setting strategies to achieve the credit risk goals and objectives set by our Board of Directors. Those goals and objectives are documented in our Credit Policy.
Mortgage Credit Risk
Overview
In our mortgage lending activities, we manage our credit risk by producing high quality loans, employing proactive collection and loss mitigation efforts and selling the majority of the loans we produce on a non-recourse basis.
Loan Quality
Our Credit Policy establishes standards for the determination of acceptable credit risks. Those standards encompass borrower and collateral quality, underwriting guidelines, and loan origination standards and procedures.
Borrower quality includes consideration of the borrower’s credit and capacity to pay. We assess credit and capacity to pay through the use of credit scores, application of a mortgage scorecard, and manual or automated underwriting of additional credit characteristics.
Collateral quality includes consideration of property value, condition, and marketability and is determined through physical inspections and the use of manual and automated valuation models.
Underwriting guidelines facilitate the uniform application of underwriting standards to all borrowers regardless of race, religion, or ethnic background. Uniformity in underwriting also provides a means for measuring and managing credit risk. This allows us, as well as government sponsored entities (“GSEs”), private investors, and the secondary markets in general, to assess risk, which provides us with more flexibility in the sale of loans.
Our conventional conforming and government underwriting guidelines comply with the guidelines established by Fannie Mae or Freddie Mac. Our underwriting guidelines for FHA-insured and VA-guaranteed mortgage loans comply with guidelines established by the U.S. Department of Housing and Urban Development and the Veterans Administration. Our underwriting guidelines for non-conforming mortgage loans, prime home equity loans, and subprime mortgage loans have been designed so that these loans are salable in the secondary mortgage market. We developed these guidelines to meet the requirements of private investors, rating agencies and third-party credit enhancement providers.
Our loan origination standards and procedures are designed to produce high quality loans. These standards and procedures encompass underwriter qualifications and authority levels, appraisal review requirements, fraud prevention, funds disbursement controls, training of our employees and on-going review of their work. We help to ensure that our origination standards are met by employing accomplished and seasoned management, underwriters, and processors and through the extensive use of technology. We also have a comprehensive training program for the continuing development of both our existing staff and new hires. In addition, we employ proprietary underwriting systems in our loan origination process that improve the consistency of underwriting standards, assess collateral adequacy, and help to prevent fraud, while at the same time increasing productivity.
In addition to our pre-funding controls and procedures, we employ an extensive post funding quality control process. Our quality control department, under the direction of the Chief Credit Officer, is responsible for completing comprehensive loan audits that consist of a re-verification of loan documentation, an in depth underwriting and appraisal review, and if necessary, a fraud investigation. We also employ a post-funding proprietary loan performance evaluation system. This system identifies fraud and poor performance of individuals and business entities associated with the origination of our loans. The combination of this system and our audit results allows us to evaluate and measure adherence to prescribed underwriting guidelines and compliance to laws and regulations to ensure that current loan production represents acceptable credit risk, as defined by the Board of Directors.
Sale of Loans
Nearly all of the mortgage loans that we originate are sold into the secondary mortgage market primarily in the form of securities, and to a lesser extent as whole loans. While we generally sell our prime mortgage loans on a non-recourse basis, either in the form of securities or whole loans, we do have potential liability under the representations and warranties we make to purchasers and insurers of the loans. In the event of a breach of such representations and warranties, we may be required to either repurchase the subject mortgage loans or indemnify the investor or insurer. In such cases, any subsequent credit loss on the mortgage loans is borne by Countrywide.
Securitization
As described below, the degree to which credit risk on the underlying loans is transferred through the securitization process depends on the structure of the securitization. Our prime first mortgage loans generally are securitized on a non-recourse basis, while prime home equity and subprime mortgage loans generally are securitized with limited recourse for credit losses.
Conforming Conventional Loans
Conforming conventional loans are generally pooled into mortgage-backed securities guaranteed by Fannie Mae. A small portion of these loans also have been sold to Freddie Mac or the Federal Home Loan Bank, through its Mortgage Partnership Finance Program. Subject to certain representations and warranties on the part of Countrywide, nearly all conventional loans securitized through Fannie Mae or Freddie Mac are sold on a non-recourse basis. Accordingly, credit losses are generally absorbed by Fannie Mae and Freddie Mac, not Countrywide. We pay guarantee fees to Fannie Mae and Freddie Mac on loans we securitize through these agencies. These fees include compensation to the respective agencies for their assumption of credit risk.
FHA-Insured and VA-Guaranteed Loans
FHA-insured and VA-guaranteed mortgage loans are generally pooled into mortgage-backed securities guaranteed by the Government National Mortgage Association (“Ginnie Mae”). A small portion of these loans have been sold to the Federal Home Loan Bank, through its Mortgage Partnership Finance Program. We are insured against foreclosure loss by the FHA or partially guaranteed against foreclosure loss by the VA. Fees charged by the FHA and VA for assuming such risks are paid directly by the mortgagors. We are exposed to credit losses on defaulted VA loans to the extent that the partial guarantee provided by the VA is inadequate to cover the total credit losses incurred. We pay guarantee fees to Ginnie Mae for Ginnie Mae’s guarantee on its securities of timely payment of principal and interest. Ginnie Mae does not assume mortgage credit risk associated with the loans securitized under its program.
Non-conforming Conventional Prime Loans
Non-conforming conventional prime mortgage loans are generally pooled into “private-label” (non-agency) mortgage-backed securities. Such securitizations involve some form of credit enhancement, such as senior/subordinated structures or mortgage pool insurance. Securitizations that involve senior/subordinated structures contain securities that assume varying levels of credit risk. Holders of subordinated securities are compensated for the credit risk assumed through a higher yield. We generally sell the subordinated securities created in connection with these securitizations and thereby transfer the related credit loss exposure, other than as described above with respect to representations and warranties made when loans are securitized.
Prime Home Equity Loans
Prime Home Equity loans are generally pooled into private-label asset-backed securities. These securities generally are credit-enhanced through over-collateralization and guarantees provided by a third-party surety. In such securitizations, Countrywide is subject to limited recourse for credit losses through retention of a residual interest.
Subprime Mortgage Loans
Subprime Mortgage Loans generally are pooled into private-label mortgage backed securities. We generally securitize these loans with limited recourse for credit losses. Such limited recourse securitizations generally have contained mortgage pool insurance as the primary form of credit enhancement, coupled with a limited corporate guarantee provided by Countrywide and/or a retained residual interest. When mortgage pool insurance is used, the associated premiums are paid directly by Countrywide. We also have pooled a portion of our subprime loans into securities guaranteed by Fannie Mae. In such cases, we have paid Fannie Mae a guarantee fee in exchange for Fannie Mae assuming the credit risk of the underlying loans. In addition, we
have securitized a portion of our Subprime Mortgage Loans on a limited recourse basis through the retention of a residual interest without the use of mortgage pool insurance.
Our exposure to credit losses related to our limited recourse securitization activities is limited to the carrying value of our subordinated interests and to the contractual limit of reimbursable losses under our corporate guarantees less the recorded liability for such guarantees. These amounts at December 31, 2003 are as follows:
The carrying value of the residual securities is net of expected future credit losses. Related to our non-recourse and limited recourse securitization activities, the total credit losses incurred for 2003 and 2002 are summarized as follows:
Mortgage Reinsurance
We provide mortgage reinsurance through contracts with several primary mortgage insurance companies on mortgage loans included in our servicing portfolio. Under these contracts, we absorb mortgage insurance losses in excess of a specified percentage of the principal balance of a given pool of loans, subject to a cap, in exchange for a portion of the pools’ mortgage insurance premium. Approximately $67.4 billion of mortgage loans in our servicing portfolio are covered by such mortgage reinsurance contracts. The reinsurance contracts place limits on our maximum exposure to losses. At December 31, 2003, the maximum aggregate losses under the reinsurance contracts were $366.3 million. We are required to pledge securities to cover this potential liability. We recorded provisions for losses related to this activity of $38.6 million in 2003.
Mortgage Loans Held for Sale
At December 31, 2003, mortgage loans held for sale amounted to $24.1 billion. While the loans are in inventory, we bear credit risk after taking into consideration primary mortgage insurance (which is generally required for conventional loans with a loan-to-value ratio greater than 80%), FHA insurance or VA guarantees. Historically, credit losses related to loans held for sale have not been significant.
Portfolio Lending Activities
We have a growing portfolio of Prime Mortgage and Prime Home Equity Loans held for investment, primarily in our bank, which amounted to $22.0 billion at December 31, 2003. A portion of the prime home equity loans held in the bank are covered by a pool insurance policy that provides partial protection against credit losses. Otherwise, we generally retain full credit exposure on these loans. Our allowance for credit losses related to all mortgage loans held for investment amounted to $78.5 million at December 31, 2003.
We also provide short-term secured mortgage loan warehouse advances to various lending institutions, which totaled $1.9 billion at December 31, 2003. We incurred no credit losses related to this activity in 2003.
Counterparty Credit Risk
We have exposure to credit loss in the event of non-performance by our trading counterparties and counterparties to our various over-the-counter derivative financial instruments. We manage this credit risk by selecting only well-established, financially strong counterparties, spreading the credit risk among many such counterparties and by placing contractual limits on the amount of unsecured credit risk from any single counterparty. The aggregate amount of counterparty credit exposure at December 31, 2003, before and after collateral held by Countrywide, was as follows:
For the year ended December 31, 2003, the Company incurred no credit losses due to non-performance of any of its counterparties.
Loan Servicing
The following table sets forth certain information regarding our servicing portfolio of single-family mortgage loans, including loans and securities held for sale or investment and loans subserviced for others, for the periods indicated.
(1)
Runoff refers to scheduled principal repayments on loans and unscheduled prepayments (partial prepayments or total prepayments due to refinancing, modification, sale, condemnation or foreclosure).
(2)
Expressed as a percentage of the total number of loans serviced excluding subserviced loans and loans purchased at a discount due to their non-performing status.
We attribute the overall decline in delinquencies in our servicing portfolio primarily to the relative overall increase in the conventional and prime home equity portfolios, which carry lower delinquency rates than the government and subprime portfolios. Management believes the delinquency rates in our servicing portfolio are consistent with industry experience for similar mortgage loan portfolios.
Inflation
An increase in inflation would have the most significant impact on our mortgage banking and capital markets operations. Interest rates normally increase during periods of rising inflation. Historically, as interest rates increase, mortgage loan production decreases, particularly from loan refinancing. An environment of gradual interest rate increases may, however, signify an improving economy or increasing real estate values, which in turn may stimulate increased home buying activity. Generally, in such periods of reduced mortgage loan production the associated profit margins also decline due to increased competition among mortgage loan originators and to higher unit costs, thus further reducing our loan production earnings. Conversely, in a rising interest rate environment, our loan servicing earnings generally increase because mortgage prepayment rates tend to slow down, thereby extending the average life of our servicing portfolio and thus reducing the
amortization and impairment of our MSRs. Within our broker-dealer operations, rising interest rates generally lead to a reduction in trading and underwriting activities in its primary niche, the mortgage securities market.
Seasonality
The mortgage banking industry is generally subject to seasonal trends. These seasonal trends reflect the pattern in the national housing market. Home sales typically rise during the spring and summer seasons and decline during the fall and winter seasons. Seasonality has less of an effect on mortgage refinancing activity, which is primarily driven by prevailing mortgage rates. In addition, mortgage delinquency rates typically rise temporarily in the winter months, driven by mortgagor payment patterns.
Liquidity and Capital Resources
We have significant short-term and long-term financing needs. Our short-term financing needs arise primarily from the warehousing of mortgage loans pending sale and the trading activities of our broker-dealer. Our long-term financing needs arise primarily from our investments in MSRs and other retained interests, along with the financial instruments acquired to manage the interest rate risk associated with those investments, as well as from the continued growth of our mortgage loan investment portfolio. As discussed in the following paragraphs, we meet our financing needs in a variety of ways, through the public corporate debt and equity markets, as well as the mortgage and asset-backed securities markets, and increasingly in the future through the deposit-gathering and other financing activities of our bank.
Liquidity Management
The objective of our liquidity management is to ensure that adequate reliable sources of cash are available to meet our potential near-term funding needs, including in times of stress within the financial markets. We manage our liquidity by financing our assets in a manner consistent with their liquidity profile. Assets that are considered illiquid are financed with long-term capital (equity and debt with a final maturity greater than six months). We stagger our long-term debt maturities and credit facility expirations to reduce refinancing risk. We also manage the timing of our short-term debt maturities to limit the amount maturing in any five day period. We diversify our financing programs, credit providers and debt investors and dealers to reduce reliance upon any one source of liquidity. Finally, we assess all sources of financing based upon its reliability, recognizing that certain financing programs are sensitive to temporary market disruptions.
We regularly forecast our potential funding needs over a three month horizon, taking into account debt maturities and potential peak balance sheet levels. Available reliable sources of liquidity are appropriately sized to meet potential future funding requirements. We currently have $52.5 billion in reliable sources of short-term liquidity, including secured and unsecured committed bank lines of credit and reusable mortgage purchase commitments totaling $28.2 billion. Our long-term debt typically consists of unsecured debt issued in the public corporate debt markets. At December 31, 2003, we had $18.2 billion in unsecured long-term debt outstanding. See “Note 14 - Notes Payable” in the financial statement section of this Report for additional descriptions of our committed financing programs.
Public Corporate Debt Markets
The public corporate debt markets are a key source of financing for us, due to their efficiency and low cost. Typically, we access these markets by issuing unsecured commercial paper and medium-term notes. We also have issued unsecured subordinated debt, convertible debt and trust-preferred securities. At December 31, 2003, we had a total of $22.9 billion in public corporate debt outstanding.
To maintain our desired level of access to the public corporate debt markets, it is critical for us to maintain investment grade credit ratings. We have consistently maintained solid investment-grade credit ratings over the past twelve years. Given our current ratings, we generally have deep access to the public
corporate debt markets. Current credit ratings at CHL, our primary issuer of public corporate debt, are as follows:
Among other things, maintenance of our current investment grade ratings requires that we have high levels of liquidity, including access to alternative sources of funding such as committed bank stand-by lines of credit, as well as a conservative capital structure. Our policy is to maintain our regulatory capital ratios at levels that are above the “well-capitalized” standards defined by the Federal Reserve Board.
At December 31, 2003 and at December 31, 2002, CFC’s regulatory capital ratios were as follows:
(1)
Minimum required to qualify as “well-capitalized.”
Our primary source of equity capital is retained earnings. We also have $1.0 billion outstanding in trust-preferred securities that receive varying degrees of “equity treatment” from rating agencies, bank lenders and regulators. In addition, we currently have a $2.2 billion deferred tax liability related to our MSRs that would offset a portion of any potential loss in the value of our MSRs and which, to that extent, can be viewed as a supplement to our equity capital. From time to time, we engage in stock offerings as a means of increasing our capital base and supporting our growth.
Issues of concern to one or more credit rating agency in the past have included our significant investment in MSRs and other retained interests, our involvement in subprime lending, as well as our liquidity and capital structure. We maintain an active dialogue with all three rating agencies, meeting throughout the year to review operational and financial performance and to address specific areas of focus.
In the unlikely event our credit ratings were to drop below “investment grade”, our access to the public corporate debt markets would be severely limited. (The cutoff for investment grade is generally considered to be a long-term rating of “BBB-”, or three gradations below our lowest current rating.) In the event of a ratings downgrade below investment grade, we would be required to rely upon alternative sources of financing, such as bank lines and private debt placements (secured and unsecured). Furthermore, we would likely be unable to retain all of our existing bank credit commitments beyond the then existing maturity dates. As a consequence, our cost of financing would rise significantly and we may have to curtail some of our capital-intensive activities, such as our ongoing investment in MSRs and other retained interests. On the other hand, given the highly liquid nature of our mortgage inventory and broker-dealer trading portfolio, we would likely be able to arrange secured financing for such assets. Over the long-term, however, it would be difficult for us to compete effectively without investment grade ratings. Management believes the likelihood of a reduction in our credit ratings to below investment grade in the foreseeable future is remote.
Asset-Backed Financing Market
A growing source of funding for us is the asset-backed financing market. This form of financing generally involves the temporary transfer of legal ownership of assets to a separate legal entity (conduit) in exchange for short-term financing. Such financing programs generally have commercial bank sponsors that provide some
form of credit enhancement to the program, for example, back-up lines of credit. Investors that purchase debt, typically commercial paper, issued by these conduits look primarily to the assets to ensure repayment, rather than to the credit standing of the companies that utilize the conduit for financing. We have used this market primarily to finance a significant portion of our mortgage loan inventory. Due to its liquid nature and short holding period, our mortgage loan inventory is a natural fit for this type of financing program. We utilize such programs as a cost-effective means to expand and diversify our sources of liquidity. At December 31, 2003, we had a borrowed a total of $9.7 billion through such asset-backed financing programs.
Secondary Mortgage Market
We rely substantially on the secondary mortgage market. Nearly all mortgage loans that we produce are sold in the secondary mortgage market, primarily in the form of Mortgage-Backed Securities (“MBS”) and asset-backed securities. The majority of the MBS we sell are guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae (collectively, “Agency MBS”). We also issue non-Agency or “private-label” MBS and asset-backed securities. Private-label MBS and asset-backed securities are registered with the SEC and have separate credit ratings. Generally, private-label MBS and asset-backed securities require some form of credit enhancement, such as over-collateralization, senior-sub structures, primary mortgage insurance, Countrywide guarantees and/or private surety guarantees.
The Agency MBS market is extremely liquid. The private-label MBS market, particularly the subprime MBS market, is significantly less liquid, although we have enjoyed essentially uninterrupted access to these markets, albeit at varying costs.
We ensure our ongoing access to the secondary mortgage market by consistently producing quality mortgages and servicing those mortgages at levels that meet or exceed secondary mortgage market standards. As described elsewhere in this document, we have a major focus on ensuring the quality of our mortgage loan production and we make significant investments in personnel and technology in this regard.
Repurchase Agreements
We also utilize short-term repurchase agreements as a means of financing primarily securities as well as mortgage loans pending sale. Although this method of financing is uncommitted and short-term in nature, it has proven to be reliable and cost effective for us.
Bank Activities
Our goal is to increase the total assets of our bank from $19.4 billion as of December 31, 2003 to $120 billion in five years. We intend to accomplish this goal by using our loan origination operations to source loans for the bank to originate and place in its portfolio. Funding for this growth will come from a variety of sources, including transfers of custodial accounts controlled by CHL, secured advances from the Federal Home Loan Bank and retail deposits, primarily CDs, generated by the bank.
Cash Flow
Cash flow used by operating activities was $1.6 billion for 2003, compared to net cash used by operating activities of $3.5 billion for 2002. The reduction in cash flow used by operations for 2003 compared to 2002 was due primarily to a $4.6 billion net increase in mortgage loans held for sale offset by a decrease in other financial instruments.
Net cash used in investing activities was $34.5 billion for 2003, compared to $14.4 billion for 2002. The increase in net cash used in investing activities was primarily attributable to a $17.7 billion net increase in loans held for investment and a $1.7 billion net increase in additions to MSRs.
Net cash provided by financing activities during 2003 totaled $36.1 billion, compared to $18.0 billion during 2002. The increase in cash provided by financing activities during 2003 was comprised of a $3.8 billion net increase in bank deposit liabilities and a $13.5 billion net increase in the growth of short-term (primarily secured) borrowings.
Off-Balance Sheet Arrangements and Aggregate Contractual Obligations
Off-Balance Sheet Arrangements and Guarantees
In the ordinary course of our business we engage in financial transactions that are not recorded on our balance sheet. (See Note 2 - “Summary of Significant Accounting Policies” in the financial statement section of this Report for a description of our consolidation policy.) Such transactions are structured to manage our interest rate credit or liquidity risks, diversify funding sources or to optimize our capital.
Substantially all of our off-balance sheet arrangements relate to the securitization of mortgage loans. Our mortgage loan securitizations are normally structured as sales, in accordance with SFAS 140, which involves the transfer of the mortgage loans to “qualifying special-purpose entities” that are not subject to consolidation. In a securitization, an entity transferring the assets is able to convert those assets into cash. Special-purpose entities used in such securitizations obtain cash to acquire the assets by issuing securities to investors. In a securitization, we customarily provide representations and warranties with respect to the mortgage loans transferred. In addition, we generally retain the right to service the transferred mortgage loans. We also, generally have the right to repurchase mortgage loans from the special-purpose entity if the remaining outstanding balance of the mortgage loans falls to a level where the cost of servicing the loans exceeds the revenues we earn.
Our prime mortgage loans generally are securitized on a non-recourse basis, while prime home equity and subprime mortgage loans generally are securitized with limited recourse for credit losses. During 2003, we securitized $11.2 billion subprime and home equity loans with limited recourse for credit losses. Our exposure to credit losses related to our limited recourse securitization activities is limited to the carrying value of our subordinated interests and to the contractual limit of reimbursable losses under our corporate guarantees less the recorded liability for such guarantees. For a further discussion of our exposure to credit risk, see the section in this Report entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Credit Risk.”
Management does not believe that any of its off-balance sheet arrangements have or are reasonably likely to have a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
The sales proceeds and cash flows from our securitizations for 2003 and additional information with respect to securitization activities are included in the financial statements section of this report (Note 9 - Securitizations).
Contractual Obligations
The following table summarizes our significant contractual obligations at December 31, 2003, with the exception of short-term borrowing arrangements and pension and post-retirement benefit plans.
(1)
See respective notes to the financial statements included in this Report.
Prospective Trends
United States Mortgage Market
Over the last decade, total mortgage indebtedness in the United States has grown at an average annual rate of eight percent. We believe that continued population growth, ongoing developments in the mortgage market and the prospect of relatively low interest rates support similar growth in the market for the foreseeable future. Some of the ongoing developments in the mortgage market that should fuel its growth include government-sponsored programs targeted to increase homeownership in low-income and minority communities, the growth of prime home equity lending as a major form of consumer finance, and the increasing efficiency of the secondary mortgage market that lowers the overall cost of homeownership.
In recent years, the level of complexity in the mortgage lending business has increased significantly due to several factors:
•
The continuing evolution of the secondary mortgage market has resulted in a proliferation of mortgage products;
•
Greater regulation imposed on the industry has resulted in increased costs and the need for higher levels of specialization; and
•
Interest rate volatility has risen over the last decade. At the same time, homeowners’ propensity to refinance their mortgages has increased as the refinance process has become more efficient and cost effective. The combined result has been large swings in the volume of mortgage loans originated from year to year. These volume swings have placed significant operational and financial pressures on mortgage lenders.
To compete effectively in this environment mortgage lenders must have a very high level of operational, technological and managerial expertise. In addition, the residential mortgage business has become more capital-intensive and therefore access to capital at a competitive cost is critical. Primarily as a result of these factors, the industry has undergone rapid consolidation.
Today, large, sophisticated financial institutions dominate the residential mortgage industry. These industry leaders are primarily commercial banks operating through their mortgage banking subsidiaries. Today, the top thirty mortgage lenders combined have a 79% share of the mortgage origination market, up from 58% five years ago.
Following is a year-over-year comparison of market share for the top five originators, according to Inside Mortgage Finance:
(1)
Comparative data not included for year in which the institution was not in the top five originators.
This consolidation trend has naturally carried over to the loan servicing side of the mortgage business. Today, the top thirty mortgage servicers combined have a 64% share of the total mortgages outstanding, up
from 53% five years ago. Following is a year-over-year comparison of market share for the top five servicers, according to Inside Mortgage Finance:
We believe this consolidation trend will continue, as the aforementioned market forces will continue to drive out weak competitors. We believe Countrywide will benefit from this trend through increased market share. In addition, we believe that irrational price competition - which from time to time has plagued the industry - should lessen in the future.
Compared to Countrywide, the other industry leaders are less reliant on the secondary mortgage market as an outlet for adjustable rate mortgages, due to their greater portfolio lending capacity. This could place us at a competitive disadvantage in the future if the demand for adjustable rate mortgages increases significantly, the secondary mortgage market does not provide a competitive outlet for these loans and we are unable to develop a portfolio lending capacity similar to the competition’s.
Housing Appreciation
Housing values affect us in several positive ways: rising housing values point to healthy demand for purchase-money mortgage financing; increased average loan balances; and a reduction in the risk of loss on sale of foreclosed real estate in the event a loan defaults. However, as housing values appreciate, prepayments of existing mortgages tend to increase as mortgagors look to tap the additional equity in their homes. Over the last several years, the housing price index has significantly outpaced the consumer price index and growth in personal income. Consequently, we expect housing values to increase at a slower rate in the coming years than in the past several years. Over the long term, we expect that housing appreciation will be positively correlated with both consumer price inflation and growth in personal income.
Regulatory Trends
The regulatory environments in which we operate have an impact on the activities in which we may engage, how the activities may be carried out and the profitability of those activities. Therefore, changes to laws, regulations or regulatory policies can affect whether and to what extent we are able to operate profitably. For example, proposed state and federal legislation targeted at predatory lending could have the unintended consequence of raising the cost or otherwise reducing the availability of mortgage credit for those potential borrowers with less than prime-quality credit histories. This could result in a reduction of otherwise legitimate subprime lending opportunities. Similarly, certain proposed state and federal privacy legislation, if passed, could have an adverse impact on our ability to cross-sell the non-mortgage products our various divisions offer to customers in a cost-effective manner.
Mortgage Originations
Following is the estimated total United States mortgage originations market for each of the last five years:
Source: Inside Mortgage Finance
Forecasters currently put the market for 2004 at between $1.8 trillion and $2.2 trillion. The forecasted reduction from 2003’s historic level is attributable to an expected decline in mortgage refinance activity. We believe that a market within the forecasted range would still be favorable for our loan production business, although we would expect increased competitive pressures to have some impact on its profitability. This forecast would imply lessening pressure on our loan servicing business due to a reduction in mortgage loan prepayment activity. In our capital markets business, such a drop in mortgage originations would likely result in a reduction in mortgage securities trading and underwriting volume, which would have a negative impact on its profitability.
Implementation of New Accounting Standards
On March 1, 2001, we adopted Statement of Financial Accounting Standards (SFAS) No. 133, “Accounting For Derivative Instruments And Hedging Activities,” and SFAS Statement No. 138, “Accounting For Certain Derivative Instruments And Certain Hedging Activities - An Amendment of SFAS No. 133” (collectively, “SFAS 133”). Under SFAS 133, all derivative instruments are recognized on the balance sheet at fair value.
At the date of adoption, we recorded certain transition adjustments as required by SFAS 133. There was no impact on net earnings because of the transition adjustments. However, the transition adjustments had the following impact on our balance sheet (in millions):
In November 1999, the Emerging Issues Task Force (“EITF”) released Issue No. 99-20, titled “Recognition of Interest Income and Impairment on Purchased and Retained Interests in Securitized Financial Assets” (“EITF 99-20”). EITF 99-20 is effective for quarters beginning after March 15, 2001. Under the guidelines of EITF 99-20, the accounting treatment of interest income and impairment of beneficial interests in securitization transactions is modified such that beneficial interests which are determined to have an other-than-temporary impairment are required to be written down to fair value with a corresponding impairment charge to earnings. We adopted EITF 99-20 for the fiscal quarter ended August 31, 2001 and there was no material impact at adoption on our financial statements.
In September 2000, SFAS No. 140 “Accounting for the Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” (“SFAS 140”) was issued, which replaced SFAS No. 125 (of the same title). SFAS 140 revises certain standards in the accounting for securitizations and other transfers of financial assets and collateral and requires some additional disclosures relating to securitization transactions and collateral, but it carries over most of SFAS 125’s provisions. We included the collateral and disclosure
provisions of SFAS 140 in our February 28, 2001 financial statements. All other provisions of this Statement were adopted on April 1, 2001, as required by the statement. The adoption of this statement had no material impact on our financial statements.
During June 2001, SFAS No. 141, “Business Combinations” (“SFAS 141”) and SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”) were issued.
SFAS 141 requires use of the purchase method of accounting for all business combinations initiated after June 30, 2001, provides specific guidance on how to identify the accounting acquirer in a business combination, provides specific criteria for recognizing intangible assets apart from goodwill, and requires additional financial statement disclosures regarding business combinations. SFAS 141 will impact our accounting for any business combinations that we may enter into in the future. However, SFAS 141’s adoption had no impact on our present financial condition or results of operations.
SFAS 142 addresses the accounting for goodwill and other intangible assets after their initial recognition. SFAS 142 changes the accounting for goodwill and other intangible assets by replacing periodic amortization of the asset with an annual test of impairment of goodwill at either the reporting segment level or one level below, providing for similar accounting treatment for intangible assets deemed to have an indefinite life. Assets with finite lives will be amortized over their useful lives. SFAS 142 also provides for additional financial statement disclosures about goodwill and intangible assets. The provisions of SFAS 142 were applicable to us beginning in the year ending December 31, 2002. We have insignificant levels of goodwill and purchased-related intangible assets and the adoption of SFAS 142 had no material impact on our financial condition or results of operations.
In August 2001, SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”) was issued. SFAS 144 retains the existing requirements to recognize and measure the impairment of long-lived assets to be held and used or to be disposed of by sale. However, SFAS 144 changes the scope and certain measurement requirements of existing accounting guidance. SFAS 144 also changes the requirements relating to reporting the effects of a disposal or discontinuation of a segment of a business. The adoption of SFAS 144 had no material impact on our financial condition or results of operations.
In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”), which is an interpretation of SFAS No. 5; “Accounting for Contingencies,” SFAS No. 57; “Related Party Disclosures,” and SFAS No. 107; “Disclosures About Fair Value of Financial Instruments.” FIN 45 clarifies the disclosure and liability recognition requirements relating to guarantees issued by an entity. Specifically, FIN 45 clarifies that entities are required to record guarantees at their fair values, including the value of the obligation to stand ready to perform over the term of the guarantee in the event the specified triggering events or conditions occur, regardless of whether the occurrence of the triggering events or conditions is deemed probable of occurring.
FIN 45 is effective for new guarantees issued or modification of guarantees made after December 31, 2002. FIN 45’s disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. The adoption of FIN 45’s measurement requirements did not have a significant impact on our financial position or results of operations.
In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), which is an interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements.” FIN 46 was amended in December 2003. FIN 46 requires business enterprises to consolidate variable interest entities which have one or more of the following characteristics:
1. The equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties.
2. The equity investors lack one or more of the following essential characteristics of a controlling financial interest:
a. The direct or indirect ability to make decisions about the entity’s activities through voting rights or similar rights
b. The obligation to absorb the expected losses of the entity if they occur
c. The right to receive expected residual returns of the entity if they occur.
As discussed in Note 18 - Company-Obligated Capital Securities of Subsidiary Trusts, the Company has issued trust-preferred securities. Based on guidance related to FIN 46, the Company will cease consolidating the subsidiaries which have issued the trust-preferred securities during the quarter ending March 31, 2004. The primary effect of this de-consolidation will be for the Company to re-classify the trust-preferred securities from mezzanine equity to debt. Interest payments relating to the trust-preferred securities are presently charged to interest expense. Therefore, this change will have no effect on the Company’s results of operations.
FIN 46 excludes qualifying special purpose entities subject to the reporting requirements of SFAS 140. FIN 46 applies upon formation to variable interest entities created after January 31, 2003, and to all variable interest entities in the first fiscal year or interim period beginning after June 15, 2003. At December 31, 2003, Countrywide’s corporate structure included either companies whose accounts were consolidated into the Company’s financial statements or which were classified as qualifying special purpose entities under SFAS 140. Therefore, the adoption of FIN 46 did not have an impact on the Company’s financial statements at December 31, 2003.
In April 2003, the FASB issued Statement No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” which is generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. SFAS 149 clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative as discussed in SFAS No. 133, clarifies when a derivative contains a financing component, amends the definition of an “underlying” to conform it to the language used in FIN 45. The adoption of SFAS 149 did not have a material effect on our financial condition or results of operations.
In May 2003, the FASB issued Statement No. 150 (“SFAS 150”), “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity in its statement of financial position. On November 7, 2003, the FASB issued FASB Staff Position 150-3 (“FSP 150-3”) deferring the effective date of SFAS 150 for certain mandatorily redeemable non-controlling interests. SFAS 150 would have required the reclassification of our trust-preferred securities from mezzanine financing to liabilities. However, the issuance of FSP 150-3 delayed this reclassification pending reconsideration of the issue by the FASB. The adoption of the remainder of SFAS 150 did not have a material effect on our financial condition or results of operation.
Forward-Looking Statements
Factors That May Affect Our Future Results
We make forward-looking statements in this report and in other reports we file with the SEC. In addition, we make forward-looking statements in press releases and our management might make forward-looking statements orally to analysts, investors, the media and others. Generally, forward-looking statements include:
•
Projections of our revenues, income, earnings per share, capital expenditures, dividends, capital structure of other financial items
•
Descriptions of our plans or objectives for future operations, products or services
•
Forecasts of our future economic performance
•
Descriptions of assumptions underlying or relating to any of the foregoing
Forward-looking statements give management’s expectation about the future and are not guarantees. Words like “believe,” “expect,” “anticipate,” “promise,” “plan” and other expressions or words of similar meanings, as well as future or conditional verbs such as “will,” “would,” “should,” “could,” or “may” are generally intended to identify forward-looking statements. There are a number of factors, many of which are beyond our control that could cause actual results to differ significantly from management’s expectations. Some of these factors are discussed below.
Readers are cautioned not to place undue reliance on forward-looking statements. Forward-looking statements speak only as of the date they are made. We do not undertake to update them to reflect changes that occur after the date they are made.
General business, economic and political conditions may significantly affect our earnings
Our business and earnings are sensitive to general business and economic conditions in the United States. These conditions include short-term and long-term interest rates, inflation, fluctuations in both debt and equity capital markets, and the strength of the U.S. economy, and the local economies in which we conduct business. If any of these conditions worsen, our business and earnings could be adversely affected. For example, business and economic conditions that negatively impact household incomes could decrease the demand for our home loans and increase the number of customers who become delinquent or default on their loans; or, a rising interest rate environment could decrease the demand for loans.
In addition, our business and earnings are significantly affected by the fiscal and monetary policies of the federal government and its agencies. We are particularly affected by the policies of the Federal Reserve Board, which regulates the supply of money and credit in the United States. The Federal Reserve Board’s policies influence the size of the mortgage origination market, which significantly impacts the earnings of our Loan Production Sector and the value of our investment in MSRs and other retained interests. The Federal Reserve Board’s policies also influence the yield on our interest-earning assets and the cost of our interest-bearing liabilities. Changes in those policies are beyond our control and difficult to predict and can have a material effect on the Company’s business, results of operations and financial condition.
Political conditions can also impact our earnings. Acts or threats of war or terrorism, as well as actions taken by the U.S. or other governments in response to such acts or threats, could impact business and economic conditions in the United States.
If we cannot effectively manage the volatility of our mortgage banking business, our earnings could be affected
The level and volatility of interest rates significantly affect the mortgage banking industry. For example, a decline in mortgage rates generally increases the demand for home loans as borrowers refinance, but also generally leads to accelerated payoffs in our mortgage servicing portfolio, which negatively impacts the value of our MSRs.
We attempt to manage interest rate risk in our mortgage banking business primarily through the natural counterbalance of our loan production and servicing operations. In addition, we also use derivatives extensively in order to manage the interest rate, or price risk, inherent in our assets, liabilities, and loan commitments. Our main objective in managing interest rate risk is to moderate the impact of changes in interest rates on our earnings over time. Our interest rate risk management strategies may result in significant earnings volatility in the short term. The success of our interest rate risk management strategy is largely dependent on our ability to predict the earnings sensitivity of our loan servicing and loan production operations in various interest rate environments. The success of this strategy impacts our net income. This impact, which can be either positive or negative, can be material.
Our accounting policies and methods are fundamental to how we report our financial condition and results of operations, and they may require management to make estimates about matters that are inherently uncertain
Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations.
We have identified several accounting policies as being “critical” to the presentation of our financial condition and results of operations because they require management to make particularly subjective or complex judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be recorded under different conditions or using different assumptions. These critical accounting policies relate to our gain from sale of loans and securities, valuation of retained interests and interest rate management activities. Because of the inherent uncertainty of the estimates associated with these critical accounting policies, we cannot provide any assurance that we will not make significant adjustments to the related amounts recorded at December 31, 2003. For more information, please refer to the “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies” section in this report.
The financial services industry is highly competitive
We operate in a highly competitive industry that could become even more competitive as a result of economic, legislative, regulatory and technological changes. Competition for mortgage loans comes primarily from large commercial banks and savings institutions. Many of our competitors have fewer regulatory constraints. For example, national banks and federal savings and loan institutions are not subject to certain state laws and regulations targeted at predatory lending practices and we could be at a competitive disadvantage with respect to fulfilling legitimate subprime credit opportunities. Another competitive consideration is that other companies have lower cost structures and others are less reliant on the secondary mortgage market for funding due to their greater portfolio lending capacity.
We face competition in such areas as mortgage product offerings, rates and fees, and customer service, both at the retail and institutional level. In addition, technological advances and heightened e-commerce activities have increased consumers’ accessibility to products and services generally. This has intensified competition among banking as well as nonbanking companies in offering financial products and services, with or without the need for a physical presence.
Changes in regulations could adversely affect our business
We are heavily regulated by banking, mortgage lending and insurance laws at the federal, state and local levels, and proposals for further regulation of the financial services industry are continually being introduced. We are subject to many other Federal, State and local laws and regulations that affect our business, including those regarding taxation and privacy. Congress and state legislatures, as well as federal and state regulatory agencies, review such laws, regulations and policies and periodically propose changes that could affect us in substantial and unpredictable ways. Such changes could, for example, limit the types of financial services and products we offer, or increase our cost to offer such services and products. It is possible that one or more legislative proposals may be adopted or regulatory changes may be implemented that would have an adverse effect on our business. Our failure to comply with such laws or regulations, whether actual or alleged, could expose us to fines, penalties or potential litigation liabilities, including costs, settlements and judgments, any of which could adversely affect our earnings.
We depend on the accuracy and completeness of information about customers and counterparties
In deciding whether to extend credit or enter into other transactions with customers and counterparties, we may rely on information furnished to us by or on behalf of customers and counterparties, including financial statements and other financial information. We also may rely on representations of customers and counterparties as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors. For example, in deciding whether to extend credit to
institutional customers, we may assume that a customer’s audited financial statements conform with GAAP and present fairly, in all material respects, the financial condition, results of operations and cash flows of the customer. Our financial condition and results of operations could be negatively impacted to the extent we rely on financial statements that do not comply with GAAP or are materially misleading.
Other Factors
The above description of risk factors is not exhaustive. Other factors that could cause actual results to differ materially from historical results or those anticipated include, but are not limited to:
•
A general decline in U.S. housing prices or activity in the U.S. housing market
•
A loss of investment-grade credit ratings, which may result in increased cost of debt or loss of access to corporate debt markets
•
A reduction in the availability of secondary markets for our mortgage loan products
•
A reduction in government support of homeownership
•
A change in our relationship with the housing-related government agencies and sponsored entities
•
Ineffectiveness of our hedging activities
•
The level of competition in each of our business segments
•
The occurrence of natural disasters or other events or circumstances that could impact the level of claims in the Insurance segment
Other risk factors are described elsewhere herein as well as in other reports and documents that we file with or furnish to the SEC. Other factors that may not be described in any such report or document that could also cause results to differ from our expectations. Each of these factors could by itself, or together with one or more other factors, adversely affect our business, results of operations and/or financial condition.
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
In response to this Item, the information set forth on pages 66 to 71 and Note 10 of this Form 10-K is incorporated herein by reference.
Item 8.
Item 8.
Financial Statements and Supplementary Data
The information called for by this Item 8 is hereby incorporated by reference from Countrywide’s Financial Statements and Auditors’ Report beginning at page of this Form 10-K.
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Not Applicable.
Item 9A.
Item 9A.
Controls and Procedures
We have conducted an evaluation, with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this annual report as required by paragraph (b) of Rules 13a-15 and 15d-15 under the Exchange Act. Based on their evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective in ensuring that material information relating to the Company, including our consolidated subsidiaries, is made known to the Chief Executive Officer and Chief Financial Officer by others within those entities during the period in which this annual report on Form 10-K was being prepared.
There has been no change in our internal control over financial reporting during the quarter ended December 31, 2003 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART III
Item 10.
Item 10.
Directors and Executive Officers of the Registrant
The information required by this Item 10 is hereby incorporated by reference from our definitive proxy statement, to be filed pursuant to Regulation 14A within 120 days after the end of the fiscal year.
Item 11.
Item 11.
Executive Compensation
The information required by this Item 11 is hereby incorporated by reference from our definitive proxy statement, to be filed pursuant to Regulation 14A within 120 days after the end of the fiscal year.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management
Equity Compensation Plan Information
The following table shows aggregate information, as of December 31, 2003, with respect to compensation plans under which equity securities of Countrywide are authorized for issuance.
(1)
Countrywide’s 2000 Equity Incentive Plan also provides for awards of Restricted Stock. Of the securities available for issuance under this plan, 1,082,956 shares of our Common Stock are available for issuance in the form of Restricted Stock.
Item 13.
Item 13.
Certain Relationships and Related Transactions
The information required by this Item 13 is hereby incorporated by reference from our definitive proxy statement, to be filed pursuant to Regulation 14A within 120 days after the end of the fiscal year.
Item 14.
Item 14.
Principal Accountant Fees and Services
The information required by this Item 14 is hereby incorporated by reference from our definitive proxy statement, to be filed pursuant to Regulation 14A within 120 days after the end of the fiscal year.
PART IV
Item 15.
Item 15.
Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a)(1) and (2) - Financial Statement Schedules.
The information called for by this section of Item 15 is set forth in the Financial Statements and Auditors’ Report beginning at page of this Form 10-K. The index to Financial Statements and Schedules is set forth at page of this Form 10-K.
(3) - Exhibits
*
Incorporated by reference

Constitutes a management contract or compensatory plan or arrangement.
(b) Reports on Form 8-K
On October 10, 2003, the Company furnished a report on Form 8-K announcing revised earnings guidance for 2003.
On October 14, 2003, the Company furnished a report on Form 8-K announcing information regarding its operational statistics for the month ended September 30, 2003.
On October 23, 2003, the Company furnished a report on Form 8-K announcing information regarding its operations and financial condition for the quarter ended September 30, 2003.
On November 10, 2003, the Company furnished a report on Form 8-K announcing information regarding its operational statistics for the month ended October 31, 2003.
On December 8, 2003, the Company furnished a report on Form 8-K announcing information regarding its operational statistics for the month ended November 30, 2003.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
COUNTRYWIDE FINANCIAL CORPORATION
By:
/s/ ANGELO R. MOZILO
Angelo R. Mozilo,
Chairman of the Board of Directors and Chief Executive Officer (Principal Executive Officer)
Dated: March 10, 2004
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant in the capacities and on the dates indicated.
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED FINANCIAL STATEMENTS AND REPORT OF
INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
For Inclusion in Form 10-K
Annual Report Filed with
Securities and Exchange Commission
December 31, 2003
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
INDEX TO FINANCIAL STATEMENTS AND SCHEDULES
December 31, 2003
All other schedules have been omitted since the required information is not present or not present in amounts sufficient to require submission of the schedules, or because the information required is included in the consolidated financial statements or notes thereto.
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
Board of Directors and Shareholders
Countrywide Financial Corporation
We have audited the accompanying consolidated balance sheets of Countrywide Financial Corporation and Subsidiaries as of December 31, 2003 and 2002 and the related consolidated statements of earnings, common shareholders’ equity, cash flows and comprehensive income for the years ended December 31, 2003 and 2002, and the ten month period ended December 31, 2001. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Countrywide Financial Corporation and Subsidiaries as of December 31, 2003 and 2002 and the consolidated results of their operations and their consolidated cash flows for the years ended December 31, 2003 and 2002, and the ten month period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States of America.
We have also audited Schedules I and II for the years ended December 31, 2003 and 2002, and the ten month period ended December 31, 2001. In our opinion, such schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information therein.
GRANT THORNTON LLP
/s/GRANT THORNTON LLP
Los Angeles, California
February 27, 2004
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollar amounts in thousands, except share data)
The accompanying notes are an integral part of these statements.
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EARNINGS
For the Years Ended December 31, 2003 and
and the Ten Months Ended December 31,
The accompanying notes are an integral part of these statements.
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF COMMON SHAREHOLDERS’ EQUITY
For the Years Ended December 31, 2003 and
and the Ten Months Ended December 31,
The accompanying notes are an integral part of this statement.
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended December 31, 2003 and
and the Ten months Ended December 31,
The accompanying notes are an integral part of these statements.
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
For the years ended December 31, 2003 and
and the Ten Months Ended December 31,
The accompanying notes are an integral part of these statements.
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 - Organization
Countrywide Financial Corporation (the “Company”), previously Countrywide Credit Industries, Inc., is a holding company which, through its principal subsidiary, Countrywide Home Loans, Inc. (“CHL”) and other subsidiaries, is engaged primarily in the U.S. residential mortgage banking business, as well as other businesses that are generally tied to the U.S. residential mortgage market. In addition to residential mortgage banking, the Company’s business activities fall into the following general categories: securities dealer, retail banking and mortgage warehouse lending, insurance underwriting and agency, and international mortgage loan processing and sub-servicing.
Note 2 -
Summary of Significant Accounting Policies
A summary of the Company’s significant accounting policies applied in the preparation of the accompanying consolidated financial statements follows.
Change in Fiscal Year
Effective January 1, 2001, the Company changed its fiscal year end from February 28 to December 31. As a result of the change, the Company’s Consolidated Statement of Earnings, Consolidated Statement of Common Shareholders’ Equity, Consolidated Statement of Cash Flows and Consolidated Statement of Comprehensive Income for the period ended December 31, 2001 consist of the ten-month period March 1, 2001 through December 31, 2001. Summary comparative data for the ten-month period ended December 31, 2000 is presented in Note 4.
Use of Estimates
In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that materially affect the reported amounts of assets and liabilities and the disclosure of contingent liabilities at the date of the financial statements and revenues and expenses during the reporting period. Actual results could differ from those estimates.
Principles of Consolidation
The Company includes both operating and special purpose entities. Inclusion of these entities in the consolidated financial statements of the Company is based on its voting interests for operating entities, and on whether its special purpose entities are “qualifying special purpose entities” (“QSPEs”) as specified by Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“SFAS 140”).
For operating entities, the consolidated financial statements include the accounts of Countrywide Financial Corporation and all majority-owned subsidiaries. All material intercompany accounts and transactions have been eliminated. Minority interests in the Company’s majority-owned subsidiaries are included in “accounts payable and accrued liabilities” on the Company’s balance sheets and the minority interest in the Company’s earnings are charged to “other operating expenses,” net of applicable income taxes. The Company has whole or majority ownership of all of its subsidiaries, and therefore has no equity method or cost-basis investees.
Countrywide has formed special purpose entities for the purpose of facilitating the sale of its loans. The beneficial interests in these entities are held by third-parties. The structure of these entities limits their activities to holding the transferred assets and transferring cash collected to the entities’ beneficial interest holders. These special purpose entities meet the definition of QSPEs as detailed in SFAS 140 and the accounts of these QSPEs are not included in the consolidated financial statements.
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company has also formed special purpose entities to facilitate the financing of loans and securities, primarily loans and securities held for sale, or to hold interests retained in securitization. The accounts of these entities are included in the consolidated financial statements as the structure of the entities is such that the Company retains control, as defined by SFAS 140, of the assets transferred to these entities.
Financial Statement Reclassifications
Certain amounts reflected in the Consolidated Financial Statements for the year ended December 31, 2002 and the ten-month period ended December 31, 2001 have been reclassified to conform to the presentation for the year ended December 31, 2003.
Statement of Financial Accounting Standards No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases” requires that certain nonrefundable fees and the related incremental direct costs associated with originating loans be deferred when incurred. How these deferred amounts are recognized in income is based on whether the loans are held for investment or are held for sale.
Net deferred amounts relating to loans held for investment generally are recognized over the life of the loan using the interest method of amortization. In the case of mortgage loans held for sale, the deferred costs are recognized when the loan is sold. These deferred amounts have been classified as a component of the gain on the sale of the loans in this period and previously reported amounts have been reclassified to agree with the current presentation. This reclassification had no impact on reported earnings in the current period or in any prior period. The deferral of origination expenses had the following effect on operating expenses for the periods presented:
In the fourth quarter of 2003, the Company consummated a 4-for-3 stock split effected as a stock dividend. All references in the accompanying consolidated balance sheet, consolidated statements of earnings and notes to consolidated financial statements to the number of common shares and earnings per share amounts have been restated accordingly.
Derivative Financial Instruments
The Company utilizes derivative financial instruments extensively in connection with its interest rate risk management activities. In addition, the Company uses derivatives to manage the foreign currency risk related to its foreign currency denominated indebtedness. (See Note 10 for further discussion.)
On March 1, 2001, the Company adopted Statement of Financial Accounting Standards No. 133, “Accounting For Derivative Instruments And Hedging Activities,” and Statement of Financial Accounting Standards No. 138, “Accounting For Certain Derivative Instruments And Certain Hedging Activities - An Amendment of FASB Statement No. 133” (collectively, “SFAS 133”). Under SFAS 133, all derivative financial instruments are recognized on the balance sheet at fair value.
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
At the date of adoption, the Company recorded certain transition adjustments as required by SFAS 133. There was no impact on net earnings because of the transition adjustments. However, the transition adjustments had the following impact on the Company’s balance sheet (in millions):
The Company designates every derivative instrument as either a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (“fair value” hedge), a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (“cash flow” hedge) or a free-standing derivative instrument. For a fair value hedge, changes in the fair value of the derivative instrument and changes in the fair value of the hedged asset or liability attributable to the hedged risk are recorded in current period earnings. For a cash flow hedge, to the extent that it is an effective hedge, changes in the fair value of the derivative are recorded in other comprehensive income within shareholders’ equity and subsequently reclassified to earnings in the same period(s) that the hedged transaction impacts net earnings; to the extent a cash flow hedge is ineffective, the ineffective portion of the hedge is reported in current period earnings. For free-standing derivative instruments, changes in the fair values are reported in current period earnings.
The Company formally documents the relationship between hedging instruments and hedged items, as well as the risk management objective and strategy for undertaking various hedge transactions. This process includes linking all derivative instruments that are designated as fair value or cash flow hedges to specific assets and liabilities on the balance sheet. The Company also formally assesses, both at the inception of the hedge and on an ongoing basis, whether the derivative instruments used are highly effective in offsetting changes in fair values or cash flows of hedged items. If it is determined that the derivative instrument is not highly effective as a hedge, hedge accounting is discontinued.
The Company discontinues hedge accounting when (1) it determines that a derivative instrument is no longer effective in offsetting changes in the fair value or cash flows of a hedged item; (2) a derivative instrument expires or is sold, terminated, or exercised; or (3) a derivative instrument is de-designated as a hedge instrument. When hedge accounting is discontinued, the derivative instrument continues to be carried on the balance sheet at its fair value. However, the carrying value of the previously hedged asset or liability is no longer adjusted for changes in fair value. When hedge accounting is discontinued because it is probable that a forecasted transaction will not occur, the derivative instrument continues to be carried on the balance sheet at its fair value, and gains and losses that were accumulated in other comprehensive income are recognized in current period earnings. When hedge accounting is discontinued because the hedging instrument is sold or terminated, the amount reported in other comprehensive income to the date of sale or termination is reported in other comprehensive income until the forecasted transaction impacts earnings. In all situations in which hedge accounting is discontinued, the derivative instrument is carried at its fair value on the balance sheet, with changes in its fair value recognized in current period earnings.
The Company occasionally purchases or originates financial instruments that contain an embedded derivative instrument. At inception, the Company assesses whether the economic characteristics of the embedded derivative instrument are clearly and closely related to the economic characteristics of the financial instrument (host contract), whether the financial instrument that embodies both the embedded derivative instrument and the host contract is currently measured at fair value with changes in fair value reported in
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earnings, and whether a separate instrument with the same terms as the embedded instrument would meet the definition of a derivative instrument.
If the embedded derivative instrument is determined not to be clearly and closely related to the host contract, is not currently measured at fair value with changes in fair value reported in earnings, and the embedded derivative instrument would qualify as a derivative instrument, the embedded derivative instrument is recorded apart from the host contract and carried at fair value with changes recorded in current period earnings.
Sales, Securitizations and Servicing of Financial Instruments
The Company securitizes substantially all of the mortgage loans it produces, and sells those securities on a regular basis in the secondary mortgage market. By-products of those securitizations are certain retained interests, including mortgage servicing rights (“MSRs”), interest-only securities, principal-only securities, and residual securities, which the Company generally holds as long-term investments. (See Note 9 for a description of MSRs.)
When the Company securitizes mortgage loans, it allocates the acquisition cost of the mortgage loans between the security sold and the retained interests, based on their relative fair values. The reported gain is the difference between the cash proceeds from the sale of the security or loan and its allocated cost. The cost allocated to the retained interests is classified accordingly on the balance sheet.
Once recorded, retained interests are periodically evaluated for impairment. Impairment occurs when the current fair value of the retained interest is less than its carrying value.
If MSRs are impaired, the impairment is recognized in current-period earnings and the carrying value of the MSRs is adjusted through a valuation allowance. If the value of the MSRs subsequently increases, the recovery in value is recognized in current-period earnings and the carrying value of the MSRs is adjusted through a reduction in the valuation allowance. For purposes of performing its MSR impairment evaluation, the Company stratifies its servicing portfolio on the basis of certain risk characteristics including loan type (fixed-rate or adjustable-rate) and note rate. Fixed-rate loans are stratified into note rate pools of fifty basis points for note rates between 6% and 10% and single pools for note rates above 10% and below 6%. Management periodically reviews the various impairment strata to determine whether the value of the impaired MSRs in a given stratum is likely to recover. When management deems recovery of the value to be unlikely in the foreseeable future, a permanent impairment write-down of the underlying MSRs to its estimated recoverable value is charged to the valuation allowance. MSRs cannot be carried above their amortized cost.
Impairment of other retained interests is recognized as a reduction to shareholders’ equity (net of tax). If the impairment is deemed to be other than temporary, it is recognized in current-period earnings. Once permanently impaired, subsequent increases in the value of other retained interests are recognized in earnings over the estimated remaining life of the investment through a higher effective yield.
Other retained interests are classified as available-for-sale securities and are carried at estimated fair value in the consolidated balance sheets.
See Note 9 for further discussion concerning the valuation of MSRs and other retained interests.
Loans
Mortgage Loans and Mortgage-Backed Securities (“MBS”) Held for Sale
Mortgage Loans Held for Sale are recorded at the principal amount outstanding net of deferred origination costs and fees and any premiums or discounts. Loan origination fees, as well as discount points and
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incremental direct origination costs, are initially recorded as an adjustment of the cost of the loan and are reflected in earnings when the loan is sold.
The cost-basis of Mortgage Loans Held for Sale is adjusted to reflect changes in the loans’ fair value as applicable through fair value hedge accounting. Mortgage Loans Held for Sale are carried at the lower of adjusted cost or market, which is computed by the aggregate method (unrealized losses are offset by unrealized gains). The market value of Mortgage Loans Held for Sale is generally based on quoted market prices for MBS.
Loans Held for Investment
Loans held for investment are carried at amortized cost reduced by a valuation allowance for credit losses inherent in the portfolio as of the balance sheet date. A loan’s cost includes its unpaid principal balance along with unearned income comprised of fees charged to borrowers offset by incremental direct origination costs for loans originated by the Company or any premiums or discounts paid for loans purchased. Unearned income is amortized over the loan’s contractual life. For revolving lines of credit, unearned income is amortized using the straight-line method. For other loans, unearned income is amortized using the interest method of accounting.
The allowance for loan losses is a valuation allowance established to provide for probable credit losses inherent in the portfolio of loans held for investment as of the balance sheet date. The Company estimates the level of its allowance for loan losses based on observed delinquency, default and loss experience, current portfolio delinquency and the results of the Company’s ongoing quality control and compliance monitoring activities.
Interest Income Recognition
Interest income is accrued as earned. Loans are placed on nonaccrual status when any portion of principal or interest is ninety days past due, or earlier when concern exists as to the ultimate collectibility of principal or interest. When a loan is placed on nonaccrual status the accrued and unpaid interest is reversed and the loan is accounted for on the cash basis. Loans return to accrual status when principal and interest become current and are anticipated to be fully collectible.
Trading Securities
Trading securities consist of mortgage securities purchased by the Company’s broker-dealer subsidiary. These securities, along with associated derivative instruments used to manage price risk, are recorded at fair value on a trade date basis, and gains and losses, both realized and unrealized, are included in Gain on Sale of Loans and Securities in the statement of earnings.
Investments in Other Financial Instruments
Investments in Other Financial Instruments include mortgage-backed and government agency securities, securitized excess servicing fees, derivative hedging instruments, and certain interests retained in securitization. The Company carries all of these assets at their estimated fair values. How the changes in fair value of the securities are recognized is dependent on how the Company has classified the respective assets:
•
Securitized excess service fees have been classified as trading securities; therefore, changes in the fair value of securitized excess servicing fees are recognized in current period earnings;
•
All other securities have been classified as available-for-sale securities; therefore, unrealized gains or losses, net of deferred income taxes, are excluded from earnings and reported as accumulated other comprehensive income, which is a separate component of shareholders’ equity. Realized gains and losses on sales of these assets are computed by the specific identification method at the time of
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disposition and are recorded in earnings. Unrealized losses that are other than temporary are recognized in earnings in the period that the other-than temporary impairment is identified.
Securities Purchased Under Agreements to Resell and Securities Sold Under Agreements to Repurchase
Transactions involving purchases of securities under agreements to resell or sales of securities under agreements to repurchase are recorded at their contractual amounts plus accrued interest and accounted for as collateralized financings, except where the Company does not have an agreement to sell (or purchase) the same or substantially the same securities before maturity at a fixed or determinable price.
Certain of the Company’s securities lending arrangements include master netting agreements whereby the counterparties are entitled and intend to settle their positions “net.” Where such arrangements are in place, the Company includes the net asset or liability in its balance sheet. At December 31, 2003, $12.6 billion of borrowings were offset against securities purchased under agreements to resell under master netting arrangements.
Deferred Acquisition Costs
The Company’s insurance carrier subsidiary, Balboa Life and Casualty (“Balboa”), incurs acquisition costs which vary with and are directly related to acquisition of new insurance policies, consisting primarily of commissions, premium taxes, and certain other underwriting costs. These costs are deferred and amortized as the related premiums are earned. Deferred acquisition costs are limited to amounts estimated to be recoverable from the related premiums and anticipated investment income less anticipated losses, loss adjustment expenses, and policy maintenance expenses. Deferred acquisition costs totaling $82.2 million and $100.2 million were included in other assets at December 31, 2003 and 2002, respectively. Amortization of policy acquisition costs totaling $184.2 million, $98.8 million and $42.0 million were included in other operating expenses for the years ended December 31, 2003 and 2002 and the ten months ended December 31, 2001, respectively.
Liability for Insurance Losses
For Balboa’s property and casualty policies, the liability for losses and loss adjustment expenses consists of a liability for the unpaid portion of estimated ultimate losses and loss adjustment expenses on claims reported through the end of the accounting period and a liability for the estimated losses and loss adjustment expenses relating to incidents incurred but not reported as of the balance sheet date.
For credit life and disability policies, the liability for losses provides for future claims, estimated based upon statutory standards, on all policies in-force at the end of the period, as well as the present value of amounts not yet due on disability claims. The liability for policy and contract claims represents the estimated ultimate net cost of all reported and unreported claims incurred through the end of the period, except for the present value of amounts not yet due on disability claims, which are included in the liability for life and disability policies.
The liability for insurance losses is established using statistical analyses and is subject to the effects of trends in claim severity and frequency and other factors. The estimate is continually reviewed and as adjustments to the liability become necessary, such adjustments are reflected in current earnings.
For mortgage reinsurance, the liability for insured losses is accrued in proportion to the amount of revenue recognized based on management’s assessment of the ultimate liability to be paid over the current and expected renewal period of the contracts. The remaining liability to be paid, along with reinsurance revenues to be earned are estimated based on the Company’s historical experience of defaults, losses and prepayments.
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Collateral
The Company reports assets it has pledged as collateral in secured borrowing and other arrangements when the secured party cannot sell or repledge the assets or the Company can substitute collateral or otherwise redeem it on short notice. The Company generally does not report assets received as collateral in secured lending and other arrangements since the debtor typically has the right to redeem the collateral on short notice.
Property, Equipment and Leasehold Improvements
Property, equipment and leasehold improvements are stated at cost, less accumulated depreciation and amortization. Depreciation is provided in amounts sufficient to relate the cost of depreciable assets to operations over their estimated service lives using the straight-line method. Leasehold improvements are amortized over the lesser of the life of the lease or service lives of the improvements using the straight-line method. Renovations and improvements that add utility or significantly extend the useful life of assets are capitalized. Repair and maintenance costs are expensed as incurred.
Capitalized Software Costs
Internal software development costs are capitalized to the extent of external direct costs of materials and services consumed in developing or obtaining internal-use computer software and, salary costs relating to employees’ time spent on the software project during the application development stage. Internally-developed software is amortized over six to ten years using the straight-line method.
Loan Servicing Fees
Loan Servicing Fees and other remuneration are received by the Company for servicing residential mortgage loans. Loan Servicing Fees are recorded net of guarantee fees paid by the Company in connection with its securitization activities. Loan Servicing Fees are recognized as earned over the life of the servicing portfolio.
Income from Other Retained Interests
Income from Other Retained Interests represents the yield on interest-only securities, principal-only securities and residual interests retained in securitization. Income on these investments is recognized using the interest method.
Insurance Premiums
Property and casualty and credit life and disability premiums are earned over the term of the policies on a pro-rata basis for all policies except for lender-placed insurance and Guaranteed Auto Protection (“GAP”), which provides coverage for leased automobiles’ residual value. For lender-placed insurance, earnings are “slowed,” or earned later in the life of the policy, due to high cancellation rates experienced early in the life of the policy. For GAP insurance, revenue recognition is correlated to the exposure and accelerated over the life of the contract. Premiums applicable to the unexpired term of policies in-force are recorded as unearned premiums. Mortgage reinsurance premiums are recognized as earned over the life of the policy.
Stock-Based Compensation
The Company generally grants stock options to employees for a fixed number of shares with an exercise price equal to the fair value of the shares at the date of grant. The Company recognizes compensation expense related to its stock option plans only to the extent that the fair value of the shares at the grant date exceeds the exercise price.
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Had the estimated fair value of the options granted been included in compensation expense, the Company’s net earnings and earnings per share would have been as follows:
The fair value of each option grant is estimated on the date of grant using a Black-Scholes option-pricing model that has been modified to consider cash dividends to be paid. To determine periodic compensation expense for purposes of this pro forma disclosure, the fair value of each option grant is amortized over the options’ vesting period. The weighted-average assumptions used to value the option grants and the resulting average estimated values were as follows:
Income Taxes
The Company utilizes an asset and liability approach in its accounting for income taxes. This approach requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial statement and tax basis carrying amounts of assets and liabilities.
Borrower and Investor Custodial Accounts
The Company holds, as custodian, funds collected from borrowers whose loans it services. These funds include loan payments pending remittance to investors and funds collected from borrowers to ensure timely payment of hazard and primary mortgage insurance and property taxes related to the properties securing the loans. These funds are not owned by the Company. These funds are held in trust and are shown on the Statement of Financial Condition for disclosure purposes only. As of December 31, 2003, $5.9 billion of the borrower and investor custodial accounts were placed as deposits in Treasury Bank and are included in bank deposit liabilities.
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Implementation of New Accounting Standards
As more fully disclosed in the preceding caption, “Derivative Financial Instruments,” the Company adopted SFAS 133 in March 2001.
In November 1999, the Emerging Issues Task Force (“EITF”) released Issue No. 99-20, titled “Recognition of Interest Income and Impairment on Purchased and Retained Interests in Securitized Financial Assets” (“EITF 99-20”). EITF 99-20 is effective for quarters beginning after March 15, 2001. Under the guidelines of EITF 99-20, the accounting treatment of interest income and impairment of beneficial interests in securitization transactions is modified such that beneficial interests which are determined to have an other-than-temporary impairment are required to be written down to fair value with a corresponding impairment charge to earnings. The Company adopted EITF 99-20 for the fiscal quarter ended August 31, 2001 and there was no material impact at adoption on the Company’s financial statements.
In September 2000, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 140 (“SFAS 140”), “Accounting for the Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” which replaces SFAS No. 125 (of the same title). SFAS 140 revises certain standards in the accounting for securitizations and other transfers of financial assets and collateral, and requires some additional disclosures relating to securitization transactions and collateral, but it carries over most of SFAS 125’s provisions. The collateral and disclosure provisions of SFAS 140 were included in the February 28, 2001 financial statements. All other provisions of this Statement were adopted on April 1, 2001, as required by the statement. The adoption of this statement did not have a material impact on the Company’s financial statements.
In June 2001, the FASB issued SFAS No. 141, “Business Combinations” (“SFAS 141”) and SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”).
SFAS 141 requires use of the purchase method of accounting for all business combinations initiated after June 30, 2001, provides specific guidance on how to identify the accounting acquirer in a business combination, provides specific criteria for recognizing intangible assets apart from goodwill and requires additional financial statement disclosures regarding business combinations. SFAS 141 will impact the Company’s accounting for any business combinations it may enter into in the future. However, SFAS 141’s adoption did not have an impact on the Company’s present financial condition or results of operations.
SFAS 142 addresses the accounting for goodwill and other intangible assets after their initial recognition. SFAS 142 changes the accounting for goodwill and other intangible assets by replacing periodic amortization of the asset with an annual test of impairment of goodwill at either the reporting segment level or one level below, providing for similar accounting treatment for intangible assets deemed to have an indefinite life. Assets with finite lives will be amortized over their useful lives. SFAS 142 also provides for additional financial statement disclosures about goodwill and intangible assets. The provisions of SFAS 142 are applicable to the Company for the year ended December 31, 2002. The Company has insignificant levels of goodwill and intangible assets and the adoption of SFAS 142 did not have a material impact on the Company’s financial condition or results of operations.
In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). SFAS 144 retains the existing requirements to recognize and measure the impairment of long-lived assets to be held and used or to be disposed of by sale. However, SFAS 144 changes the scope and certain measurement requirements of existing accounting guidance and also changes the requirements relating to reporting the effects of a disposal or discontinuation of a segment of a business. The provisions of SFAS 144 are applicable to the Company for the year ended December 31, 2002. The adoption of SFAS 144 did not have a material impact on the Company’s financial condition or results of operations.
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In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”), which is an interpretation of SFAS No. 5; “Accounting for Contingencies,” SFAS No. 57; “Related Party Disclosures,” and SFAS No. 107; “Disclosures About Fair Value of Financial Instruments.” FIN 45 clarifies the disclosure and liability recognition requirements relating to guarantees issued by an entity. Specifically, FIN 45 clarifies that entities are required to record guarantees at their fair values, including the value of the obligation to stand ready to perform over the term of the guarantee in the event the specified triggering events or conditions occur, regardless of whether the occurrence of the triggering events or conditions is deemed probable of occurring.
FIN 45 is effective for new guarantees issued or modification of guarantees made after December 31, 2002. FIN 45’s disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. The adoption of FIN 45’s measurement requirements did not have a significant impact on Countrywide’s financial position or results of operations.
In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), which is an interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements.” FIN 46 was amended in December 2003. FIN 46 requires business enterprises to consolidate variable interest entities which have one or more of the following characteristics:
1. The equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties.
2. The equity investors lack one or more of the following essential characteristics of a controlling financial interest:
a. The direct or indirect ability to make decisions about the entity’s activities through voting rights or similar rights
b. The obligation to absorb the expected losses of the entity if they occur
c. The right to receive expected residual returns of the entity if they occur.
As discussed in Note 18 - Company-Obligated Capital Securities of Subsidiary Trusts, the Company has issued trust-preferred securities. Based on guidance related to FIN 46, the Company will cease consolidating the subsidiaries which have issued the trust-preferred securities during the quarter ending March 31, 2004. The primary effect of this de-consolidation will be for the Company to re-classify the trust-preferred securities from mezzanine equity to debt. Interest payments relating to the trust-preferred securities are presently charged to interest expense. Therefore, this change will have no effect on the Company’s results of operations.
FIN 46 excludes qualifying special purpose entities subject to the reporting requirements of SFAS 140. FIN 46 applies upon formation to variable interest entities created after January 31, 2003, and to all variable interest entities in the first fiscal year or interim period beginning after June 15, 2003. At December 31, 2003, Countrywide’s corporate structure included either companies whose accounts were consolidated into the Company’s financial statements or which were classified as qualifying special purpose entities under SFAS 140. Therefore, the adoption of FIN 46 did not have an impact on the Company’s financial statements at December 31, 2003.
In April 2003, the FASB issued Statement No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” which is generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. SFAS 149 clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative as discussed in SFAS No. 133, clarifies when a derivative contains a financing component, amends the definition of an
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“underlying” to conform it to the language used in FIN 45. The adoption of SFAS 149 did not have a material effect on the Company’s financial condition or results of operations.
In May 2003, the FASB issued Statement No. 150 (“SFAS 150”), “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity in its statement of financial position. On November 7, 2003, the FASB issued FASB Staff Position 150-3 (“FSP 150-3”) deferring the effective date of SFAS 150 for certain mandatorily redeemable non-controlling interests. SFAS 150 would have required the reclassification of the Company’s trust-preferred securities from mezzanine financing to liabilities. However, the issuance of FSP 150-3 delayed this reclassification pending reconsideration of the issue by the FASB. The adoption of the remainder of SFAS 150 did not have a material effect on the Company’s financial condition or results of operations.
Note 3 -
Earnings Per Share
Basic earnings per share is determined using net earnings divided by the weighted average shares outstanding during the period. Diluted earnings per share is computed by dividing net earnings available to common shareholders by the weighted average shares outstanding, assuming all potential dilutive common shares were issued.
The following table summarizes the basic and diluted calculations for the years ended December 31, 2003 and 2002 and the ten months ended December 31, 2001:
During the years ended December 31, 2003 and 2002 and the ten months ended December 31, 2001, options to purchase 1.4 million shares, 1.2 million shares and 1.7 million shares, respectively, were outstanding but not included in the computation of earnings per share because they were anti-dilutive.
As more fully discussed in Note 14, the Company has outstanding debentures convertible into common stock of the Company upon the stock reaching certain specified levels, or if the credit ratings of the debentures drops below investment grade. At December 31, 2003, the conditions providing the holders of the debentures the right to convert their securities to shares of common stock during the quarter ending March 31, 2004 had been met; therefore, the effect of conversion of the debentures was included in the Company’s calculation of diluted earnings per share.
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Note 4 -
Transition Period Comparative Data
Effective January 1, 2001, the Company changed its fiscal year from February 28 to December 31. Information for the transition period is representative of the ten months beginning March 1, 2001 through December 31, 2001.
The following table presents certain financial information for the ten-months ended December 31, 2001 and December 31, 2000, respectively:
Note 5 - Trading Securities
Trading securities, which consist of trading securities owned and trading securities pledged as collateral, at December 31, 2003 and 2002 include the following:
As of December 31, 2003, $10.0 billion of the Company’s trading securities had been pledged as collateral for financing purposes, of which the counterparty has the contractual right to sell or re-pledge $4.1 billion. For
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the year ended December 31, 2003, the Company recorded $26.2 million in gains on trading securities that related to trading securities still held at the reporting date.
Note 6 - Securities Purchased Under Agreements to Resell
It is the policy of the Company to obtain possession of collateral with a market value equal to or in excess of the principal amount loaned under resale agreements. Collateral is valued daily, and the Company may require counterparties to deposit additional collateral or may return collateral pledged when appropriate.
As of December 31, 2003, the Company had accepted collateral with a fair value of $11.8 billion for which it had the contractual ability to sell or re-pledge. As of December 31, 2003, the Company had re-pledged $10.8 billion of such collateral for financing purposes, of which $1.2 billion related to amounts offset against securities purchased under agreements to resell under master netting arrangements.
As of December 31, 2002, the Company had accepted collateral with a fair value of $5.9 billion for which it had the contractual ability to sell or re-pledge. As of December 31, 2002, the Company had re-pledged $5.7 billion of such collateral for financing purposes.
Note 7 -
Mortgage Servicing Rights
The activity in Mortgage Servicing Rights (“MSRs”) for the years ended December 31, 2003 and 2002 and the ten months ended December 31, 2001 is as follows:
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The estimated fair value of mortgage servicing rights was $6.9 billion, $5.4 billion and $6.1 billion as of December 31, 2003, 2002 and 2001, respectively. (See Note 9 - “Securitizations” for discussion of the valuation of MSRs.)
The following table summarizes the Company’s estimate of amortization of its existing MSRs for the five-year period ending December 31, 2008. This projection was developed using the assumptions made by management in its December 31, 2003 valuation of MSRs. The assumptions underlying the following estimate will change as market conditions and portfolio composition and behavior change, causing both actual and projected amortization levels to change over time. Therefore, the following estimates will change in a manner and amount not presently determinable by management.
Note 8 - Investments in Other Financial Instruments
Investments in other financial instruments as of December 31, 2003 and 2002 include the following:
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All of the securities listed above are classified as available-for-sale, with the exception of the securitized excess servicing fees.
At December 31, 2003, the Company had pledged $4.4 billion of home equity-backed securities to secure repurchase agreements, and $546.9 million of mortgage-backed securities to secure Federal Home Loan Bank advances. Amortized cost and fair value of available-for-sale securities as of December 31, 2003 and December 31, 2002 are as follows:
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At December 31, 2003, the Company did not hold any securities classified as available-for-sale that had been in a continuous unrealized loss position for more than twelve months.
Gross gains and losses realized on the sales of available-for-sale securities are as follows:
Note 9 - Securitizations
The Company routinely originates, securitizes and sells mortgage loans into the secondary mortgage market. In general, prime mortgage loan securitizations are structured without recourse to the Company.
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However, the Company generally has limited recourse on the prime home equity and subprime mortgage loans it securitizes through retention of a subordinated interest or through a corporate guarantee of losses up to a negotiated maximum amount. While the Company generally does not retain credit risk on the prime mortgage loans it securitizes, it does have potential liability under representations and warranties it makes to purchasers and insurers of the loans. At December 31, 2003, the Company had a liability for losses relating to representations and warranties included in other liabilities totaling $90.7 million. The Company recognized gains of $5.5 billion from sales of mortgage loans in securitizations in the year ended December 31, 2003.
When the Company securitizes mortgage loans it generally retains the MSRs and, depending on the nature of the securitization, may also retain interest-only securities, principal-only securities and subordinated and residual interests.
MSRs arise from contractual agreements between the Company and investors (or their agents) in MBS and mortgage loans. The value of MSRs is derived from the net positive cash flows associated with the servicing contract. Under these contracts, the Company performs loan servicing functions in exchange for fees and other remuneration. The servicing functions typically performed include: collecting and remitting loan payments, responding to borrower inquiries, accounting for principal and interest, holding custodial (impound) funds for payment of property taxes and insurance premiums, counseling delinquent mortgagors, supervising foreclosures and property dispositions, and generally administering the loans. For performing these functions, the Company receives a servicing fee ranging generally from 0.25% to 0.50% annually on the remaining outstanding principal balances of the loans. The servicing fees are collected from the monthly payments made by the mortgagors. In addition, the Company generally receives other remuneration consisting of float benefits derived from collecting and remitting mortgage payments, as well as rights to various mortgagor-contracted fees such as late charges, reconveyance charges, and prepayment penalties. In addition, the Company generally has the right to solicit the mortgagors for other products and services, such as second mortgages and insurance, as well as a new first mortgage for those considering refinancing or purchasing a new home.
Considerable judgment is required to determine the fair values of our retained interests. Unlike government securities and other highly liquid investments, the precise market value of retained interests cannot be readily determined, because these assets are not actively traded in stand-alone markets.
The Company’s MSR valuation process combines the use of a sophisticated discounted cash flow model, extensive analysis of current market data, and senior financial management oversight to arrive at an estimate of fair value at each balance sheet date. The cash flow assumptions and prepayment assumptions used in the discounted cash flow model are based on the Company’s own empirical data drawn from the historical performance of its MSRs, which management believes are consistent with assumptions used by market participants valuing MSRs. The most critical assumptions used in the valuation of MSRs include mortgage prepayment speeds and the discount rate (projected LIBOR plus option-adjusted spread). These variables can and generally will change from quarter to quarter as market conditions and projected interest rates change. The Company determines the fairness of its MSR valuation quarterly by comparison to the following market data (as available): MSR trades; MSR broker valuations; prices of interest-only securities, and; peer group MSR valuation surveys.
For the other retained interests, the Company also estimates fair value through the use of discounted cash flow models. The key assumptions used in the valuation of its other retained interests include mortgage prepayment speeds, discount rates, and for residual interests containing credit risk, the net lifetime credit losses. (See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Credit Risk Management” section of this document for further discussion of credit risk). The Company has incorporated cash flow and prepayment assumptions based on its own empirical data drawn from the historical
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
performance of the loans underlying its other residual interests, which management believes are consistent with assumptions other major market participants would use in determining the assets’ fair value.
Key economic assumptions used in determining the fair value of MSRs at the time of securitization are as follows:
(1)
Option-adjusted spread over LIBOR.
Key economic assumptions used in determining the fair value of other retained interests at the time of securitization are as follows:
The following table summarizes cash flows between the Company and securitization special purpose entities:
(a)
Represents cash flows received on retained interests other than servicing fees.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Key economic assumptions used in subsequently measuring the fair value of the Company’s MSRs at December 31, 2003, 2002 and 2001, and the effect on the fair value of those MSRs from adverse changes in those assumptions, are as follows:
Key economic assumptions used in subsequently measuring the fair value of the Company’s other retained interests at December 31, 2003, 2002 and 2001, and the effect on the fair value of those other retained interests from adverse changes in those assumptions are as follows:
These sensitivities are hypothetical and should be used with caution. As the figures indicate, changes in fair value based on a 10% variation in individual assumptions generally cannot be extrapolated. Also, in the above tables, the effect of a variation in a particular assumption on the fair value of the retained interest is calculated independently without changing any other assumption. In reality, changes in one factor may result in changes in another which might magnify or counteract the sensitivities.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table presents information about delinquencies and components of prime home equity and subprime loans for which the Company has retained some level of credit risk:
The Company incurred credit losses of $95.5 million and $90.1 million related to the mortgage loans above during the years ended December 31, 2003 and 2002, respectively.
Note 10 -
Financial Instruments
Derivative Financial Instruments
The primary market risk facing the Company is interest rate risk. The most predominate type of interest rate risk at Countrywide is price risk, which is the risk that the value of our assets or liabilities will change due to changes in interest rates. To a lesser extent, interest rate risk also includes the risk that the net interest income from our mortgage loan and investment portfolios will change in response to changes in interest rates. From an enterprise perspective, the Company manages this risk through the natural counterbalance of its loan production and servicing businesses along with various financial instruments, including derivatives, which are used to manage the interest rate risk related specifically to its committed pipeline, mortgage loan inventory and MBS held for sale, MSRs, trading securities and other retained interests, as well as a portion of its debt. The overall objective of the Company’s interest rate risk management activities is to reduce the variability of earnings caused by changes in interest rates.
Risk Management Activities Related to Mortgage Loan Inventory and Committed Pipeline
Description of Risk Management Activities
The Company is exposed to price risk relative to its Mortgage Loan Inventory and its Committed Pipeline. The Mortgage Loan Inventory is comprised of mortgage loans and MBS held by the Company pending sale. The Mortgage Loan Inventory is presently held on average 30 days. The Committed Pipeline is comprised of loan applications in process where the Company has provided an interest rate lock commitment (“IRLC”). IRLCs guarantee the rate and points on the underlying mortgage for a specified period, generally from seven to sixty days.
The Company is exposed to price risk from the time an IRLC is made to a mortgage applicant (or financial intermediary) to the time the related mortgage loan is sold. During this period, the Company is exposed to losses if mortgage rates rise, because the value of the IRLC or mortgage loan declines. To manage this price risk the Company utilizes derivatives, primarily forward sales of MBS and options to buy and sell MBS, as well as options on Treasury futures contracts. Certain of these transactions qualify as “fair value” hedges under SFAS 133. (See the following section titled “Accounting for Risk Management Activities” for further discussion.)
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The price risk management of the Committed Pipeline is complicated by the fact that the ultimate percentage of applications that close within the terms of the IRLC is variable. The probability that the loan will fund within the terms of the IRLC is driven by a number of factors, in particular the change, if any, in mortgage rates subsequent to the lock date. In general, the probability increases if mortgage rates rise, and decreases if mortgage rates fall. This is due primarily to the relative attractiveness of current mortgage rates compared to the applicant’s committed rate. The probability that a loan will fund within the terms of the IRLC is also influenced by the source of the application, age of the application, purpose for the loan (purchase or refinance), and the application approval rate. The Company has developed closing ratio estimates using its historical data that take into account all of these variables, as well as renegotiations of rate and point commitments that tend to occur when mortgage rates fall. The closing ratio estimates are utilized to estimate the quantity of loans that will fund within the terms of IRLCs.
To manage the price risk associated with the Committed Pipeline, the Company uses a combination of net forward sales of MBS and put and call options on MBS or Treasury futures. As a general rule, the Company enters into forward sales of MBS in an amount equal to the portion of the Committed Pipeline expected to close, assuming no change in mortgage rates. The Company acquires put and call options to protect against the variability of loan closings caused by changes in mortgage rates, by using the current closing ratio estimates to determine the amount of optional coverage required.
The Company manages the price risk related to the Mortgage Loan Inventory primarily by entering into forward sales of MBS. The value of these forward sales moves in opposite direction to the value of the Mortgage Loan Inventory. The Company reviews its Committed Pipeline and Mortgage Inventory risk profiles on a daily basis.
The Company uses the following derivative instruments in its risk management activities related to the Committed Pipeline and Mortgage Loan Inventory:
•
Forward Sales of MBS: represents an obligation to sell a MBS at a specific price in the future; therefore, its value increases as mortgage rates rise.
•
Forward Purchases of MBS: represents an obligation to buy a MBS at a specific price in the future; therefore, its value increases as mortgage rates fall.
•
Long Call Options on MBS: represents a right to buy a MBS at a specific price in the future; therefore, its value increases as mortgage rates fall.
•
Long Put Options on MBS: represents a right to sell a MBS at a specific price in the future; therefore, its value increases as mortgage rates rise.
•
Long Call Options on Treasury Futures: represents a right to acquire a Treasury futures contract at a specific price in the future; therefore, its value increases as the benchmark Treasury rate falls.
•
Long Put Options on Treasury Futures: represents a right to sell a Treasury futures contract at a specific price in the future; therefore, its value increases as the benchmark Treasury rate rises.
•
Short Eurodollar Futures Contracts: represents standardized exchange-traded contracts, the value of which is tied to spot Eurodollar rates at specified future dates. The value of these futures contracts increases when Eurodollar rates rise.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table summarizes the balance or notional amounts, as applicable, of Mortgage Loan Inventory, Committed Pipeline and the related derivatives instruments at December 31, 2003.
Accounting for Risk Management Activities
In general, the risk management activities connected with 80% or more of the fixed rate Mortgage Inventory has qualified as a “fair value” hedge under SFAS 133. The Company recognized pre-tax losses of $72.8 million and $2.4 million, representing the ineffective portion of such fair value hedges of Mortgage Inventory, for the years ended December 31, 2003 and 2002, respectively. This amount along with the change in the fair value of the derivative instruments that were not designated as hedge instruments under SFAS 133 are included in gain on sale of loans in the consolidated statements of earnings. The derivative instruments that did not qualify as hedges under SFAS 133 were primarily those used to manage the price risk related to a portion of the Company’s adjustable rate and non-conforming mortgage inventory.
IRLCs are derivative instruments as defined by SFAS 133. As such, IRLCs are recorded at fair value with changes in fair value recognized in current period earnings (as a component of gain on sale of loans). The Company estimates the fair value of an IRLC based on the change in estimated fair value of the underlying mortgage loan and the probability that the mortgage loan will fund within the terms of the IRLC. The change in fair value of the underlying mortgage loan is based upon quoted MBS prices. The change in fair value of the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
underlying mortgage loan is measured from the lock date. Therefore, at the time of issuance the estimated fair value of an IRLC is zero. (Subsequent to issuance, the value of an IRLC can be either positive or negative, depending on the change in value of the underlying mortgage loan.) Closing ratios derived from the Company’s recent historical empirical data are utilized to estimate the quantity of mortgage loans that will fund within the terms of the IRLCs. Because IRLCs are derivatives under SFAS 133, the associated risk management activities of the Committed Pipeline do not qualify for hedge accounting under SFAS 133. The “freestanding” derivative instruments that are used to manage the price risk in the Committed Pipeline are marked to fair value and recorded as a component of gain on sale of loans in the statement of earnings.
Risk Management Activities Related to Mortgage Servicing Rights (MSRs) and Other Retained Interests
Description of Risk Management Activities
MSRs and other retained interests, specifically interest-only securities and residual securities, are generally subject to a loss in value when mortgage interest rates decline. MSRs and other retained interests represent the present value of cash flow streams that are closely linked to the expected life of the underlying loan servicing portfolio. Declining mortgage interest rates generally precipitate increased mortgage refinancing activity, which decreases the expected life of the loans in the servicing portfolio, thereby decreasing the value of the MSRs and other retained interests. Reductions in the value of these assets impacts earnings through impairment charges. To moderate the effect on earnings of impairment, the Company maintains a portfolio of financial instruments, including derivatives, which increase in aggregate value when interest rates decline. This portfolio of financial instruments is collectively referred to herein as the “Servicing Hedge”. A portion of the Servicing Hedge has in the past qualified as a “fair value” hedge under SFAS 133 (see the following section titled “Accounting for Risk Management Activities” for further discussion).
The Company currently uses the following financial instruments in its Servicing Hedge:
•
Interest Rate Floors: represents a right to receive cash if a reference interest rate falls below a contractual strike rate; therefore, its value increases as the reference interest rate falls. The reference interest rates used in the Company’s interest rate floors include mortgage rates, Treasury rates, and U.S. dollar (“USD”) LIBOR.
•
U.S. Treasury Securities: consists of notes and bonds with maturities ranging generally from ten to thirty years. As interest rates decrease, the values of these securities generally increase.
•
Long Treasury Futures: represent the agreement to purchase a treasury security at a specific price in the future; therefore, its value increases as the benchmark Treasury rate falls.
•
Long Call Options on Treasury and Eurodollar Futures: represents a right to acquire a Treasury or Eurodollar futures contract at a specific price in the future; therefore, its value increases as the benchmark Treasury or Eurodollar deposit rate falls.
•
Long Put Options on Treasury and Eurodollar Futures: represents a right to sell a Treasury or Eurodollar futures contract at a specific price in the future; therefore, its value increases as the benchmark Treasury or Eurodollar deposit rate rises.
•
Long Call Options on MBS: represents a right to buy an MBS at a specific price in the future; therefore, its value increases as mortgage rates decline.
•
Forward Purchases of MBS: represents an obligation to buy a MBS at a specific price in the future; therefore, its value increases as mortgage rates fall.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
•
Interest Rate Swaps: represents a mutual agreement to exchange interest rate payments; one party paying a fixed rate and another paying a floating rate tied to a reference interest rate (e.g., USD LIBOR). For use in the Servicing Hedge, the Company generally receives the fixed rate and pays the floating rate; therefore, the contract increases in value as interest rates decline.
•
Receiver Swaptions: represents a right to enter into a predetermined Interest Rate Swap at a future date in which, upon exercise of its right, the Company receives the fixed rate and pays the floating rate; therefore, the contract increases in value as interest rates decline.
•
Payor Swaptions: represents a right to enter into a predetermined Interest Rate Swap at a future date in which, upon exercise of its right, the Company pays the fixed rate and receives the floating rate; therefore, the contract generally increases in value as interest rates rise.
•
Principal-Only Securities: consist of mortgage trust principal-only securities and Treasury principal-only securities (“Strips”). These securities have been purchased at discounts to their par value. As interest rates decrease, the values of these securities generally increase.
These instruments are used in tandem to manage the overall risk portfolio of the MSRs and other retained interests. The Company reviews its retained interests risk profile on a daily basis.
The following table summarizes the notional amounts of derivative contracts included in the Servicing Hedge.
The Servicing Hedge is intended to reduce the impact on reported earnings of MSRs and other retained interest impairment that generally results from a decline in mortgage rates. Should mortgage rates increase the value of the MSRs and other retained interests are expected to increase while the value of the Servicing Hedge is expected to decrease. With respect to the various options and floors included in the Servicing Hedge, the Company is not exposed to loss beyond its initial outlay to acquire these derivative instruments, plus any unrealized gains recognized to date. With respect to the interest rate swap contracts and interest rate futures contracts included in the Servicing Hedge as of December 31, 2003, the Company estimates that its maximum exposure to loss over the contractual terms is $1.1 billion and $452 million, respectively.
Accounting for Risk Management Activities
The changes in fair value of derivative contracts included in the Servicing Hedge are recorded as a component of the gain or loss from the Servicing Hedge in the statement of earnings. Principal-only and U.S. Treasury securities included in the Servicing Hedge are held as available-for-sale securities. The changes in fair value of such securities included in the Servicing Hedge are recorded in accumulated other comprehensive income. Realized gains or losses on sales of these securities are recorded as a component of the gain or loss from the Servicing Hedge in the statement of earnings.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
During the nine months ended November 30, 2001, a portion of the Servicing Hedge qualified as a “fair value” hedge under SFAS 133. At no other time has any portion of the Servicing Hedge qualified as a hedge under SFAS 133.
In a “fair value” hedge under SFAS 133, the cost basis of the MSRs is adjusted for the change in fair value of the MSRs attributable to the hedged risk, with a corresponding amount included as a component of impairment or recovery of retained interests in the statement of earnings.
The following table summarizes the change in fair value of the MSRs and the related derivative instruments that qualified for hedge accounting under SFAS 133 for the nine months ended November 30, 2001.
The Company recognized in earnings for the ten months ended December 31, 2001 a gain of $14.3 million, which represents the amount of hedge ineffectiveness for the portion of the Servicing Hedge that qualified as a “fair value” hedge under SFAS 133. There was no portion of the related hedge instruments’ gain or loss that was excluded from the assessment of hedge effectiveness.
Risk Management Activities Related to Issuance of Long-Term Debt
The Company enters into interest rate swap contracts which enable it to convert a portion of its fixed-rate, long-term debt to U.S. dollar LIBOR-based floating-rate debt (notional amount of $1.2 billion) and to enable the Company to convert a portion of its foreign currency-denominated fixed-rate, long-term debt to U.S. dollar LIBOR-based floating-rate debt (notional amount of $96.4 million). These transactions are designed as fair value hedges under SFAS 133. For the years ended December 31, 2003 and 2002, the Company recognized a pre-tax gain of $0.02 million and $3.1 million, representing the ineffective portion of such fair value hedges of debt. This amount is included in interest charges in the statement of earnings.
The Company also enters into interest rate swap contracts which enable it to convert a portion of its floating-rate, long-term debt to fixed-rate, long-term debt (notional amount of $779.9 million) and to convert a portion of its foreign currency-denominated, fixed-rate, long-term debt to U.S. dollar fixed-rate debt (notional amount of $1.2 billion). These transactions are designed as cash flow hedges under SFAS 133. For the years ended December 31, 2003 and 2002, the Company recognized a pre-tax loss of $0.05 million and $0.5 million, representing the ineffective portion of such cash flow hedges. As of December 31, 2003, deferred net gains or losses on derivative instruments included in other comprehensive income that are expected to be reclassified as earnings during the next 12 months are not considered to be material.
Payments on interest rate swaps are based on a specified notional amount. In connection with the debt fair value hedges, the Company has entered into swaps in which the rate received is fixed and the rate paid is adjustable and is indexed to LIBOR (“Receiver Swap”). In connection with the debt cash flow hedges, the Company has entered into swaps in which the rate paid is fixed and the rate received is adjustable and is indexed to LIBOR (“Payer Swap”).
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following summarizes the notional amounts of and the average interest rates on the swaps as of December 31, 2003:
Payments are due periodically through the termination date of each contract. The contracts expire between March, 2004 and June, 2027.
Risk Management Activities Related to the Broker-Dealer Securities Trading Portfolio
In connection with its broker-dealer activities, the Company maintains a trading portfolio of fixed income securities, primarily MBS. The Company is exposed to price changes in its trading portfolio arising from interest rate changes during the period it holds the securities. To manage this risk, the Company utilizes the following derivative instruments:
•
Forward Sales of To-Be Announced (“TBA”) MBS: represents an obligation to sell agency pass-through MBS that has not yet been issued at a specific price and at a specific date in the future; therefore, its value increases as mortgage rates rise.
•
Forward Purchases of TBA MBS: represents an obligation to purchase agency pass-through MBS that have not yet been issued at a specific price at a specific date in the future; therefore, its value increases as mortgage rates fall.
•
Forward Sale of U.S. Treasury Securities: represents a standardized exchange-traded agreement to sell a specific quantity of U.S. Treasury securities for a specific price at a specific date in the future; therefore, its value increases when interest rates rise.
•
Short Fed Funds and Eurodollar Futures Contracts: represents a standardized exchange-traded contract, the value of which is tied to spot Fed Funds or Eurodollar rates at specified future dates. The value of these contracts increases when Fed Funds or Eurodollar rates rise.
•
Interest Rate Swaps: represents a mutual agreement to exchange interest rate payments; one party paying a fixed rate and another paying a floating rate tied to a reference interest rate (e.g. USD LIBOR). For use in its trading portfolio risk management activities, the Company receives the floating rate and pays the fixed rate; therefore, its value increases as rates rise.
The following summarizes the notional amounts of the derivative contracts included in broker-dealer’s trading portfolio, at December 31, 2003:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Fair Value of Financial Instruments
The following disclosure of the estimated fair value of financial instruments as of December 31, 2003 and 2002 is made by the Company using available market information and appropriate valuation methods. In some cases considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methods may have a material effect on the estimated fair value amounts.
The fair value estimates as of December 31, 2003 and 2002 were based on pertinent information that was available to management as of the respective dates. Although management is not aware of any factors that
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since those dates and, therefore, current estimates of fair value may differ significantly from the amounts presented herein.
The following describes the methods used by the Company in estimating fair values:
Mortgage Loans and Mortgage-Backed Securities Held for Sale
Fair value is estimated using the quoted market prices for securities backed by similar types of loans and dealer commitments to purchase loans on a servicing-retained basis.
Trading Securities
Fair value is estimated using quoted market prices.
Securities Purchased Under Agreements to Resell
These financial instruments are recorded at accreted cost, which approximates fair value.
Loans Held for Investment
Fair value is estimated through the use of discounted cash flow models. Re-warehoused FHA-insured and VA-guaranteed loans and warehouse lending advances are recorded at realizable value, which approximates fair value.
Investments in Other Financial Instruments:
Principal-Only-Securities
Fair value is estimated through the use of a proprietary, “static” (single rate path) discounted cash flow model. The Company has incorporated mortgage prepayment assumptions in its valuation model that it believes other major market participants would consider in deriving the fair value of principal-only securities.
Other Interests Retained in Securitization
Fair value is estimated through the use of proprietary, “static” (single rate path) discounted cash flow models. The Company has incorporated mortgage prepayment and credit loss assumptions in its valuation models that it believes other major market participants would consider in deriving the fair value of its retained interests.
Mortgage-Backed Securities
Fair value is estimated using quoted market prices.
Collateralized Mortgage Obligations
Fair value is estimated using quoted market prices.
U.S. Treasury Securities and Obligations of U.S. Government Corporations and Agencies
Fair value is estimated using quoted market prices.
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Other Financial Instruments
Other financial instruments are primarily composed of tax-exempt municipal bonds, asset-backed securities, and foreign government bonds. Fair value is estimated using quoted market prices.
Notes Payable
Fair value is estimated by discounting remaining payments using applicable current market rates.
Securities Sold Under Agreements to Repurchase
These financial instruments are recorded at their accreted balances which approximate fair value.
Securities Sold Not Yet Purchased
Fair value is estimated using quoted market prices.
Deposit Liabilities
The fair value for the checking account liability is equal to the amount payable on demand at the reporting date. (This value is also the carrying amount.) The fair value of money market accounts and certificates of deposit is estimated using a discounted cash flow calculation that applies interest rates currently being offered on similar accounts.
Corporate Guarantees
Fair value is estimated through the use of a proprietary two part loss model: a loan-level frequency model estimated with survival analysis, and a loan-level severity model estimated with multiple least square regressions. The modeling process incorporates the use of relevant risk factors.
Company Obligated Mandatorily Redeemable Capital Trust Pass-Through Securities
Fair value is estimated as the present value of future contracted cash flows based upon current market prices for U.S. Treasury notes of similar characteristics adjusted for the estimated credit premium or discount for the Company.
Derivatives
Fair value is defined as the amount that the Company would receive or pay to terminate the contracts at the reporting date. Market or dealer quotes are available for many derivatives; otherwise, pricing or valuation models are applied using current market information to estimate fair value. The Company estimates the fair value of an IRLC based on the change in estimated fair value of the underlying mortgage loan and the probability that the mortgage loan will fund within the terms of the IRLC. The change in fair value of the underlying mortgage loan is based upon quoted MBS prices. The change in fair value of the underlying mortgage loan is measured from the lock date. Therefore, at the time of issuance the estimated fair value of an IRLC is zero (Subsequent to issuance, the value of an IRLC can be either positive or negative depending on the change in value of the underlying mortgage loan.) Closing ratios derived using the Company’s recent historical empirical data are utilized to estimate the quantity of mortgage loans that will fund within the terms of the IRLCs.
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Counterparty Credit Risk
The Company is exposed to credit loss in the event of non-performance by its trading counterparties and counterparties to its various over-the-counter (non-exchange-traded) financial instruments. The Company manages this credit risk by selecting only well-established, financially strong counterparties, spreading the credit risk among many such counterparties, and by placing contractual limits on the amount of unsecured credit risk from any single counterparty. The Company’s exposure to credit risk in the event of default by a counterparty is the current cost of replacing the contracts, net of any available collateral retained by the Company.
The total amount of counterparty credit exposure as of December 31, 2003, before and after applicable collateral held, is as follows:
Note 11 -
Property, Equipment and Leasehold Improvements
Property, equipment and leasehold improvements consist of the following:
Depreciation and amortization expense amounted to $82.1 million, $41.2 million and $45.7 million for the years ended December 31, 2003, 2002 and the ten months ended December 31, 2001, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 12 - Loans Held for Investment and Allowance for Loan Losses
Loans held for investment as of December 31, 2003 and 2002 include the following:
At December 31, 2003, mortgage loans held for investment totaling $5.5 billion and $9.8 billion were pledged to secure securities sold under agreements to repurchase and Federal Home Loan Bank advances, respectively.
At December 31, 2003, the Company had accepted collateral with a fair value of $2.0 billion securing warehouse lending advances for which it had the contractual ability to sell or re-pledge. As of December 31, 2003, no such mortgage loan collateral had been re-pledged.
Total allowance for loan losses as of December 31, 2003 and December 31, 2002 are $78.4 million and $42.0 million, respectively.
Changes in the allowance for the loan losses were as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 13 - Other Assets
Other assets as of December 31, 2003 and 2002 include the following:
At December 31, 2003, the Company had pledged $609.7 million of other assets to secure repurchase agreements, of which the counterparty has the right to sell or re-pledge the entire amount.
Note 14 -
Notes Payable
Notes payable as of December 31, 2003 and 2002 consists of the following:
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Medium-Term Notes
As of December 31, 2003, outstanding medium-term notes issued by Countrywide Home Loans (“CHL”) under various shelf registrations filed with the Securities and Exchange Commission or issued by CHL under its Euro medium-term note program were as follows:
As of December 31, 2003, $1.3 billion of foreign currency-denominated medium-term notes were outstanding. Such notes are denominated in Yen, Deutsche Marks, French Francs, Portuguese Escudos and Euros. These notes have been effectively converted to U.S. dollars through currency swaps.
Asset-Backed Commercial Paper
In April 2003, the Company formed a wholly-owned special purpose entity for the purpose of issuing commercial paper in the form of short-term secured liquidity notes (“SLNs”) to finance certain of its Mortgage Loan Inventory. The entity issues short-term notes with maturities of up to 180 days, extendable to 300 days. The SLNs bear interest at prevailing money market rates approximating LIBOR. The SLN program’s capacity, based on aggregate commitments from underlying credit enhancers, was $18.2 billion at December 31, 2003. The Company has pledged $10.0 billion in mortgage loans to secure the asset-backed commercial paper. For the year ended December 31, 2003, the average borrowings under this facility totaled $7.9 billion, and the weighted average interest rate borne by the commercial paper was 1.18%. At December 31, 2003, the weighted average interest rate borne by the commercial paper was 1.16%.
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Federal Home Loan Bank Advances
As of December 31, 2003, outstanding advances from the Federal Home Loan Bank were as follows:
All of the advances have fixed interest rates. The advances are secured by $10.3 billion of mortgage loans.
Convertible Debentures
The Company has issued zero-coupon Liquid Yield Option Notes (“LYONs”), with an aggregate face value of $675 million, or $1,000 per note, due upon maturity on February 8, 2031. The LYONs were issued at a discount to yield 1.0% to maturity, or 8.25% to the first call date. The LYONs are senior indebtedness of the Company.
Holders of LYONs may require the Company to repurchase all or a portion of their LYONs at the original issue price plus accrued original issue discount on the following dates.
The Company may pay the purchase price in cash, common stock or a combination thereof.
Beginning on February 8, 2006 and on any date thereafter, the Company may redeem the LYONs at the original issue price plus accrued original issue discount.
Holders of LYONs may surrender LYONs for conversion into 15.43 shares of the Company’s common stock per LYON in any calendar quarter, if, as of the last day of the preceding calendar quarter, the closing sale price of the Company’s common stock, for at least 20 trading days in a period of 30 consecutive trading days ending on the last trading day of such preceding calendar quarter, is more than a specified percentage, beginning at 135% and declining 0.21% per quarter thereafter, of the accreted conversion price per share of common stock on the last day of trading of such preceding calendar quarter (the “Contingent Conversion Stock Price”.) The accreted conversion price per share is equal to the original issue price of a LYON plus the accrued original issue discount, with that sum divided by the number of shares to be issued upon a conversion of a LYON. The Contingent Conversion Stock Price at December 31, 2003 was $87.44 per share. At December 31, 2003, the LYONs conversion contingency had been met, making the notes convertible during
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
the first quarter of 2004. Convertibility of the LYONs in subsequent quarters will depend on the Company’s future stock price performance.
Holders may also surrender a LYON for conversion during any period in which the credit rating assigned to the LYONs by either Moody’s or Standard & Poor’s falls below investment grade level.
Maturities of Notes Payable
Maturities of notes payable are as follows:
Commercial Paper and Backup Credit Facilities
As of December 31, 2003, CHL had unsecured credit agreements (revolving credit facilities) with a group of commercial banks permitting CHL to borrow an aggregate maximum amount of $5.5 billion. The composition of the facilities was as follows:
As consideration for these facilities, CHL pays annual commitment fees of $4.9 million. The purpose of these credit facilities is to provide liquidity backup for CHL’s commercial paper program. No amount was outstanding under these revolving credit facilities at December 31, 2003. All of the facilities contain various financial covenants and restrictions, certain of which require the Company and CHL to maintain specified net worth amounts and that limit the amount of dividends that can be paid by the Company or CHL. Management believes the Company is in compliance with those covenants and restrictions. For the year ended December 31, 2003, the average commercial paper outstanding was $2.1 billion and the weighted average borrowing rate was 1.22%.
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Pre-Sale Funding Facilities
As of December 31, 2003, CHL had uncommitted revolving credit facilities that are secured by conforming mortgage loans held for sale. As of December 31, 2003, the Company had no outstanding borrowings under any of these facilities.
Note 15 - Deposits
Deposits as of December 31, 2003 and 2002 include the following:
The total of time certificates of deposit and other time deposits issued and outstanding were $3.3 billion and $793 million at December 31, 2003 and 2002, respectively. Substantially all of those deposits were interest bearing. The contractual maturities of those deposits are shown in the following table.
The amount of time deposits with a denomination of $100,000 or more was approximately $1.7 billion and $295 million at December 31, 2003 and 2002, respectively.
The contractual maturities of time deposits with denominations of $100,000 or more are shown in the following table.
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There were no demand deposit overdrafts at December 31, 2003 and 2002.
Note 16 - Committed Reusable Purchase Facilities
As of December 31, 2003, the Company had in place a reusable $4.0 billion commitment from a multi-seller asset-backed commercial paper conduit to purchase conventional, conforming loans held for sale from the Company. As consideration for the facility, CHL pays annual commitment fees of $5.0 million.
This multi-seller commercial paper conduit was established and is owned by several major, third-party financial institutions. Using funds raised through with the issuance of commercial paper, these conduits purchase residential mortgage loans from the Company, either directly or through a trust or other vehicle. The Company has no obligation to repurchase loans from this conduit other than for breach of representations and warranties made by the Company in connection with the sale of the loans. The Company has no direct or indirect financial ownership or other interest in the conduit. Accordingly, transfers of loans to this facility are accounted for as sales.
Note 17 -
Securities Sold Under Agreements to Repurchase
The Company routinely enters short-term financing arrangements to sell securities under agreements to repurchase. The repurchase agreements are collateralized by mortgage loans and securities. All securities underlying repurchase agreements are held in safekeeping by broker-dealers or banks. All agreements are to repurchase the same, or substantially identical, securities.
The weighted-average borrowing rate for these arrangements for the year ended December 31, 2003 was 1.15%. The weighted average borrowing rate on repurchase agreements outstanding as of December 31, 2003 was 1.24%. The repurchase agreements had a weighted-average maturity of two days at December 31, 2003. At December 31, 2003, repurchase agreements were secured by $2.5 billion of loans held for sale and MBS held for sale, $10.0 billion of trading securities, $11.2 billion of securities purchased under agreements to resell, $4.4 billion in investments in other financial instruments, and $5.5 billion of loans held for investment.
Note 18 -
Company-obligated Capital Securities of Subsidiary Trusts
Countrywide Capital I (the “Subsidiary Trust I”), a subsidiary trust of the Company, has outstanding $300 million of 8% Capital Trust Pass-through Securities (the “8% Capital Securities”). In connection with the Subsidiary Trust I issuance of the 8% Capital Securities, CHL issued to the Subsidiary Trust I, $309 million of its 8% Junior Subordinated Deferrable Interest Debentures (the “Subordinated Debt Securities I”). The Subordinated Debt Securities I are due on December 15, 2026, with interest payable semi-annually on June 15 and December 15 of each year. The Company has the right to redeem at par, plus accrued interest, the 8% Capital Securities at any time on or after December 15, 2006. The sole assets of the Subsidiary Trust I are, and will be, the Subordinated Debt Securities I.
Countrywide Capital III (the “Subsidiary Trust III”), a subsidiary trust of the Company, has outstanding $200 million of 8.05% Subordinated Capital Income Securities, Series A (the “8.05% Capital Securities”). In connection with the Subsidiary Trust III issuance of 8.05% Capital Securities, CHL issued to the Subsidiary Trust III, $206 million of its 8.05% Junior Subordinated Deferrable Interest Debentures (the “Subordinated Debt Securities III”). The Subordinated Debt Securities III are due on June 15, 2027 with interest payable semi-annually on June 15 and December 15 of each year. The sole assets of the Subsidiary Trust III are, and will be, the Subordinated Debt Securities III.
In April 2003, Countrywide Capital IV (the “Subsidiary Trust IV”), a subsidiary trust of the Company, issued $500 million of 6.75% preferred securities, which are fully and unconditionally guaranteed by the Company and CHL (the “6.75% Securities”). In connection with the issuance by Countrywide Capital IV of
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the 6.75% Securities, the Company issued to Countrywide Capital IV $500 million of its 6.75% Junior Subordinated Debentures, which are fully and unconditionally guaranteed by CHL (the “Subordinated Debentures”). Countrywide Capital IV exists for the sole purpose of issuing the 6.75% Securities and investing the proceeds in the Subordinated Debentures. The Subordinated Debentures are due on April 1, 2033, with interest payable quarterly on January 1, April 1, July 1 and October 1 of each year. The Company has the right to redeem, at 100% of their principal amount plus accrued and unpaid interest to the date of redemption, the 6.75% Securities at any time on or after April 11, 2008.
In relation to Subsidiary Trusts I and III, the Company has the right to defer payment of interest by extending the interest payment period, from time to time, for up to 10 consecutive semi-annual periods. If interest payments on the debentures are so deferred, the Company may not declare or pay dividends on, or make a distribution with respect to, or redeem, purchase or acquire, or make a liquidation payment with respect to, any of its capital stock.
In relation to Subsidiary Trust IV, the Company has the right to defer payment of interest on the Subordinated Debentures for up to 20 consecutive quarterly periods by extending the payment period. If interest payments on the Subordinated Debentures are so deferred, the company may not, among other things, declare or pay dividends on, or make a distribution with the respect to, or redeem, purchase or acquire, or make a liquidation payment with respect to, any of its capital stock.
Note 19 - Shareholders’ Equity
In January 2000, the Company entered a three-year equity put option agreement with National Indemnity Company (“National Indemnity”), a property and casualty insurance company, which is a subsidiary of Berkshire Hathaway, Inc. The Company terminated the put option agreement on January 2, 2002, and paid a termination fee of $0.2 million.
In February 1988, the Board of Directors of the Company declared a dividend distribution of one preferred stock purchase right (“Right”) for each outstanding share of the Company’s common stock. As a result of stock splits and stock dividends, 0.399 of a Right is presently associated with each outstanding share of the Company’s common stock issued before the Distribution Date (as defined below). Each Right, when exercisable, entitles the holder to purchase from the Company one one-hundredth of a share of Series A Participating Preferred Stock, par value $.05 per share, of the Company (the “Series A Preferred Stock”), at a price of $145, subject to adjustments in certain cases to prevent dilution.
The Rights are evidenced by the common stock certificates and are not exercisable or transferable, apart from the common stock, until the date (the “Distribution Date”) of the earlier of a public announcement that a person or group, without prior consent of the Company, has acquired 20% or more of the common stock (“Acquiring Person”), or ten days (subject to extension by the Board of Directors) after the commencement of a tender offer made without the prior consent of the Company.
In the event a person becomes an Acquiring Person, then each Right (other than those owned by the Acquiring Person) will entitle its holder to purchase, at the then current exercise price of the Right, that number of shares of common stock, or the equivalent thereof, of the Company, which at the time of such transaction, would have a market value of two times the exercise price of the Right. The Board of Directors of the Company may delay the exercise of the Rights during the period in which they are exercisable only for Series A Preferred Stock (and not common stock).
In the event that, after a person has become an Acquiring Person, the Company is acquired in a merger or other business combination, as defined for the purposes of the Rights, each Right (other than those held by the Acquiring Person) will entitle its holder to purchase, at the then current exercise price of the Right, that number of shares of common stock, or the equivalent thereof, of the other party (or publicly-traded parent
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thereof) to such merger or business combination which at the time of such transaction would have a market value of two times the exercise price of the Right. In November 2001, the Company extended the life of the Rights to February 10, 2012.
On October 23, 2003, the Company also declared a 4-for-3 split of the Company’s $0.05 par value common stock, effected as a stock dividend payable on December 18, 2003 to shareholders of record on December 2, 2003. As a result of the split, approximately 46.1 million additional shares were issued. All references in the accompanying consolidated balance sheets, consolidated statements of earnings, and notes to consolidated financial statements to the number of common shares and earnings per share amounts have been restated to reflect the stock split.
Note 20 - Employee Benefits
Stock Option Plans
The Company has stock option plans (the “Plans”) that provide for the granting of both qualified and non-qualified options and shares of restricted stock to employees and directors. Options are generally granted at the average market price of the Company’s common stock on the date of grant and are exercisable beginning one year from the date of grant and expire up to ten years from the date of grant. Options vest over a period of three to four years.
Stock option transactions under the Plans were as follows:
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Status of the outstanding stock options under the Plans as of December 31, 2003 was as follows:
Pension Plan
The Company has a defined benefit pension plan (the “Plan”) covering substantially all of its employees. The Company’s policy is to contribute the amount actuarially determined to be necessary to pay the benefits under the Plan, and in no event to pay less than the amount necessary to meet the minimum funding standards of ERISA. In the year ended December 31, 2003, the Company made the maximum tax-deductible contribution to the Plan.
In the year ended December 31, 2003, the Company changed certain of its actuarial assumptions. Specifically, the discount rate was lowered from 6.5% to 6.0%. This change resulted in an increase of $11.0 million to the accumulated benefit obligation at December 31, 2003. In the ten-month period ended December 31, 2001, the Company amended the Plan to include employee sales commissions in the calculation of benefit obligations, resulting in an additional plan obligation of $4.2 million at December 31, 2001. The following plan information was measured as of December 31, 2003.
The following table sets forth the Plan’s funded status and amounts recognized in the Company’s financial statements.
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The accumulated benefit obligation for all defined benefit pension plans was $108 million and $68 million at December 31, 2003 and 2002.
The following table sets forth the components of net periodic benefit cost for the years ended December 31, 2003 and 2002 and the ten-month period ended December 31, 2001.
The weighted-average assumptions used in calculating the amounts above for the years ended December 31, 2003 and 2002 were as follows:
Pension expense for the years ended December 31, 2003 and 2002 and the ten-month period ended December 31, 2001 was $41.9 million, $20.0 million and $11.0 million, respectively. The Company makes contributions to the Plan in amounts that are deductible in accordance with federal income tax regulations.
The Company reviews historical rates of return for equity and fixed income securities, as well as current economic conditions, to determine the expected long term rate of return on plan assets. The plan’s total portfolio is currently estimated to return 6.0% above the rate of inflation over the long term. The assumed rate
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of return is based on 70% of the portfolio being invested in equities yielding a 7% real return, and the remaining 30% of assets being invested in fixed income securities yielding a 3.8% real return. Consideration is given to diversification and periodic rebalancing of the portfolio based on prevailing market conditions.
The Company’s pension plan weighted-average asset allocations at December 31, 2003 and 2002, by asset category are as follows:
The Company’s pension trust assets are invested with a long term focus to achieve a return on investment that is based on levels of liquidity and investment risk that management believes are prudent and reasonable. The investment portfolio contains a diversified blend of equity and fixed income investments. The equity investments are diversified across U.S. and non-U.S. equities, as well as value, growth, and medium and large capitalizations. The portfolio’s asset mix is reviewed regularly, and the portfolio is rebalanced based on existing market conditions. Investment risk is measured and monitored on a regular basis through quarterly portfolio reviews, annual liability measurements and periodic asset/liability analyses.
The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid:
Defined Contribution Plan
The Company has a defined contribution plan (“401(k) Plan”) covering all full-time employees of the Company who have at least one year of service and are age 21 or older. Participants may contribute up to 16 percent of pre-tax annual compensation, as defined in the plan agreement. Participants may also contribute, at the discretion of the plan administrator, amounts representing distributions from other qualified defined benefit or contribution plans. The Company makes a discretionary matching contribution equal to 50 percent of the participant contributions up to a maximum contribution of 6 percent of the participants’ base compensation, as defined in the plan agreement. The 401(k) Plan is subject to the provisions of ERISA. The Company recorded $21.0 million, $14.6 million, and $8.7 million in expense for matching contributions for the years ended December 31, 2003 and 2002 and the ten months ended December 31, 2001, respectively.
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Note 21 -
Income Taxes
Components of the provision for income taxes are as follows:
The following is a reconciliation of the statutory federal income tax rate to the effective income tax rate as reflected in the consolidated statements of earnings:
The components of income taxes payable are as follows:
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The tax effects of temporary differences that gave rise to deferred income tax assets and liabilities are presented below:
Note 22 - Regulatory and Agency Capital Requirements
In connection with the acquisition of Treasury Bank, CFC became a bank holding company. As a result, the Company is subject to regulatory capital requirements imposed by the Board of Governors of the Federal Reserve. The Company is also subject to U.S. Department of Housing and Urban Development, Fannie Mae, and Freddie Mac and Government National Mortgage Association (“Ginnie Mae”) net worth requirements.
Regulatory capital is assessed for adequacy by three measures: Tier 1 Leverage Capital, Tier 1 Risk-Based Capital and Total Risk-Based Capital. Tier 1 Leverage Capital includes common shareholders’ equity, preferred stock and capital securities that meet certain guidelines detailed in the capital regulations, less goodwill, the portion of MSRs not includable in regulatory capital (generally, the carrying value of MSRs in excess of Tier 1 Capital, net of associated deferred taxes) and other adjustments. Tier 1 Leverage Capital is measured with respect to average assets during the quarter. The Company is required to have a Tier 1 Leverage Capital ratio of 4.0% to be considered adequately capitalized and 5.0% to be considered well capitalized.
The Tier 1 Risk-Based Capital ratio is calculated as a percent of risk-weighted assets at the end of the quarter. The Company is required to have a Tier 1 Risk-Based Capital ratio of 4.0% to be considered adequately capitalized and 6.0% to be considered well capitalized.
Total Risk-Based Capital includes preferred stock and capital securities excluded from Tier 1 Capital, mandatory convertible debt, and subordinated debt that meets certain regulatory criteria. The Total Risk-Based Capital ratio is calculated as a percent of risk-weighted assets at the end of the quarter. The Company is required to have a Total Risk-Based Capital ratio of 8.0% to be considered adequately capitalized and 10.0% to be considered well capitalized.
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The following table presents the actual capital ratios and amounts, and minimum required capital ratios for the Company to maintain a “well-capitalized” status by the Board of Governors of the Federal Reserve at December 31, 2003 and at December 31, 2002:
(1)
Minimum required to qualify as “well-capitalized.”
The Company and CHL are required to maintain specified levels of shareholders’ equity to remain a seller/servicer in good standing by Fannie Mae, Freddie Mac, the U.S. Department of Housing and Urban Development, and Ginnie Mae. Such equity requirements generally are tied to the size of CHL’s servicing portfolio. At December 31, 2003, the Company and CHL’s equity requirements for these agencies ranged up to $750 million. The Company had agency capital of $7.9 billion and CHL had agency capital ranging from $2.5 billion to $3.3 billion at December 31, 2003.
Note 23 - Segments and Related Information
The Company has five business segments which include: Mortgage Banking, Capital Markets, Banking, Insurance, and Global Operations.
The Mortgage Banking Segment is comprised of three distinct sectors: Loan Production, Loan Servicing, and Loan Closing Services.
The Loan Production Sector of the Mortgage Banking segment originates prime and subprime mortgage loans through a variety of channels on a national scale. Through the Company’s retail branch network, which consists of the Consumer Markets Division and Full Spectrum Lending, Inc., the Company sources mortgage loans directly from consumers, as well as through real estate agents and home builders. The Wholesale Lending Division sources mortgage loans primarily from mortgage brokers. The Correspondent Lending Division acquires mortgage loans from other financial institutions. The Loan Servicing Sector of the Mortgage Banking Segment includes investments in MSRs and other retained interests, as well as the Company’s loan servicing operations and subservicing for other domestic financial institutions. The Loan Closing Services Sector of the Mortgage Banking segment is comprised of the LandSafe companies, which provide credit reports, appraisals, title reports and flood determinations to the Company’s Loan Production Sector, as well as to third parties.
The Capital Markets Segment primarily includes the operations of Countrywide Securities Corporation, a registered broker-dealer specializing in the mortgage securities market. In addition, it includes the operations of Countrywide Asset Management Corporation, Countrywide Servicing Exchange and CCM International Ltd.
The Banking Segment’s operations are comprised of Treasury Bank, National Association (“Treasury Bank” or the “Bank”), and of Countrywide Warehouse Lending. Treasury Bank invests primarily in mortgage loans sourced from the Loan Production Sector. Countrywide Warehouse Lending provides temporary financing secured by mortgage loans to third-party mortgage lenders.
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The Insurance Segment activities include Balboa Life and Casualty Group, a national provider of property, life, and liability insurance; Balboa Reinsurance Company, a primary mortgage reinsurance company, and Countrywide Insurance Services, Inc., a national insurance agency offering a specialized menu of insurance products directly to consumers.
The Global Segment operations include those of Global Home Loans Limited, a provider of loan origination processing and servicing in the United Kingdom; UKValuation Limited, a provider of property valuation services in the UK; and Countrywide International Technology Holdings Limited, a licensor of loan origination processing, servicing, and residential real estate value assessment technology.
In general, intercompany transactions are recorded on an arms-length basis. However, the rate at which the Bank reimburses CHL for origination costs incurred on mortgage loans funded by the Bank is determined on an incremental cost basis, which is less than the rate that the Bank would pay to a third party.
Included in the tables below labeled “Other” are the holding company activities and certain reclassifications to conform management reporting to the consolidated financial statements:
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Note 24 - Quarterly Financial Data (Unaudited)
The following tables reflect summarized, unaudited quarterly data for each quarter in the years ended December 31, 2003 and 2002.
(1)
Earnings per share is computed independently for each of the quarters presented. Therefore, the sum of the quarterly earnings per share amounts may not equal the annual amount. This is caused by rounding and the averaging effect of the number of share equivalents utilized throughout the year, which changes with the market price of the common stock.
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Note 25 - Summarized Financial Information
Summarized financial information for Countrywide Financial Corporation and subsidiaries is as follows:
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Summarized information for Countrywide Capital Trusts is as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 26 - Business Acquisitions
In May 2001, the Company acquired all of the outstanding common stock of Treasury Bank for a cash price of $3.2 million. The acquisition of Treasury Bank was accounted for using the purchase method of accounting. Accordingly, a portion of the purchase price was allocated to assets acquired and liabilities assumed based on their estimated fair market value at the date of acquisition. The fair value of identifiable assets acquired and liabilities assumed was $75.3 million and $72.6 million, respectively. The acquisition did not have a material impact on the Company’s earnings per share.
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Note 27 - Loan Servicing
The following table sets forth certain information regarding the Company’s servicing portfolio of single-family mortgage loans, including loans and securities held-for-sale and loans subserviced for others, for the periods indicated:
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(1)
Runoff refers to scheduled principal repayments on loans and unscheduled prepayments (partial prepayments or total prepayments due to refinancing, modification, sale, condemnation or foreclosure).
(2)
Expressed as a percentage of the total number of loans serviced excluding subserviced loans and loans purchased at a discount due to their non-performing status.
Properties securing the mortgage loans in the Company’s servicing portfolio are geographically disbursed. The following is a summary of the geographical distribution of loans included in the Company’s servicing portfolio for states with more than five percent of the servicing portfolio (as measured by unpaid principal balance) at December 31, 2003:
Servicing Compensation
As compensation for performance of servicing functions under its various loan servicing contracts, the Company is paid a monthly service fee that is generally expressed as a percentage of the current unpaid principal balance of the underlying loans. The loan servicing contracts generally specify a base service fee of between 0.25% and 0.50% per annum. With regard to its servicing contracts with Fannie Mae, Freddie Mac and Ginnie Mae, the Company can effectively retain a larger net service fee principally through its methods of securitization. In general, the larger the net servicing fee retained, the smaller the net cash proceeds received upon securitization. Therefore, the decision to retain net service fees above the contractual minimum amounts is based on the Company’s assessment of the underlying economics. As of December 31, 2003, the weighted average service fee, net of applicable guarantee fees, of the Company’s portfolio of loans serviced for others was 0.327% per annum.
In addition to service fees, the Company is generally entitled to float benefits related to its collection of mortgagor principal, interest, tax and insurance payments. The amount of float varies depending on the terms of the servicing contract and timing of receipt of payments from the mortgagors. The Company also is generally entitled to various fees that it collects associated with the mortgages such as late charges, prepayment penalties and re-conveyance fees, among others. The Company also generally has the right to solicit the mortgagors for other products and services that it offers, such as insurance and second mortgage loans. The value of the net service fees and other related income in excess of the cost to service the loans,
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including the costs of advances on behalf of delinquent mortgagors, underlies the Company’s investment in MSRs.
As part of its loan servicing responsibilities, the Company is required to advance funds to cover delinquent scheduled principal and interest payments to security holders, as well as to cover delinquent tax and insurance payments to maintain the status of the loans. The Company had $1.0 billion of such advances outstanding at December 31, 2003 included in other assets. Generally, servicing advances are recoverable from either the mortgagor, the insurer of the loan, or the investor through the non-recourse provision of the loan servicing contract. These advances are recorded on the balance sheet at realizable value.
Note 28 - Credit Losses Related to Securitized Loans
Nearly all of the mortgage loans produced by the Company are securitized and sold into the secondary mortgage market. While the Company generally securitizes prime mortgage loans on a non-recourse basis, it does have potential liability under the representations and warranties made to purchasers and insurers of the securities. In the event of a breach of such representations and warranties, the Company may be required to either repurchase the subject mortgage loans or indemnify the investor or insurer. In such cases, any subsequent credit loss on the mortgage loans is borne by Countrywide.
Securitization
As described below, the degree to which credit risk on the underlying loans is transferred through the securitization process depends on the structure of the securitization. Prime first mortgage loans generally are securitized on a non-recourse basis, while prime home equity and subprime mortgage loans generally are securitized with limited recourse for credit losses.
Conforming Conventional Loans
Conforming conventional loans are generally pooled into mortgage-backed securities guaranteed by Fannie Mae. A small portion of these loans also have been sold to Freddie Mac or the Federal Home Loan Bank, through its Mortgage Partnership Finance Program. Subject to certain representations and warranties on the part of the Company, substantially all conventional loans securitized through Fannie Mae or Freddie Mac are sold on a non-recourse basis. Accordingly, credit losses are generally absorbed by Fannie Mae and Freddie Mac and not the Company. The Company pays guarantee fees to Fannie Mae and Freddie Mac on loans it securitizes through these agencies, which include compensation to the respective agencies for their assumption of credit risk.
FHA-Insured and VA-Guaranteed Loans
FHA-insured and VA-guaranteed mortgage loans are generally pooled into mortgage-backed securities guaranteed by Ginnie Mae. A small portion of these loans have been sold to the Federal Home Loan Bank, through its Mortgage Partnership Finance Program. The company is insured against foreclosure loss by the FHA or partially guaranteed against foreclosure loss by the VA. Fees charged by the FHA and VA for assuming such risks are paid by the mortgagors. The Company is exposed to credit losses on defaulted VA loans to the extent that the partial guarantee provided by the VA is inadequate to cover the total credit losses incurred. The Company pays guarantee fees to Ginnie Mae for Ginnie Mae’s guarantee on its securities of timely payment of principal and interest. Ginnie Mae does not assume mortgage credit risk associated with the loans securitized under its program.
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Non-conforming Conventional Loans
Non-conforming conventional prime mortgage loans are generally pooled into “private-label” (non-agency) mortgage-backed securities. Such securitizations involve some form of credit enhancement, such as senior/subordinated structures or mortgage pool insurance. Securitizations that involve senior/subordinated structures contain securities that assume varying levels of credit risk. Holders of subordinated securities are compensated for the credit risk assumed through a higher yield. The Company generally sells the subordinated securities created in connection with these securitizations and thereby transfers the related credit loss exposure, other than as described above with respect to representations and warranties made when loans are securitized.
Prime Home Equity Loans
Prime home equity loans are generally pooled into private-label asset-backed securities. These securities generally are credit-enhanced through over-collateralization and guarantees provided by a third-party surety. In such securitizations, the Company is subject to limited recourse for credit losses through retention of a residual interest.
Subprime Loans
Subprime loans generally are pooled into private-label mortgage backed securities. The Company generally securitizes these loans with limited recourse for credit losses. Such limited recourse securitizations generally have contained mortgage pool insurance as the primary form of credit enhancement, coupled with a limited corporate guarantee provided by Countrywide and/or a retained residual interest. When mortgage pool insurance is used, the associated premiums are paid directly by the Company. We also have pooled a portion of our subprime loans into securities guaranteed by Fannie Mae. In such cases, the Company has paid Fannie Mae a guarantee fee in exchange for Fannie Mae assuming the credit risk of the underlying loans. In addition, the Company has securitized a portion of our subprime loans on a limited recourse basis through the retention of a residual interest without the use of mortgage pool insurance.
The Company’s exposure to credit losses related to its limited recourse securitization activities is limited to the carrying value of its subordinated interests and to the contractual limit of reimbursable losses under its corporate guarantees less the recorded liability for such guarantees. These amounts at December 31, 2003 are as follows:
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The carrying value of the residual securities is net of expected future credit losses. Related to the Company’s non-recourse and limited recourse securitization activities, the total credit losses incurred for the years ended December 31, 2003 and 2002 are summarized as follows:
Note 29 - Commitments and Contingencies
Legal Proceedings
The Company and certain subsidiaries are defendants in various legal proceedings involving matters generally incidental to their business. Although it is difficult to predict the ultimate outcome of these proceedings, management believes, based on discussions with counsel, that any ultimate liability will not materially affect the consolidated financial position or results of operations of the Company and its subsidiaries.
Commitments to Buy or Sell Mortgage-Backed Securities and Other Derivatives Contracts
In connection with its open commitments to buy or sell MBS and other derivative contracts, the Company may be required to maintain margin deposits. With respect to the MBS commitments, these requirements are generally greatest during periods of rapidly declining interest rates. With respect to other derivative contracts, margin requirements are generally greatest during periods of increasing interest rates. The total such margin deposits placed by the Company at December 31, 2003 was $293.9 million.
Lease Commitments
The Company leases office facilities under lease agreements extending through July 31, 2013. Future minimum annual rental commitments under these non-cancelable operating leases with initial or remaining terms of one year or more are as follows:
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Rent expense was $109.7 million, $80.0 million and $48.6 million for the years ended December 31, 2003 and 2002 and the ten-month period ended December 31, 2001, respectively.
Restrictions on Transfers of Funds
The Company and certain of its subsidiaries are subject to regulatory and credit agreement restrictions which limit their ability to transfer funds to the Company through intercompany loans, advances or dividends. Pursuant to revolving credit facilities existing at December 31, 2003, the Company and CHL are required to maintain minimum consolidated net worth of $2.5 billion and $1.5 billion, respectively.
Mortgage Reinsurance
Countrywide has entered mortgage reinsurance agreements with several primary mortgage insurance companies. Under these agreements, the Company is obligated to absorb mortgage insurance losses in excess of a specified percentage of the principal balance of a given pool of loans, subject to a cap, in exchange for a portion of the pools’ mortgage insurance premiums. Approximately $67.4 billion of the servicing portfolio is covered by such mortgage reinsurance agreements. Management believes it has adequate valuation allowances in place to cover anticipated losses.
Note 30 - Subsequent Events
On January 26, 2004, the Company’s Board of Directors declared a dividend of $0.22 per share payable March 1, 2004 to shareholders of record on February 11, 2004.
On January 9, 2004, Countrywide’s stockholders approved an amendment to the Company’s Restated Certificate of Incorporation increasing the number of shares of common stock the Company has the authority to issue to 500,000,000.
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
COUNTRYWIDE FINANCIAL CORPORATION
BALANCE SHEETS
December 31, 2003 and 2002
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT - (Continued)
COUNTRYWIDE FINANCIAL CORPORATION
STATEMENTS OF EARNINGS
For the Years Ended December 31, 2003 and
and the Ten Months Ended December 31,
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT - (Continued)
COUNTRYWIDE FINANCIAL CORPORATION
STATEMENTS OF CASH FLOWS
For the Years Ended December 31, 2003 and
and the Ten Months Ended December 31,
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT - (Continued)
STATEMENTS OF COMPREHENSIVE INCOME
For the Years Ended December 31, 2003 and
and the Ten Months Ended December 31,
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
For the Years Ended December 31, 2003 and
and the Ten Months Ended December 31,
(1)
Actual losses charged against the valuation allowance, net of recoveries and reclassification.
EXHIBIT LIST

Constitutes a management contract or compensatory plan or arrangement.