Securities registered pursuant to Section 12(b) of the
Act:
Title of Each Class
Name of Each Exchange on Which Registered
Common Stock, $.05 Par Value
New York Stock Exchange
Pacific Stock Exchange
Preferred Stock Purchase Rights
New York Stock Exchange
Pacific Stock Exchange
Securities registered pursuant to Section 12(g) of the
Act:
None
Indicate by check mark whether the registrant (1) has filed
all reports required to be filed by Section 13 or 15(d) of
the Securities Exchange Act of 1934 during the preceding
12 months (or for such shorter period that the registrant
was required to file such reports) and (2) has been subject
to such filing requirements for the past
90 days. Yes þ No o
Indicate by check mark if disclosure of delinquent filers
pursuant to Item 405 of Regulation S-K is not
contained herein and will not be contained, to the best of
registrant’s knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this
Form 10-K or any amendment to this
Form 10-K. o
Indicate by check mark whether the registrant is an accelerated
filer (as defined in Exchange Act
Rule 12b-2). Yes þ No o
Based on the closing price for shares of Common Stock as of
June 30, 2004, the last business day of the
registrant’s most recently completed second fiscal quarter,
the aggregate market value of Common Stock held by
non-affiliates was $19,596,110,016. For the purposes of the
foregoing calculation only, all directors and executive officers
of the registrant have been deemed affiliates.
As of March 8, 2005, there were 584,449,297 shares of
Countrywide Financial Corporation Common Stock, $0.05 par
value, outstanding.
PART I
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, Banking, Capital Markets,
Insurance and Global Operations. We primarily conduct the
following operations in these segments:
•
Mortgage Banking — We originate, purchase,
securitize and service mortgage loans nationwide.
•
Banking — We operate a federally-chartered bank
that primarily invests in mortgage loans and home equity lines
of credit primarily sourced through our mortgage banking
operation. We also provide short-term secured financing to
mortgage lenders through a non-depository lending company.
•
Capital Markets — We operate an institutional
broker-dealer that primarily specializes in trading and
underwriting mortgage-backed securities. We also manage within
this segment the acquisition and disposition of mortgage loans
on behalf of Countrywide Home Loans, our primary Mortgage
Banking subsidiary.
•
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.
•
Global Operations — We provide mortgage loan
application processing and mortgage loan servicing on behalf of
a financial institution in the United Kingdom through a
majority-owned joint venture with that institution.
Mortgage banking continues to be our core business, generating
65% of our pre-tax earnings in 2004. Our other segments
generated the following percentages of our pre-tax earnings in
2004: Banking — 16%; Capital Markets — 13%;
Insurance — 5%; and Global Operations — 1%.
We have pursued diversification in recent years to capitalize on
meaningful opportunities that 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
and “Note 24 — Segments and Related
Information” in the financial statement 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 Web site 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 Web site, 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 Web site and available in print upon request.
Loan Production
We produce our residential mortgage loans within the Mortgage
Banking, Banking and Capital Markets segments.
1
Types of Loans
We originate and purchase residential mortgage loans that
generally fall into one of the following three categories:
•
Prime Mortgage Loans — These are prime credit
quality first-lien mortgage loans secured by single-
(one-to-four) family residences.
•
Prime Home Equity Loans — These are prime
credit quality second-lien mortgage loans, including home equity
lines of credit, secured by single- (one-to-four) family
residences.
•
Subprime Mortgage Loans (“Nonprime Mortgage Loans”
or “Nonprime Lending”) — 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 them for a prime loan.
The majority of our loan production consists of Prime Mortgage
Loans. Prime Mortgage Loans include conventional mortgage loans,
loans insured by the Federal Housing Administration
(“FHA”) and loans guaranteed by the Veterans
Administration (“VA”). A significant portion of the
conventional loans qualify for inclusion in guaranteed mortgage
securities backed by Fannie Mae or Freddie Mac (“conforming
loans”). Some of the conventional loans we produce either
have an original loan amount in excess of the Fannie Mae and
Freddie Mac loan limit for one-family loans ($359,650 for 2004)
or otherwise do not meet Fannie Mae or Freddie Mac guidelines.
In certain tables and elsewhere in this Report, FHA and VA loans
may be referred to, both individually and separately as
Government Loans.
The following table summarizes our loan production by business
segment and by loan type:
For additional 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. We group these activities into
three business sectors — Loan Production, Loan
Servicing and Loan Closing Services. See the section in
this Report entitled “Management’s Discussion and
Analysis of Financial Condition and Results of
Operations — Seasonality” for a discussion of the
effect of seasonality on our business.
2
Loan Production Sector
We produce mortgage loans through four divisions of Countrywide
Home Loans — Consumer Markets, Wholesale Lending,
Correspondent Lending and Full Spectrum Lending. Full Spectrum
Lending was a subsidiary until it was merged into Countrywide
Home Loans at the end of 2004.
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
four major business channels: the Branch Network channel, the
Business-to-Consumer channel, the Business-to-Business channel
and the Strategic Business Development channel.
The Branch Network channel originates mortgage loans primarily
through relationships with real estate agents and builders. As
of December 31, 2004, this network consisted of 577 branch
offices in 49 states and the District of Columbia.
The Business-to-Consumer channel originates mortgage loans
directly from the consumer through the Internet and through our
call centers. This channel focuses on customer retention by
providing mortgage customers with an efficient and convenient
means to refinance their existing mortgage. As of
December 31, 2004, the Business-to-Consumer channel
consisted of three call centers and three centralized processing
centers.
The Business-to-Business channel originates mortgage loans by
working with relocation companies and corporate relocation
departments to provide loans to relocating employees of various
companies. This channel, operating as a third-party outsourcing
solution, also provides loan sales, processing and closing
services to institutions such as banks, thrifts and financial
planners.
The Strategic Business Development channel originates mortgage
loans through relationships with organizations that influence
the placement of mortgage services. This channel focuses on
facilitation, development and deployment of joint ventures and
other revenue sharing arrangements with builders, real estate
agents and other entities.
For 2004, Countrywide was ranked by Inside Mortgage Finance
as the second largest retail lender, in terms of volume,
among residential retail mortgage lenders nationwide.
Wholesale Lending Division
Our Wholesale Lending Division funds and helps originate
mortgage loans through mortgage loan brokers and other financial
intermediaries.
3
As of December 31, 2004, 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 37,000 mortgage loan brokers nationwide.
For 2004, Countrywide 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, 2004, this Division served approximately
2,100 approved lenders, who are subject to initial and ongoing
credit evaluation and monitoring, operating in all
50 states and the District of Columbia.
For 2004, Countrywide was ranked by Inside Mortgage Finance
as the largest correspondent lender, in terms of volume,
among residential correspondent mortgage lenders nationwide.
Full Spectrum Lending Division
The Full Spectrum Lending Division primarily originates Nonprime
Mortgage Loans through a network of 160 retail branch offices
located in 38 states, as well as five call centers. The
branches of this Division are supported by five fulfillment
centers that underwrite and fund branch-originated loans. This
Division’s mortgage production is generated primarily
through referrals from our other loan production divisions,
direct mailings to prospective borrowers, affinity relationships
and the Internet.
Affordable and Multicultural Home Loan Programs
For more than a decade, we have pursued a variety of affordable
home loan initiatives designed to increase homeownership
opportunities for low-to moderate-income borrowers and those
with a wide variety of cultural roots. Our long-time 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-to moderate-income borrowers
and others with financial, employment or personal situations
which might prevent them from qualifying for traditional
mortgages. These loan programs enable 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.
We are approved to participate in more than 800 mortgage loan
programs that assist with down payments and closing costs. These
programs are offered by state, county and city agencies,
municipalities and non-profit organizations.
We have made other significant commitments to affordable lending
and multicultural markets initiatives designed to increase
homeownership opportunities among minority and immigrant
communities. In early 2005, we extended our five-year We
House America Campaign, with a goal of originating $1.0
trillion in loans to targeted homebuyers by the end of 2010. As
of December 31, 2004, we had funded $341 billion
toward this goal.
Credit and Interest Rate Risk
As a mortgage banker, we have historically sold substantially
all the mortgage loans that we produced, generally through
securitizations. However, we do not always sell loans
immediately after production. Instead, we may decide to sell
certain loans in later periods as part of our overall management
of interest rate risk. The timing of such sales can have a
material impact, which can be either positive or negative, on
our results, particularly in the short term. When we securitize
our mortgage loans we retain limited credit risk. This credit
risk arises through representations and warranties that we make
as part of our securitization activities, as well
4
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.”
We typically bear interest rate risk from the time a loan
application is taken through the sale of the loan. Thereafter,
we continue to bear interest rate risk related to the interests
we retain in the loans sold, which are typically in the form of
mortgage servicing rights and residual securities. 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
When we sell mortgage loans, we generally retain the rights to
service these loans, as explained in the following paragraph. We
refer to these rights as mortgage servicing rights
(“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. The results of the Loan
Servicing Sector include the performance of these interests, as
well as of the operational and other financial activities
related to servicing mortgage loans.
In servicing mortgage loans, we collect and remit loan payments,
respond to customer 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. We receive servicing fees
and other remuneration in return for performing these functions.
Mortgage Servicing Rights, Other Retained Interests and the
Servicing Hedge
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 11 —
Securitizations” in the financial statement section of this
Report.
MSRs and other retained interests 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, primarily derivative contracts, which generally
increases in value when interest rates decline. This portfolio
of financial instruments is collectively referred to herein as
the “Servicing Hedge.” See
“Note 12 — 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 four primary locations: two in California and
two in Texas.
Customer Service
Our Customer Service Call Centers managed almost 39 million
contacts with customers in 2004. These contacts were primarily
handled through our Customer Service Representatives, Automated
Phone System and Web site (www.customers.countrywide.com). This
division also prints monthly statements and oversees outbound
customer correspondence. Approximately 17% of our customers have
chosen to receive electronic statements, which reduces the cost
and improves the timeliness of providing loan information to
them.
5
Remittance Processing
Our Remittance Processing division processes all payments, loan
payoffs and payoff demand statements. Approximately 33% of our
customers make their monthly payments electronically using
various automated payment methods.
Collections and Loss Mitigation
Our Collections 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 and comply with 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
accounting records on behalf of our mortgage investors,
including Fannie Mae, Ginnie Mae and Freddie Mac, as well as
more than 600 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, acting as a foreclosure
trustee, performing property inspections, and insurance tracking
and premium payment processing.
6
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:
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 customers referred by our loan production
divisions.
Competition
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.
•
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 significant fluctuations 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 have a
combined 84% share of the mortgage origination market, up from
61% five years ago.
8
This consolidation trend also is reflected in loan servicing.
Today, the top 30 mortgage servicers combined have a 70% share
of the total mortgages outstanding, up from 58% 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 consumer demand for
adjustable-rate mortgages continues, the secondary mortgage
market does not continue to provide a competitive outlet for
these loans, and we are unable to develop an adequate
portfolio-lending capacity.
Generally, we compete as a mortgage banker by consistently
offering a wide selection of mortgage loans through all
marketing channels on a national scale, by providing
high-quality service, and by pricing our mortgage loans at
competitive rates.
Banking Segment
Our Banking Segment consists of the following operations:
•
Treasury Bank, N.A., an FDIC-insured, federally-chartered
bank
•
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. For liquidity and asset-liability management
purposes, we also invest in collateralized mortgage obligations
and other securities to supplement Treasury Bank’s loan
portfolio.
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 58 of our one- or
two-person financial centers, 53 of which are located in
Countrywide Home Loans’ retail branch offices as of
December 31, 2004. We also sell these deposit products
online, from call centers and through deposit brokers (generally
well-recognized financial intermediaries). Countrywide Bank also
offers commercial deposit accounts to title and mortgage
insurance companies through a developing commercial business
unit. A significant 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 also 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 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, 2004, Treasury Bank had total assets of
$41.0 billion, including $5.2 billion of investment
securities and $34.2 billion of loans receivable. At
December 31, 2004, Treasury Bank had deposits of
$20.0 billion, including $7.9 billion of custodial
balances controlled by Countrywide Home Loans. Treasury
Bank’s non-performing assets totaled $21.8 million at
December 31, 2004, all of which were loans receivable.
Countrywide Warehouse Lending
We provide committed and uncommitted lines of credit to mortgage
bankers to finance their mortgage loan inventories
(“warehouse”). 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
sellers. 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.
9
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 7,600 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 deposit rates that
are among the most competitive in the industry.
Our Banking Segment’s competitive position is significantly
enhanced by its 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. As discussed above, Treasury Bank
sells retail deposit products through financial centers placed
within certain of Countrywide Home Loans’ 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.
Capital Markets Segment
Our Capital Markets Segment consists primarily 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:
•
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
•
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 underwriting corporate debt
issued by Countrywide Home Loans
•
Trading of securities issued by the U.S. Department of the
Treasury
•
Arranging short-term financing of fixed-income securities by
institutional investors
•
Acting as broker of residential mortgage loans, including
Nonprime Loans, on behalf of Countrywide Home Loans
•
Managing mortgage loan securitization conduits on behalf of
Countrywide Home Loans
Most of our securities 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.
10
Countrywide Asset Management Corporation
We manage the acquisition and disposition of loans from third
parties as well as loans originated by Countrywide Home Loans,
on behalf of Countrywide Home Loans. These are typically
delinquent or otherwise illiquid residential mortgage loans
which have primarily been originated under FHA and VA programs.
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 relating to defaulted FHA and
VA program loans.
Countrywide Commercial Real Estate Finance
Corporation
During the fall of 2004, we entered the commercial real estate
finance business. We originate and hold an inventory of
commercial mortgage loans for the purpose of sale or
securitization. These loans are serviced by third parties who
specialize in commercial mortgage loan servicing. When we sell
the loans through securitizations, Countrywide Securities
Corporation is expected to act as the underwriter for those
transactions.
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 the mortgage securities market, we can
offer information, products and services tailored to the unique
needs of institutional customers in that market. In contrast,
many of our competitors offer a broad range of products and
services, which may place us at a competitive disadvantage.
For 2004, according to Inside MBS & ABS, we
ranked second among Non-Agency MBS Underwriters.
Insurance Segment
Our Insurance Segment’s primary activities are:
•
Offering property, casualty, life and credit insurance as an
underwriter and as an insurance agency
•
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, an insurance underwriter/carrier, and
Countrywide Insurance Services Group, an 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 offers the following product
lines:
•
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 alert a lender when there is a lapse in a borrower’s
11
insurance, for more than 14.5 million loans, including
nearly 6.1 million loans serviced within our mortgage
banking operations.
•
Homeowners — We underwrite retail homeowners
insurance and home warranty plans for consumers.
•
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
“Excellent” rating from A.M. Best Company, an
insurance company rating and information service. The
“Excellent” 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 insurance
agency that provides consumers, in particular our mortgage
customers, with homeowners insurance, life insurance, disability
insurance, automobile insurance and various other insurance
products.
Balboa Reinsurance Company
We provide a mezzanine layer of reinsurance coverage for losses
between minimum and maximum specified amounts 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% 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, term life, credit-life and credit-disability
marketplaces are dominated by large, well-known providers.
Consumers select such insurance based on 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 leading 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:
•
Loan Processing and Subservicing — We provide
mortgage loan application processing and mortgage loan
subservicing in the UK through Global Home Loans Limited (GHL),
a majority-owned joint venture. In 2004, we processed more than
17.2 billion pounds sterling ($31.4 billion) in loans,
all of which are subserviced for Barclays Bank, PLC, our joint
venture partner. At December 31, 2004, Global’s
subservicing portfolio was 62 billion pounds sterling
($118 billion).
•
Offshore Services — Operations commenced in
India in May 2004 and we are currently providing business
process and technology services to the Company in both the U.S.
and UK.
12
•
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 the Global Operations
Segment for use in its activities.
Competition
Our competitors in this segment include business process
outsourcers and technology companies operating in Europe and
India. We compete by leveraging Countrywide’s mortgage
expertise and our 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:
•
Warehousing of mortgage loans pending sale
•
Trading activities of our broker-dealer
•
Providing mortgage warehouse credit to others
Our long-term financing needs arise primarily from the following:
•
Investments in mortgage loans
•
Investments in MSRs and other interests that we retain when we
securitize mortgage loans
Sources of Financing
We meet our short- and long-term financing needs primarily
through the following means:
•
Unsecured commercial paper and medium-term notes
•
Short-term repurchase agreements
•
Asset-backed financings
•
Deposit-gathering
•
Federal Home Loan Bank advances
•
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
12 years, we have consistently maintained solid
investment-grade ratings. Countrywide Financial Corporation
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. We also must maintain 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.
We rely substantially on the secondary mortgage market as a
source of long-term capital to support our mortgage banking
operations. 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.
13
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.
Our primary source of equity capital is retained earnings. In
addition, we have outstanding $1.0 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.
For a further discussion of our liquidity and capital management
see the section in this Report entitled “Management’s
Discussion and Analysis of Financial Condition and Results of
Operations — Liquidity and Capital Management.”
Regulations
Regulations Applicable to Bank Holding Companies and
Financial Holding Companies
General
We are a registered bank holding company under the Bank Holding
Company Act (the “BHC Act”) and a financial holding
company under the Gramm-Leach-Bliley Act (the “GLB
Act”), and as such, are subject to supervision and
examination by the Board of Governors of the Federal Reserve
System (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. The FRB is empowered to impose
civil money penalties for violations of banking statutes and
regulations. Regulation by the FRB is primarily intended to
protect depositors of the Bank and the Bank Insurance Fund of
the Federal Deposit Insurance Corporation, not our shareholders
or creditors.
Limitation on Activities
The activities of bank holding companies and their subsidiaries
are generally limited to the business of banking, managing or
controlling banks or furnishing or performing services for their
subsidiaries, 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. 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 activities. 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
timeframes.
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
14
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.
To be classified as “adequately capitalized,” 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
“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, 2004, the Company was in compliance with all
of the FRB’s capital adequacy guidelines. For further
information regarding the Company’s capital ratios, see
“Note 23 — 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 new 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 regulations require 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.
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. The OCC has the
power to impose civil money penalties for violations of banking
statutes and regulations. Regulation by this agency is primarily
intended to protect the depositors of the Bank and the Bank
Insurance Fund of the FDIC, not shareholders or other creditors
of the Company or the Bank.
15
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, 2004, the
Bank was in compliance with the OCC’s minimum capital
requirements and satisfied the requirements to be classified as
well capitalized.
The Bank must be well capitalized and well managed for the
Company to remain a financial holding company. On
December 31, 2004, the Bank’s Leverage ratio was 7.8%,
the Tier-1 Risked Based Capital ratio was 11.8% and Total-Risk
Based Capital ratio was 12.0%.
Deposit Insurance and Assessments
The deposits of the Bank are insured by the Bank Insurance Fund
(“BIF”) 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 currently
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 that 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, as such term is defined in applicable
regulation.
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
(“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
Countrywide Financial Corporation and its nonbank subsidiaries
are affiliates of the Bank within the meaning of
Sections 23A and 23B of the Federal Reserve Act and
regulations promulgated thereunder. Transactions between a bank
and an affiliate are generally subject to the requirement that
they be on terms and conditions, including credit standards,
substantially the same as, or at least as favorable to the bank
as, those prevailing at the time for comparable transactions
with non-affiliates or, in the absence of comparable
transactions, on terms and conditions that would be offered to
nonaffiliates. In addition, certain transactions between a bank
and an affiliate, such as asset purchases by a bank from an
affiliate, and bank extensions of
16
credit to or for the benefit of an affiliate, are defined as
“covered transactions”, and are subject to
quantitative limitations and more stringent qualitative
restrictions, including but not limited to collateralization and
safety and soundness requirements.
Other Banking Activities
The investments and activities of the Bank are also subject to
regulation by federal banking agencies, with respect to:
Investments for the Bank’s account (including limitations
on investments)
•
Unsecured commercial paper and medium-term notes
•
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
•
Mergers and acquisitions
The OCC’s conditions for approval of the Company’s
acquisition of the Bank in May 2001 required 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 ended on May 17, 2004.
As discussed below, the non-bank subsidiaries of the Company are
subject to supervision and examination by the FRB and may be
subject to the supervision of, and regulation and licensure by,
other state and federal regulatory agencies. There are also 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 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”)
17
•
The Department of Veteran Affairs (the “VA”)
•
Fannie Mae, Freddie Mac and Ginnie Mae
•
The Federal Home Loan Bank (“FHLB”)
•
State regulatory authorities
The rules, regulations and requirements of these entities, among
other things, impose licensing obligations on the Company or its
subsidiaries, 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 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 lending practices with respect to borrowers with
blemished credit. In general, these laws and regulations would
or will impose new loan disclosure requirements; restrict or
prohibit certain loan terms, fees and charges such as prepayment
penalties; and 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 United
States 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
The Company, by virtue of its ownership of 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 insurers’ 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.
18
Pursuant to the Holding Company Acts, the Company 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, and dividends and investments between the
insurance company entity and other entities within the holding
company group.
Global Operations
The mortgage loan application processing and servicing business
of our Global Operations Segment is regulated by the Financial
Services Authority in the United Kingdom.
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. We 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.
We may decide to opt in to certain new capital and other
regulatory requirements proposed by the Basel Committee on
Banking Supervision. These proposed requirements, which are
often referred to as the Basel II Accord, would, among other
things, modify the capital charge applicable to credit risk and
incorporate a capital charge for operational risk. The Basel II
Accord also places greater reliance on market discipline than
current standards. We have not yet determined whether to opt in
to the Basel II Accord.
If we choose to opt in, Countrywide Financial Corporation will
be required to implement advanced measurement techniques
employing internal estimates of certain key risk drivers to
derive capital requirements. Prior to our implementation of the
new capital regime, we will be required to demonstrate to our
primary federal regulators that our measurement approaches meet
relevant supervisory standards. We have not yet determined
whether to opt in to the Basel II Accord. Although opting
into Basel II may require us to meet more onerous
computational requirements, we believe it may provide a more
favorable capital treatment with respect to home loans.
U.S. regulators have proposed an effective date of
January 1, 2007 with certain transitional implementation
arrangements. If Countrywide Financial Corporation opt in, the
Basel II Accord requirements would replace existing risk-based
capital requirements, but not the leverage capital requirements
imposed under U.S. law and regulation.
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.
19
Workforce
At December 31, 2004, we had a workforce of 42,141,
including regular employees and temporary staff, engaged in the
following activities:
Workforce
Mortgage Banking:
Loan Production:
Consumer Markets Division
12,937
Wholesale Lending Division
3,768
Correspondent Lending Division
1,775
Full Spectrum Lending Division
5,567
Production Technology
1,024
Total Loan Production
25,071
Loan Servicing
6,331
Loan Closing Services
1,146
Banking
1,213
Capital Markets
569
Insurance
1,899
Global Operations
1,846
Corporate Administration and Other
4,066
Total
42,141
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 may make forward-looking statements orally or in
presentations 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
•
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.”
20
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 presents our consolidated loan production by
loan type for the periods indicated:
The following table presents our Capital Markets mortgage loan
production by loan type, which consists of mortgage loans
managed on behalf of Countrywide Home Loans, for the periods
indicated:
The primary executive and administrative offices of Countrywide
are located in and around Calabasas, California.
Calabasas, California — We own our headquarters
facility, which consists of approximately 245,000 square
feet and is situated on 20 acres of land. Our Corporate
Accounting, Tax and Legal Departments are located in an 86,000
square foot office building that we have leased with an option
to purchase.
Thousand Oaks, California — We own a 158,000 square
foot office building that houses the executive and
administrative operations of Treasury Bank.
Rosemead, California — We sublease, with an option to
purchase a 215,000 square foot facility that houses loan
production and certain subsidiary operations.
West Hills, California — We lease and sublease
approximately 282,000 square feet, where our Correspondent
Lending and Wholesale Divisions are located. We also own two
buildings totaling 162,000 square feet in Agoura Hills,
California, housing loan production technology operations.
28
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 that
will be renovated to house loan servicing operations and other
business units. We also lease 304,000 square feet that house the
Balboa Life & Casualty insurance tracking operations
and a variety of operating subsidiaries.
Westlake Village, California — We own a 258,000 square
foot facility which houses our marketing, treasury and other
administrative operations.
Irvine, California — We lease a 136,000 square foot
office building that houses the executive and administrative
operations of Balboa Life & Casualty.
Lancaster, California — We lease, with an option to
purchase, 202,000 square feet of office buildings. The Lancaster
facilities currently house loan servicing operations.
Plano, Texas — We own four office buildings totaling
approximately 958,000 square feet on 38.5 acres that house
additional loan servicing, loan production, data processing and
subsidiary operations.
Chandler, Arizona — We own two office buildings and
land totaling approximately 154,000 square feet which currently
houses certain Full Spectrum Lending and loan production
technology operations. We intend to develop the land into
additional office space.
Fort Worth, Texas — We own a 458,000 square foot
facility that houses loan servicing and various other
administrative operations.
Additional space located in Woodland Hills, Calabasas Hills and
Pasadena, California, is currently under lease for certain
operations including: loan production, human resources,
accounting and other administrative operations. These leases
provide an additional 369,000 square feet on varying terms. In
addition, we lease space for our branch offices throughout the
United States.
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.
Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5.
Market for the Company’s Common Stock, Related
Stockholder Matters and Issuer Purchase of Equity
Securities
The Company’s common stock is listed on the New York Stock
Exchange and the Pacific Stock Exchange (Symbol: CFC). The
following table sets forth the high and low sales prices (as
reported by the
29
New York Stock Exchange) for the Company’s common stock and
the amount of cash dividends declared during the last two
periods:
Adjusted to reflect subsequent stock dividends and splits.
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, 2004
and 2003, the Company declared quarterly cash dividends totaling
$0.37 and $0.15 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 Loans’ 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.”
30
As of December 31, 2004 there were 1,967 shareholders
of record of the Company’s common stock, with 581,648,881
common shares outstanding.
The following table shows Company repurchases of its common
stock for each calendar month during the quarter ended
December 31, 2004.
Total Number of
Shares Purchased
Maximum Number of
Total Number
as Part of Publicly
Shares That May Yet Be
of Shares
Average Price Paid
Announced Plan
Purchased Under the
Calendar Month
Purchased(1)(2)
per Share(2)
or Program(1)
Plan or Program(1)
October
—
—
n/a
n/a
November
—
—
n/a
n/a
December
—
—
n/a
n/a
Total
—
—
n/a
n/a
(1)
The Company has no publicly announced plans or programs to
repurchase its stock. The shares indicated in this table
represent only the withholding of a portion of restricted shares
to cover taxes on vested restricted shares.
(2)
The shares purchased and the price paid per share have not been
adjusted for stock splits.
(Dollar amounts in thousands, except per share data)
Statement of Earnings Data(1):
Revenues:
Gain on sale of loans and securities
$
4,836,945
$
5,890,325
$
3,471,218
$
1,601,990
$
907,973
Interest income
4,629,795
3,342,200
2,253,296
1,806,596
1,324,066
Interest expense
(2,608,338
)
(1,940,207
)
(1,461,066
)
(1,474,719
)
(1,330,724
)
Net interest income (expense)
2,021,457
1,401,993
792,230
331,877
(6,658
)
Provision for loan losses
(71,775
)
(48,204
)
(26,565
)
(26,108
)
—
Net interest income (expense) after provision for loan
losses
1,949,682
1,353,789
765,665
305,769
(6,658
)
Loan servicing fees and other income from retained interests
3,269,587
2,804,338
2,028,922
1,367,381
1,227,474
Amortization of MSRs
(1,940,457
)
(2,069,246
)
(1,267,249
)
(805,533
)
(518,199
)
Impairment of retained interests
(648,137
)
(1,432,965
)
(3,415,311
)
(1,472,987
)
(915,589
)
Servicing hedge (losses) gains
(215,343
)
234,823
1,787,886
908,993
797,148
Net loan servicing fees and other income (loss) from retained
interests
465,650
(463,050
)
(865,752
)
(2,146
)
590,834
Net insurance premiums earned
782,685
732,816
561,681
316,432
274,039
Commissions and other revenue
531,665
464,762
358,855
248,506
167,386
Total revenues
8,566,627
7,978,642
4,291,667
2,470,551
1,933,574
Expenses:
Compensation expenses
3,137,045
2,590,925
1,773,318
968,232
702,626
Occupancy and other office expenses
717,526
586,648
447,723
291,571
262,370
Insurance claims expenses
390,203
360,046
277,614
134,819
106,827
Advertising and promotion expenses
171,585
103,902
86,278
54,068
71,557
Other operating expenses
554,395
491,349
363,711
233,242
204,159
Total expenses
4,970,754
4,132,870
2,948,644
1,681,932
1,347,539
Earnings before income taxes
3,595,873
3,845,772
1,343,023
788,619
586,035
Provision for income taxes
1,398,299
1,472,822
501,244
302,613
211,882
Net earnings
$
2,197,574
$
2,372,950
$
841,779
$
486,006
$
374,153
Per Share Data(2):
Earnings
Basic
$
3.90
$
4.44
$
1.69
$
1.01
$
0.81
Diluted
$
3.63
$
4.18
$
1.62
$
0.97
$
0.79
Cash dividends declared
$
0.37
$
0.15
$
0.09
$
0.10
$
0.10
Weighted average shares outstanding:
Basic
563,981,000
533,920,000
498,960,000
481,356,000
459,730,000
Diluted
605,722,000
567,252,000
520,137,000
500,415,000
476,243,000
Selected Balance Sheet Data at End of Period(1):
Total assets
$
128,495,705
$
97,977,673
$
58,058,531
$
37,244,419
$
22,983,012
Short-term debt
$
54,433,129
$
51,830,250
$
28,311,361
$
15,210,374
$
7,300,030
Long-term debt
$
32,645,665
$
20,131,623
$
14,145,014
$
11,425,096
$
8,171,496
Common shareholders’ equity
$
10,310,076
$
8,084,716
$
5,161,133
$
4,087,642
$
3,559,264
Operating Data (In millions):
Loan servicing portfolio(3)
$
838,322
$
644,855
$
452,405
$
336,627
$
293,600
Volume of loans originated
$
363,006
$
434,864
$
251,901
$
123,969
$
68,923
(1)
Certain amounts in the Consolidated Financial Statements have
been reclassified to conform to current year presentation.
(2)
Adjusted to reflect subsequent stock dividends, splits, and
EITF 04-8, which required the Company to include the
assumed conversion of its convertible debentures in earnings per
share.
(3)
Includes warehoused loans and loans under subservicing
agreements.
32
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, Banking,
Capital Markets, 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 2004, total U.S. residential mortgage production
declined 25% from 2003’s record-setting market to an
estimated $2.9 trillion. This decline was largely attributable
to a decline in mortgage refinance activity caused by interest
rates rising from the historically low levels reached in 2003.
This change in the direction and level of interest rates
notwithstanding, our mortgage banking operations achieved their
second best annual performance in 2004, as the reduction in
mortgage loan production resulting from higher interest rates
was partially offset by an increase in market share. During
2004, we became the largest originator of mortgage loans
increasing our market share from 11.4% to 12.7% (Source of
Mortgage Market: Mortgage Bankers Association). This
mortgage banking performance was bolstered by increased profits
from our diversified businesses, in particular the Banking
Segment. As a result our net earnings reached
$2,197.6 million in 2004, a decrease of
$175.4 million, or 7%, from 2003.
For 2005, forecasters predict a 11% to 23% reduction in total
U.S. mortgage production, due to an expected continuation
in the decline in mortgage refinance activity. We believe that a
market within the forecasted range would still be conducive to a
profitable loan production business, although we would expect
increased competitive pressures to impact the profits earned by
that business. A reduction in mortgage refinance activity should
result, however, in an increase in profitability from our
investment in mortgage servicing rights (“MSRs”). We
also expect that a decline in mortgage production would result
in a reduction in mortgage securities trading and underwriting
volume, which may negatively impact the profitability of our
Capital Markets Segment. We plan to grow our investment in
mortgage loans at the Bank irrespective of the mortgage market.
As a result, we expect earnings in our Banking Segment to
increase.
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 MSRs, 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 selling substantially
all of the mortgage loans that we produce, limiting credit
recourse to Countrywide in those transactions, and by 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, 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
33
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
industry 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 continue as the
leader in the mortgage banking business. 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 our use of derivatives to manage interest rate
risk. Our critical accounting policies involve the following
three areas: 1) accounting for gains on sales of loans and
securities; 2) accounting for MSRs and other retained
interests, including valuation of these retained interests; and
3) 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 and to a lesser extent as whole loans. 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.
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. The
timing of such gain recognition is dependent on meeting very
specific accounting criteria and, as a result, the gain on sale
may be recorded in a different accounting period from when the
securitization was completed.
Here is an example of how this accounting works:
Carrying value of mortgage loans underlying a security(1)
$
1,000,000
Fair Values:
Security
$
998,000
Retained Interests
12,000
Total fair value
$
1,010,000
Computation of gain on sale of security:
Sales proceeds
$
998,000
Less: Cost allocated to security ($1,000,000 x
($998,000÷$1,010,000))
988,119
Gain on sale
$
9,881
Initial recorded value of retained interests
($1,000,000 — $988,119)
$
11,881
(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.
34
Accounting for MSRs and Other Retained Interests
Once MSRs have been recorded, they must be periodically
evaluated for impairment. Impairment occurs when the current
fair value of the MSRs falls below the asset’s carrying
value. We stratify our MSRs by predominate risk characteristic
when evaluating for impairment.
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, 2004, the MSR impairment valuation allowance
was $1.1 billion.) If impairment is deemed to be other than
temporary, the valuation allowance is applied to reduce the cost
basis of the MSRs. Absent hedge accounting, MSRs cannot be
carried above their amortized cost basis.
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.
We account for other retained interests recognized before
July 1, 2004, as available-for-sale securities. For these
investments, 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 these other
retained interests in earnings over the estimated remaining life
of the investment through a higher effective yield. Other
retained interests recognized on or after July 1, 2004, are
accounted for as trading securities with all changes in
estimated fair value recognized in current-period earnings.
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 and extensive analysis of current
market data to arrive at an estimate of fair value at each
balance sheet date. Senior financial management exercises
extensive and active oversight of this process. The cash flow
assumptions and prepayment assumptions used in our discounted
cash flow model are based on our empirical data drawn from the
historical performance of our MSRs, which we believe are
consistent with assumptions used by market participants valuing
similar MSRs. The key 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 assess
the reasonableness 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 our 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 in
this Report for further discussion of credit risk.) We develop
cash flow and prepayment assumptions based on our own empirical
data drawn from the historical performance of the loans
underlying our other retained interests, which we believe are
consistent with assumptions that other major market participants
would use in determining the assets’ fair value.
35
The following table shows the key assumptions we used to
determine the fair values of our MSRs at December 31, 2004,
and the value sensitivity of our MSRs to changes in such
assumptions.
MSRs
(Dollar amounts
in thousands)
Fair value of MSRs
$
8,882,917
Carrying value of MSRs
$
8,729,929
Carrying value as a percentage of MSR portfolio
1.15
%
Weighted-average service fee
0.34
%
Weighted-average life (in years)
6.1
Multiple of net service fee
3.4
Weighted-average annual prepayment speed
22.0
%
Impact of 10% adverse change
$
452,705
Impact of 20% adverse change
$
859,520
Weighted-average OAS(1)
6.0
%
Impact of 10% adverse change
$
156,338
Impact of 20% adverse change
$
306,544
(1) Option-adjusted spread over LIBOR.
The yield implied in the market value of the MSRs was 10.4% at
December 31, 2004.
The following table shows the key assumptions we used to
determine the fair values of our other retained interests at
December 31, 2004, and the value sensitivity of our other
retained interests to changes in such assumptions.
Other Retained
Interests
(Dollar amounts
in thousands)
Fair value of retained interests
$
1,908,504
Weighted-average life (in years)
2.5
Weighted-average annual prepayment speed
34.8
%
Impact of 10% adverse change
$
211,947
Impact of 20% adverse change
$
394,330
Weighted-average annual discount rate
18.1
%
Impact of 10% adverse change
$
46,376
Impact of 20% adverse change
$
88,818
Weighted-average net lifetime credit losses
2.0
%
Impact of 10% adverse change
$
80,833
Impact of 20% adverse change
$
158,730
These sensitivities are solely for illustrative purposes 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 tables, the effect of a variation in a
particular assumption on the fair value of the retained
interests is calculated without changing any other assumption.
In reality, changes in one factor may coincide with changes in
another, which could compound or counteract the sensitivities.
36
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. A primary requirement to
qualify for hedge accounting is the demonstration 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, or
choose not to, qualify certain interest rate risk management
activities for hedge accounting, then the change in fair value
of the associated derivative financial instruments is reflected
in current-period earnings, while the change in fair value of
the related asset or liability may 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
typically between seven 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, adjusted
for 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 date we issue
the commitment. 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
influenced 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 application, age of the
application, purpose for the loan (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 calculate the number
of loans that we expect to fund within the terms of the IRLCs.
Stock Split Effected as Stock Dividends
In April 2004 and August 2004, we completed a 3-for-2 and a
2-for-1 stock split respectively, effected as stock dividends.
In addition, in the fourth quarter of 2004 the Emerging Issues
Task Force reached a consensus on Issue No. 04-8, which required
the Company to include the assumed conversion of its convertible
debentures in diluted earnings per share. All references in this
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 adjusted accordingly.
Net earnings were $2,197.6 million during 2004, a 7%
decrease from 2003. The decrease in our earnings was driven
primarily by a decrease in the profitability of our Mortgage
Banking Segment. The Mortgage Banking Segment produced pre-tax
earnings of $2,335.7 million for 2004, a decrease of 21%
from 2003. In the
37
Mortgage Banking Segment, improved financial performance of our
MSRs was more than offset by a decline in the profitability of
our Loan Production Sector. Although net earnings decreased 7%
from prior year, earnings per share for 2004 decreased 13% to
$3.63 as a result of an increase in the average number of
diluted shares outstanding during the period.
Loan Production Sector pre-tax earnings were
$2,684.3 million for 2004, a decrease of
$1,403.6 million from the prior year. The decrease in the
profitability of the Loan Production Sector resulted from lower
Prime Mortgage Loan production and sales combined with a
compression in margins, which was caused by generally higher
mortgage interest rates; increased borrower demand for
lower-margin adjustable-rate mortgages; greater pricing
competition; and, higher loan origination costs. Production
Sector profitability in 2004 was bolstered by increased sales of
higher-margin Nonprime Mortgage and Prime Home Equity Loans.
The pre-tax loss in the Loan Servicing Sector, which
incorporates the performance of our MSRs and other retained
interests, was $433.5 million, an improvement of
$799.9 million from the year-ago period. The reduced
pre-tax loss was primarily attributable to a decrease in the
combined amount of amortization and impairment, net of Servicing
Hedge (losses) gains, which totaled $2,799.7 million in
2004, compared to $3,267.4 million in the year-ago period.
Profits from our Diversified Businesses were up significantly in
2004. In particular, our Banking Segment increased its pre-tax
earnings by $295.3 million from the year-ago period,
primarily as the result of increases in the balance of mortgage
loans held by Treasury Bank. In total, Diversified Businesses
contributed $1,260.2 million in pre-tax earnings for 2004,
an increase of 41% from the year-ago period.
The Mortgage Banking Segment includes the Loan Production, Loan
Servicing and Loan Closing Services 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.
Loan Production Sector
The Loan Production Sector produces mortgage loans through the
four production divisions of Countrywide Home Loans
(“CHL”) — Consumer Markets, Wholesale
Lending, Correspondent Lending and Full Spectrum Lending. Full
Spectrum Lending, Inc. was a subsidiary of CFC until it merged
with CHL in December 2004.
The pre-tax earnings of the Loan Production Sector are
summarized below:
Decreased demand for residential mortgages from the historic
levels experienced in 2003 resulted in lower production volume
in 2004. The resulting decline in our production was moderated
by an increase in our market share from the year-ago period. Our
mortgage loan production market share was 12.7% in 2004, up from
11.4% in 2003 (Source of Mortgage Market: Mortgage Bankers
Association).
Revenues declined over the prior year due primarily to a
reduction in production and sales volumes and to decreased
margins on Prime Mortgage Loans. Sales of Prime Mortgage Loans
were $268.2 billion in the current period compared to
$363.2 billion in the prior year. We attribute the decline
in margins on Prime Mortgage Loans to increased price
competition caused by the significant reduction in refinance
activity, as well as to the shift in consumer preference towards
adjustable rate mortgages, which generally carry lower margins
than 30-year fixed-rate mortgages. The decline in Prime Mortgage
Loan revenues was partially offset by increased production and
sales of higher margin Nonprime Mortgage and Prime Home Equity
Loans. Combined sales of Nonprime Mortgage and Prime Home Equity
Loan products were $56.5 billion in 2004 compared to
$11.1 billion in 2003. The increase in total revenues as a
percentage of loan volume in 2004 is attributable to a shift in
mix toward Nonprime Mortgage and Prime Home Equity Loans, which
generally have higher revenues, as a percentage of the loan
balance, than Prime Mortgage Loans.
Operating expenses increased, both in dollars and in proportion
to loan production volume, compared to the prior year. Expenses
increased primarily due to an increase in sales and marketing
costs and to a general reduction in productivity from the very
high levels achieved during the peak of refinance activity in
2003. The increase in sales and marketing costs were related to
increased production in 2004 of purchase Prime Mortgage Loans,
Nonprime Mortgage Loans and Prime Home Equity Loans, as well as
to an increase in the percentage of total loans produced through
our retail channels. We continued to expand our loans production
operations in 2004 despite a decline in the overall market to
support our long-term objective of market share growth.
Mortgage Banking loan production volume for 2004 decreased 20%
in comparison to 2003. Non-purchase loan production declined by
42%, while purchase production increased by 33%. The increase in
purchase loans is significant because this component of the
mortgage market offers relatively stable growth, averaging
11% per year 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 by interest rate type:
In 2004, 49% of our loan production was adjustable-rate in
comparison to 18% in 2003. The shift in homeowner preferences
toward adjustable-rate mortgages in 2004 was driven by an
increase in 30-year fixed mortgage rates, coupled with the
availability of attractive product alternatives such as hybrid
adjustable-rate and short-term pay-option adjustable-rate
mortgages that provide a relatively low fixed rate for the first
three to ten years of the mortgage.
40
The volume of Mortgage Banking Prime Home Equity and Nonprime
Mortgage Loans produced (which is included in our total volume
of loans produced) increased 104% during the current period from
the prior period. Details are shown in the following table.
Prime Home Equity and Nonprime Mortgage Loans generally provide
higher profit margins, and the demand for such loans is believed
to be less interest rate sensitive than the demand for Prime
Mortgage Loans. Consequently, we believe these loans will be a
significant component of the Loan Production Sector’s
future profitability, in particular if mortgage rates continue
to rise.
During 2004, the Loan Production Sector operated at
approximately 111% of planned operational capacity, compared to
123% during the year-ago period. 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 our loan
operations personnel multiplied by the number of loans we expect
each loan operations staff person to process under normal
conditions. As loan production volume has declined, there has
been a reduction in productivity to more sustainable levels that
has resulted in higher overall unit costs. We plan to continue
building our sales staff despite a potential further drop in
loan origination volume as a primary means to increase our
market share, particularly for purchase loans.
The following table summarizes the number of people included in
the Loan Production Sector workforce:
The commissioned sales force of the Consumer Markets Division
numbered 4,825, at December 31, 2004, an increase of 1,341
or 38% compared to December 31, 2003. The commissioned
sales force contributed $36.9 billion in purchase
originations during 2004, a 43% increase over the year-ago
period. The purchase production generated by the commissioned
sales force represented 75% of the Consumer Markets
Division’s purchase production for 2004. In addition, the
Consumer Markets Division has expanded its branch network to 577
branch offices at December 31, 2004, an increase of 111
offices over the year-ago period.
The Wholesale Lending Division and Full Spectrum Lending
Division also continued to grow their sales forces as a means to
increase market share. At December 31, 2004, the sales
force in the Wholesale Lending Division numbered 1,123, an
increase of 27% compared to December 31, 2003. The Full
Spectrum Lending Division expanded its sales force by 1,544, or
77%, compared to December 31, 2003, and has expanded its
branch network to 160 branch offices at December 31, 2004,
an increase of 63 offices over the prior year.
Loan Servicing Sector
The Loan Servicing Sector includes a significant processing
operation, consisting of approximately 6,300 employees who
service our 6.2 million mortgage loans. Also included in
the Loan Servicing Sector’s results is the performance of
our investments in MSRs and other retained interests and
associated risk management activities, as well as profits from
subservicing activities in the United States. The long-term
performance of this sector is impacted primarily by the level of
interest rates and the corresponding impact on the level of
projected and actual prepayments in our servicing portfolio.
The following table summarizes the results for the Loan
Servicing Sector:
The pre-tax loss in the Loan Servicing Sector was
$433.5 million during 2004, an improvement of
$799.9 million from the prior year. During the current
year, mortgage rates were generally higher than in the prior
year, which resulted in lower actual and projected prepayments.
Such lower prepayments resulted in lower amortization and
impairment. The combined amounts of amortization and impairment,
were $2,584.3 million and $3,502.2 million during 2004
and 2003, respectively.
42
Long-term Treasury and swap rates are the indices that underlie
the derivatives that constitute the primary components of the
Servicing Hedge. There was little change in these rates from
December 31, 2003 to December 31, 2004. The Servicing
Hedge loss of $215.3 million in 2004 resulted primarily
from time value decay on the options included in the Servicing
Hedge. 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.
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. In a stable
interest rate environment, we would expect to incur no
significant impairment charges; however, we would expect to
incur losses related to the Servicing Hedge driven primarily by
time decay on options used in the hedge. The level of such
Servicing Hedge losses depends on various factors such as the
size and composition of the hedge, the shape of the yield curve
and the level of implied interest rate volatility.
Our servicing portfolio grew to $838.3 billion at
December 31, 2004, a 30% increase from December 31,2003. At the same time, the overall weighted-average note rate
of loans in our servicing portfolio declined from 6.1% to 5.9%.
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 $85.0 million in pre-tax
earnings, representing a decrease of 13% from the prior year.
The decrease in LandSafe’s pre-tax earnings was primarily
due to the decrease in our loan origination activity.
Diversified Businesses
To leverage our mortgage banking franchise, as well as to reduce
the variability of earnings due to changes in mortgage interest
rates, we have engaged in other financial services. These other
businesses are grouped into the following segments: Banking,
Capital Markets, Insurance and Global Operations.
Banking Segment
Our banking strategy includes holding loans in portfolio that
historically would have been immediately securitized and sold
into 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.
The Banking Segment achieved pre-tax earnings of
$582.5 million during 2004, as compared to
$287.2 million for the year-ago period. Following is the
composition of pre-tax earnings by company:
The increase in net interest income is primarily due to a
$15.8 billion increase in average interest-earning assets,
primarily mortgage loans, combined with an increase in net
interest margin (net interest income divided by average earning
assets) of 17 basis points. The margin increase was the
result of a change in the mix of interest-earning assets toward
mortgage loans and the reduced amortization of loan origination
costs and purchase premiums on securities resulting from lower
prepayments on mortgage loans and securities.
44
The composition of the Bank’s balance sheets was as follows:
The Banking Segment also includes the operation of CWL.
CWL’s pre-tax earnings decreased by $6.7 million
during 2004 in comparison to the prior year, primarily due to a
6% decrease in average mortgage warehouse advances, which in
turn resulted from an overall decline in the mortgage
originations market.
Capital Markets Segment
Our Capital Markets Segment achieved pre-tax earnings of
$479.1 million for 2004, an increase of $36.8 million,
or 8%, from the year-ago period. Total revenues were
$761.4 million, an increase of $85.4 million, or 13%,
compared to the year-ago period. Capital Markets benefited by
underwriting the Production Sector’s Prime Home Equity and
Nonprime Mortgage Loan securitizations, which increased
significantly in the current year. This benefit was offset by a
less favorable mortgage-related fixed income securities market.
These factors led to reduced mortgage-backed securities trading
volumes and margins. This segment has expanded its staffing and
infrastructure to invest in the development of new lines of
business such as U.S. Treasury securities trading,
commercial real estate finance and broker-dealer operations in
Japan, which largely contributed to an increase in expenses of
$48.6 million, or 21%, compared to the year-ago period.
45
The following table shows revenues, expenses and pre-tax
earnings of the Capital Markets Segment:
During 2004, the Capital Markets Segment generated revenues
totaling $319.1 million from its conduit activities, which
include brokering and managing the acquisition and sale or
securitization of whole loans on behalf of CHL. Conduit revenues
for 2004 increased 18% in comparison to the prior year,
primarily as a result of an increase in margins on sales of
distressed assets and increased sales of Nonprime Mortgage Loans.
Underwriting revenues increased $117.2 million over the
prior year as a result of increased sales of our nonprime and
home equity securities.
Trading revenues declined 45% due to a decrease in the size of
the overall mortgage market, which resulted in a decline in
mortgage securities trading volume and margins. Trading volumes
declined 26% from the prior year before giving effect to the
introduction by the Company of U.S. Treasury securities
trading. Including U.S. Treasury securities, the total
securities volume traded increased 9% over the prior year.
Effective January 15, 2004, Countrywide Securities
Corporation (“CSC”) became a “Primary
Dealer” and as such is an authorized counterparty with the
Federal Reserve Bank of New York in its open market operations.
The U.S. Treasury securities trading operation is still in
its development stages and has not yet produced significant net
revenues.
The following table shows the composition of CSC securities
trading volume, which includes intersegment trades with the
mortgage banking operations, by instrument:
Approximately 15% and 12% of the segment’s non-U.S.
Treasury securities trading volume was with CHL during 2004 and
2003, respectively.
46
Insurance Segment
The Insurance Segment’s pre-tax earnings increased 15% over
the prior year, to $160.1 million. The following table
shows pre-tax earnings by business line:
Our mortgage reinsurance business produced $134.9 million
in pre-tax earnings, an increase of 31% over the year-ago
period, driven primarily by growth of 7% in the mortgage loans
included in our loan servicing portfolio that are covered by
reinsurance contracts, combined with an overall increase in the
ceded premium percentage.
Our Life and Casualty insurance business produced pre-tax
earnings of $49.5 million, a decrease of $6.5 million
from the prior year. The decline in earnings was driven by
$67.9 million in estimated losses relating to hurricane
damage sustained in Florida during 2004 in comparison to
$10.1 million of catastrophic losses in the prior year,
partially offset by a decline in non-catastrophic losses and a
$21.1 million, or 3.5%, increase in net earned premiums
during 2004 in comparison to the prior year. The growth in net
earned premiums was primarily attributable to growth in the
lender-placed auto and voluntary homeowner insurance lines of
business.
Our Life and Casualty insurance operations manage insurance risk
by reinsuring portions of their 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.
47
Global Operations Segment
Global Operations pre-tax earnings totaled $41.9 million,
an increase of $16.3 million in comparison to the prior
year. The increase in earnings was due partly to growth in the
portfolio of mortgage loans subserviced on behalf of Global Home
Loans’ minority joint venture partner, Barclays Bank PLC.
In addition, a favorable shift in foreign exchange rates
contributed $5.6 million to increase earnings along with a
$6.5 million software impairment in 2003, which did not
recur in the current period.
Detailed Line Item Discussion of Consolidated Revenue
and Expense Items
Gain on Sale of Loans and Securities
Gain on sale of loans and securities is summarized below:
Gain on sale of Prime Mortgage Loans decreased in 2004 as
compared to 2003, due primarily to lower Prime Mortgage Loan
production and sales combined with lower margins. The decline in
margins from the high levels realized in 2003 was due to
increased price competition as a result of lower homeowner
demand for refinance mortgage loans, combined with a shift in
homeowner preference toward adjustable-rate mortgages, which
generally carry lower margins than 30-year fixed-rate mortgages.
Gain on sale of Prime Home Equity and Nonprime Mortgage Loans
increased in 2004 compared to 2003, due primarily to increased
sales of these loans, offset somewhat by lower margins on the
sale of Nonprime Mortgage Loans. Inventory of these products had
been accumulated during recent periods of high origination
volume.
Reperforming loans are reinstated loans that had previously
defaulted and were repurchased from mortgage securities we
issued. 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.
A change in Ginnie Mae rules related to the repurchase of
defaulted loans from Ginnie Mae securities has reduced the
amount of loans available for repurchase, which has contributed
to a lower gain on sale related to these items.
The increase in Capital Markets’ underwriting revenues was
due to increased sales of our nonprime and home equity
securities combined with an increase in third-party underwriting
business. The increase in Capital Markets’ gain on sale
related to its conduit activities was due to increased margins
on sales of distressed assets combined with increased sales of
Nonprime Mortgage Loans. Capital Markets’ revenues from its
trading
48
activities consist of gain on sale and interest income. In a
steep yield curve environment, which generally existed during
2004 and 2003, trading revenues derive largely or entirely from
net interest income earned during the securities’ holding
period. As the yield curve flattens, the mix of revenues will
naturally 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, the
slope of the yield curve, and the effectiveness of our
associated interest rate risk management activities.
Provision for loan losses related to loans held for investment
(71,775
)
(48,204
)
Net interest income after provision for loan losses
$
1,949,682
$
1,353,789
The increase in net interest income from Mortgage Banking loans
and securities reflects an increase in the average inventory of
mortgage loans during 2004 as compared to 2003. Prime Home
Equity Loans had been accumulated in prior periods resulting in
a higher average inventory balance of such loans in the current
year as compared to the year-ago period. Also contributing to
the increase in net interest income from Mortgage Banking is a
decline in the overall borrowing rate as a result of the use of
more cost-effective short-term financing.
Net interest expense from custodial balances decreased in the
current period due to the decrease in loan payoffs from the
year-ago period. We are required 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 the payoff float. The amount of
such interest passed through to the security holders was
$296.7 million and $406.8 million in the 2004 and
2003, respectively.
Interest expense allocated to the Loan Servicing Sector
increased primarily due to an increase in total Servicing Sector
assets.
The decrease in interest income related to reperforming loans is
a result of a decrease in the average balance of such loans held.
The increase in net interest income from the Banking Segment was
primarily attributable to growth in the average investment in
mortgage loans in the Bank. Average assets in the Banking
Segment increased to $32.0 billion during 2004, an increase
of $15.5 billion over the year-ago period. The average net
interest spread earned increased to 2.26% during 2004 from 2.04%
during 2003.
49
The decrease in net interest income from the Capital Markets
securities portfolio is attributable to a decrease in the
average net spread earned from 1.44% in 2003 to 0.93% in 2004,
partially offset by an increase of 28% in the average inventory
of securities held. The decrease in net spread earned on the
securities portfolio is primarily due to an increase in
short-term financing rates.
Loan Servicing Fees and Other Income from Retained
Interests
Loan servicing fees and other income from retained interests are
summarized below:
Total loan servicing fees and other income from retained
interests
$
3,269,587
$
2,804,338
The increase in servicing fees, net of guarantee fees, was
principally due to a 33% increase in the average servicing
portfolio, partially offset by a reduction in the overall
annualized net service fee earned from 0.35% of the average
portfolio balance during 2003 to 0.33% during 2004. The
reduction in the overall net service fee was largely due to
agreements we reached with certain loan investors to reduce our
contractual servicing fee rate. The resulting excess yield has
been securitized and sold or is included on the balance sheet as
trading securities.
The decrease in income from other retained interests was due
primarily to a slight decrease in the yield on these investments
during 2004. These investments include interest-only and
principal-only securities as well as residual interests that
arise from the securitization of nonconforming mortgage loans,
particularly Nonprime Mortgage and Prime Home Equity Loans.
Amortization of Mortgage Servicing Rights
We recorded amortization of MSRs of $1,940.5 million, or an
annual rate of 22.0%, during 2004 as compared to
$2,069.2 million, or an annual rate of 26.5%, during 2003.
The reduction in the amortization rate reflects the increase in
the estimated life of the servicing portfolio, which is
attributable to the effect of comparatively higher interest
rates during the current period on estimated future prepayments.
Partially offsetting the lower amortization rate was a higher
MSR asset balance attributable to net growth in the servicing
portfolio during 2004.
Impairment of Retained Interests and Servicing Hedge
(Losses) Gains
Impairment of retained interests and Servicing Hedge (losses)
gains are detailed below:
Servicing Hedge (losses) gains recorded in earnings
$
(215,343
)
$
234,823
50
Impairment of MSRs in 2004 resulted generally from a decline in
their estimated fair value, driven by a slight decrease in
mortgage rates during the year. However, impairment of MSRs was
lower in 2004 than in 2003 because mortgage rates were generally
higher during the current year than in 2003. Impairment of MSRs
during 2003 resulted from a reduction in the estimated fair
value of MSRs, primarily driven by the decline in mortgage rates
during much of the period. In 2004, we recognized impairment of
other retained interests, primarily as a result of a decline in
the value of nonprime securities. The collateral underlying
certain of these residuals is fixed-rate while the pass-through
rate is floating. An increase in projected short-term interest
rates during the current period resulted in a compression of the
spread on such residuals, which resulted in a decline in their
value.
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.
There was little change in long-term Treasury and swap rates
from December 31, 2003 to December 31, 2004. The
Servicing Hedge loss of $215.3 million in 2004 resulted
primarily from time value decay on the options included in the
Servicing Hedge. 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. 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.
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 due to an
increase in premiums earned on lender-placed and voluntary lines
of businesses combined with an increase in reinsurance premiums.
Commissions and Other Income
Commissions and other income consisted of the following:
Compensation expenses increased $546.1 million, or 21%,
during 2004 as compared to 2003. In the Loan Production Sector,
compensation expenses increased $382.3 million, or 25%, as
a result of a 22% increase in average staff combined with an
increase in incentive compensation, which averaged 0.30% of the
volume of loans originated in 2004, compared to 0.21% in 2003.
In the Loan Servicing Sector, compensation expense rose
$34.0 million, or 14%, to accommodate a 22% increase in the
number of loans serviced. Compensation expenses increased in all
other business segments and corporate areas, reflecting growth
in the Company.
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.
52
Occupancy and Other Office Expenses
Occupancy and other office expenses are summarized below:
Occupancy and other office expenses for 2004 increased by
$130.9 million, or 22%. Personnel growth in our loan
production operations accounted for 89% of this increase.
Insurance Claim Expenses
Insurance claim expenses were $390.2 million for 2004 as
compared to $360.0 million for 2003. The increase in
insurance claim expenses was due mainly to $67.9 million of
estimated losses resulting from hurricane damage sustained in
Florida during 2004 in comparison to $10.1 million of
catastrophic losses in the prior year. The increase in
catastrophic claim expenses was partially offset by lower
non-catastrophic claims experience in both voluntary homeowners
and lender-placed insurance lines during 2004.
Advertising and Promotion Expenses
Advertising and promotion expenses increased 65% from 2003,
reflecting the shift in our loan product and production channel
mix.
Loss on servicing-related advances consists primarily of losses
during the period arising from unreimbursed servicing advances
on defaulted loans and credit losses arising from defaulted
VA-guaranteed loans. (See the “Credit Risk Management”
section of this Report for a further discussion of credit risk.)
Insurance expense increased due to an increase in mortgage
insurance related to growth in the Bank’s loan portfolio.
Our diluted earnings per share for 2003 totaled $4.18, a 158%
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, Diversified Businesses
achieved a substantial overall increase in earnings in 2003.
Industry-wide, mortgage loan production reached a record level
of $3.8 trillion in 2003, up from $2.9 trillion during
2002 (Source of Mortgage Market: Mortgage Bankers
Association). 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 also drove high
production margins in 2003. 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 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 Diversified 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.
Our Mortgage Banking Segment includes the Loan Production, Loan
Servicing and Loan Closing Sectors. 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.
55
Loan Production Sector
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 11.4% in 2003, up from
8.8% in 2002 (Source of Mortgage Market: Mortgage Bankers
Association). 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.
Mortgage Banking loan production for 2003 increased 64% in
comparison to 2002. 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 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
56
would potentially choose adjustable-rate mortgages in a higher
interest rate environment. Such a shift in homeowner preferences
may favor portfolio lenders, which by the nature of their
business model are better able to fund 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 Nonprime 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 Nonprime 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, we believe these loans will be a
significant component of the sector’s future profitability,
in particular if mortgage rates should rise significantly.
During 2003, the Loan Production Sector operated at
approximately 123% 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 had been reduced
by approximately 3,000.
The following table summarizes the number of people included in
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 and
Full Spectrum Lending Divisions 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. Full
Spectrum Lending expanded its sales force by 981, or 96%, during
2003.
Loan Servicing Sector
The following table summarizes the results for the Loan
Servicing Sector:
The Loan Servicing Sector experienced continued losses during
2003, driven by high amortization and impairment of the
Company’s retained interests. The amortization and
impairment charges reflect the loss in
58
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.
During 2003, we securitized a portion of our net servicing fees.
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
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.
Diversified Businesses
To leverage our mortgage banking franchise, 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:
Banking, Capital Markets, Insurance and Global Operations.
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 composition of the Bank’s balance sheets was as follows:
December 31
2003
2002
(Dollar amounts in millions)
Assets
Cash
$
143
$
164
Short-term investments
350
300
Mortgage loans held for investment, net
14,686
1,903
Available-for-sale securities
3,564
2,591
FHLB & FRB stock
394
68
Other assets
231
85
$
19,368
$
5,111
Liabilities
Deposits:
Company-controlled escrow deposit accounts
$
5,901
$
2,259
Customer
3,427
855
FHLB advances
6,875
1,000
Other borrowings
1,508
309
Other liabilities
162
54
17,873
4,477
Shareholder’s equity
1,495
634
$
19,368
$
5,111
Non-accrual loans
$
4.4
$
0.6
Capital ratios:
Tier 1 Leverage
8.6
%
12.5
%
Tier 1 Risk-based capital
12.8
%
27.8
%
Total Risk-based capital
12.9
%
27.9
%
The increase in net interest income was primarily due to a
$9.0 billion increase in average interest-earning assets
(primarily mortgage loans), combined with an increase in net
interest margin (net interest income divided by average earning
assets) of 33 basis points. The margin increase was the
result of a more favorable asset mix and lower loan and
securities prepayments.
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.
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, which
consisted of a robust mortgage securities market, high mortgage
securities price volatility and low short-term financing costs.
61
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 conduit mortgage loans sold. During
2003, the conduit mortgage loans sold totaled
$38.1 billion, an 81% increase in comparison to
$21.1 billion 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 CSC
securities trading volume, which includes inter-segment trades
with our mortgage banking operations, by instrument:
Approximately 12% and 13% of the segment’s
non-U.S. Treasury 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.
62
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:
Our mortgage reinsurance business produced $102.8 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 the liability for insurance claims. The liability
for reinsurance claims is a function of expected remaining
claims losses and premiums.
Our Life and Casualty insurance business produced pre-tax
earnings of $56.0 million, an increase of
$54.9 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.
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 Bank, PLC.
63
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:
Gain on sale of loans and securities increased in 2003 as
compared to 2002, due primarily 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. Subsequently, the remaining loans were securitized and
sold during 2004 with the gain on sale of these loans being
reflected in that period.
Reperforming 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
reperforming loans was 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.
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. The
increase in underwriting revenues was due to increased
third-party underwriting during 2003. 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.
64
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.
Provision for loan losses related to loans held for investment
(48,204
)
(26,565
)
Net interest income after provision for loan losses
$
1,353,789
$
765,665
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 home equity AAA
asset-backed securities is due to an increase in the average
inventory of securities held.
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 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 2.0% in 2003 from 1.9% in 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 was the result of a flatter yield curve.
65
Loan Servicing Fees and Other Income from Retained
Interests
Loan servicing fees and other income from retained interests are
summarized below:
Total loan servicing fees and other income from retained
interests
$
2,804,338
$
2,028,922
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
interest-only strips.
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 Nonprime Mortgage
Loans and Prime Home Equity Loans.
Higher prepayment penalty income in 2003 was the result of the
increase in Nonprime Mortgage 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 estimated future net MSR cash flows. The estimation
was based on forecasts of higher mortgage prepayments in 2003
compared to 2002, coupled with an increase in the cost basis of
the MSRs arising from growth in the servicing portfolio.
Impairment of Retained Interests and Servicing Hedge
Gains
Impairment of retained interests and Servicing Hedge gains are
detailed below:
During 2003 and 2002, impairment of MSRs and other retained
interests resulted generally from a reduction in the estimated
fair value of those investments, which was primarily driven by
the decline in mortgage rates during these periods.
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.
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:
Compensation expenses increased $817.6 million, or 46%,
during 2003 as compared to 2002. 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
67
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.
Compensation expenses increased in all other business segments,
reflecting their growth.
In the Capital Markets Segment, incentive bonuses increased
$35.1 million, or 34%, reflecting an 81% growth in
revenues. Banking Segment compensation expenses increased by
$30.1 million, or 98%, 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 by 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 are summarized below:
Occupancy and other office expenses for 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.
68
Insurance Claims Expenses
Insurance claim expenses were $360.0 million for 2003, as
compared to $277.6 million for 2002. The increase in
insurance claim expenses was attributable to higher net premiums
earned and a $31.5 million increase in the insurance claims
expenses of Balboa Reinsurance from 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.
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.
Legal and consulting fees increased from the prior year due
primarily to increased levels of these services.
Quantitative and Qualitative Disclosures About Market Risk
The primary market risk we face is interest rate risk. Interest
rate risk includes the risk that the value of our assets and
liabilities will change due to changes in interest rates.
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 interest rate 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 the values of our interest rate lock
commitments, Mortgage Loan Inventory and MBS held for sale, MSRs
and other retained interests, and trading securities, 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, which is comprised of
several of the Company’s senior financial executives,
maintains responsibility for management of this risk.
Interest Rate Lock Commitments and Mortgage
Inventory
We are exposed to interest rate risk from the time an interest
rate lock commitment (“IRLC”) is made to a mortgage
applicant or financial intermediary to the time the resulting
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 risk, we use derivatives,
primarily forward sales of MBS and options to buy and sell MBS,
as well as options on Treasury futures contracts.
69
IRLCs guarantee the rate and points on the underlying mortgage
for a specified period, generally from seven to 60 days.
Managing the interest rate risk related to IRLCs 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
marketplace changes in mortgage rates. In general, the
percentage of applications 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 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 interest rate risk associated with IRLCs, 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
IRLCs 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 interest rate risk related to our Mortgage Loan
Inventory primarily by entering into forward sales of MBS. The
value of these forward sales moves in the opposite direction of
the value of the Mortgage Loan Inventory. We actively manage our
IRLCs and Mortgage Inventory risk profiles on a daily basis.
We use the following derivative instruments in our risk
management activities related to the IRLCs and Mortgage Loan
Inventory:
•
Forward Sales of MBS: represents an obligation to sell an MBS at
a specified price in the future. Its value increases as mortgage
rates rise.
•
Forward Purchases of MBS: represents an obligation to buy an MBS
at a specified price in the future. Its value increases as
mortgage rates fall.
•
Long Call Options on MBS: represents a right to buy an MBS at a
specified price in the future. Its value increases as mortgage
rates fall.
•
Long Put Options on MBS: represents a right to sell an MBS at a
specified price in the future. Its value increases as mortgage
rates rise.
•
Long Call Options on Treasury Futures: represents a right to
acquire a Treasury futures contract at a specified price in the
future. 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 specified price in the future.
Its value increases as the benchmark Treasury rate rises.
•
Short Eurodollar Futures Contracts: represents a standardized
exchange-traded contract, the value of which is tied to spot
Eurodollar rates at specified future dates. Its value increases
when Eurodollar rates rise.
Mortgage Servicing Rights (MSRs) and Other Retained
Interests
Our MSRs and other retained interests are generally subject to
loss in value when mortgage rates decline. Declining mortgage
rates generally precipitate increased mortgage 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 generally
increase in aggregate value when interest rates decline (the
“Servicing Hedge”).
70
We currently use, or have used in the past, the following
financial instruments in our Servicing Hedge:
•
Interest Rate Floors: represents a right to receive cash if a
reference interest rate falls below a contractual strike rate.
Its value increases as reference interest rates fall. The
reference interest rates used 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 10 to 30 years. As
interest rates decrease, the value of these securities generally
increases.
•
Long Treasury Futures: represent an agreement to purchase a
Treasury security at a specified price in the future. 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 specified price in the future. 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
specified price in the future. 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
specified price in the future. Its value increases as mortgage
rates fall.
•
Forward Purchases of MBS: represents an obligation to buy an MBS
at a specified price in the future. Its value increases as
mortgage rates fall.
•
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 generally
receive the fixed rate and pay the floating rate. Such contracts
increase in value as rates fall.
•
Receiver Swaptions: represents a right to enter into a
predetermined Interest Rate Swap at a future date upon exercise
of the right we receive the fixed rate and pay the floating
rate. These contracts increase in value as rates fall.
•
Payor Swaptions: represents a right to enter into a
predetermined Interest Rate Swap at a future date, whereupon
exercise of the right we pay the fixed rate and receive the
floating rate. These contracts increase in value as rates rise.
•
Principal-Only Securities: consist of mortgage trust
principal-only securities and Treasury principal-only
securities. These securities have been purchased at discounts to
par value. As interest rates decrease, the value of these
securities generally increase.
These instruments are combined to manage the overall risk
profile of the MSRs and other retained interests. We actively
manage our retained interests risk profile on a daily basis.
Securities Trading Activities
Within our Capital Markets operations, 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 specified price and at a specified
date in the future. 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 specified price at a specified date in the future. Its
value increases as mortgage rates fall.
71
•
Forward Sale of U.S. Treasury Securities: represents a
standardized exchange-traded agreement to sell a specified
quantity of U.S. Treasury securities for a specified price
at a specified date in the future. Its value increases when
interest rates rise.
•
Short Futures Contracts: represents standardized exchange-traded
contracts, 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.
•
Long Futures Contracts: represents standardized exchange-traded
contracts, the value of which is tied to the spot Fed Funds or
Eurodollar rates at specified future dates. The value of these
contracts increases when Fed Funds or Eurodollar rates fall.
•
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. Such contracts increase in value as
rates rise.
•
Long Put Options on Futures Contracts: represents a right to
sell futures contracts, 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
•
Long Call Options on Futures Contracts: represents a right to
purchase futures contracts, the value of which is tied to spot
Fed Funds or Eurodollar rates at specific future dates. The
value of these contracts increases when Fed Funds or Eurodollar
rates fall.
Treasury Bank
The primary component of Treasury Bank’s earnings is net
interest income derived from our 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. Interest rate swaps are also
used to efficiently and cost effectively convert long-term
fixed-rate deposits to adjustable-rate deposits. 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 fixed- and floating-rate 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.
We employ various commonly used modeling techniques to value our
financial instruments in connection with these sensitivity
analyses. For mortgage loans, MBS, MBS forward contracts,
collateralized mortgage obligations and MSRs, option-adjusted
spread (“OAS”) models are used. The primary
assumptions used in these models 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
72
assumption used in this model is implied market volatility of
interest rates. Other retained interests are valued using zero
volatility discounted cash flow models. The primary assumptions
used in these models are prepayment rates, discount rates and
credit losses. All relevant cash flows associated with the
financial instruments are incorporated in the various models.
Based upon this modeling, the following table summarizes the
estimated change in fair value of our interest rate-sensitive
assets, liabilities and commitments as of December 31,2004, given several hypothetical, instantaneous, parallel-shifts
in the yield curve:
Change in Fair Value
Change in Interest Rate (basis points)
–100
–50
+50
+100
(In millions)
MSRs and other financial instruments:
MSR and other retained interests
$
(3,068
)
$
(1,581
)
$
1,230
$
2,189
Impact of Servicing Hedge:
Swap-based
2,256
967
(543
)
(702
)
Treasury-based
848
269
(70
)
(102
)
MSRs and other retained interests, net
36
(345
)
617
1,385
Committed Pipeline
107
100
(214
)
(493
)
Mortgage Loan Inventory
758
487
(656
)
(1,411
)
Impact of associated derivative instruments:
Mortgage-based
(1,012
)
(634
)
894
2,001
Treasury-based
289
104
(19
)
(20
)
Eurodollar-based
(106
)
(62
)
88
190
Committed Pipeline and Mortgage Loan Inventory, net
36
(5
)
93
267
Treasury Bank:
Securities portfolio
74
49
(71
)
(153
)
Mortgage loans
388
217
(250
)
(523
)
Deposit liabilities
(204
)
(104
)
106
213
Federal Home Loan Bank Advances
(292
)
(142
)
134
261
Treasury Bank, net
(34
)
20
(81
)
(202
)
Notes payable and capital securities
(477
)
(239
)
237
474
Impact of associated derivative instruments:
Swap-based
120
59
(58
)
(116
)
Notes payable and capital securities, net
(357
)
(180
)
179
358
Insurance company investment portfolios
34
18
(21
)
(43
)
Net change in fair value related to MSRs and other financial
instruments
$
(285
)
$
(492
)
$
787
$
1,765
Net change in fair value related to broker-dealer trading
securities
$
(11
)
$
(3
)
$
(8
)
$
(24
)
73
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, 2003, given
several hypothetical (instantaneous) parallel shifts in the
yield curve:
Change in Fair Value
Change in Interest Rate (basis points)
–100
–50
+50
+100
(In millions)
Net change in fair value related to MSRs and other financial
Instruments
$
(668
)
$
(630
)
$
831
$
1,747
Net change in fair value related to broker-dealer trading
securities
$
(1
)
$
2
$
(10
)
$
(28
)
These sensitivity analyses are limited in that they were
performed at a particular point in time; only contemplate
certain movements in interest rates; do not incorporate changes
in interest rate volatility or changes in the relationship of
one interest rate index to another; 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 result from changes in interest rates.
In addition, not all of the changes in fair value would impact
current period earnings. For example, MSRs are carried by
impairment stratum at the lower of amortized cost or market
value. Consequently, absent hedge accounting, any increase in
the value of a particular MSR stratum above its amortized cost
basis would not be reflected in current-period earnings. In
addition, our debt is carried at its unpaid principal balance
net of issuance discount or premium; therefore, absent hedge
accounting, changes in the market value of our debt are not
recorded in current-period earnings. For these reasons, the
preceding estimates should not be viewed as an earnings forecast.
Market Risk — Foreign Currency Risk
In order to diversify our funding sources globally, we
occasionally issue medium-term notes denominated in a foreign
currency. We manage the foreign currency risk associated with
these medium-term notes through cross-currency swap
transactions. The terms of the cross-currency swaps effectively
convert all foreign currency-denominated medium-term notes into
U.S. dollar obligations, thereby eliminating the associated
foreign currency risk. 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, securities
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 our credit risk goals and
objectives. Those goals and objectives are documented in our
Credit Policy.
Mortgage Credit Risk
Overview
In our mortgage lending activities, we manage our credit risk
through credit policy, underwriting, quality control and
surveillance activities as well as through use of credit
enhancements, especially nonrecourse and limited recourse
securitizations. We also employ proactive collection and loss
mitigation efforts.
74
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 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 or the
Veterans Administration. Our underwriting guidelines for
non-conforming mortgage loans, Prime Home Equity Loans, and
Nonprime 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 ongoing
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 pre- and 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 with laws and regulations.
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, we bear any
subsequent credit loss on the mortgage loans.
75
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 Mortgage Loans generally are securitized on a non-recourse
basis, while Prime Home Equity and Nonprime 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 or Freddie
Mac. A small portion of these loans also has been sold to the
Federal Home Loan Bank, through its Mortgage Partnership Finance
Program. Subject to certain representations and warranties we
make, nearly all conventional loans securitized through Fannie
Mae or Freddie Mac are sold on a non-recourse basis. We pay
guarantee fees to these agencies to compensate them for their
assumption of credit risk on the securitized loans.
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 has 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, overcollateralization 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 risk
subject to representations and warranties we make when the 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.
Nonprime Mortgage Loans
Nonprime Mortgage Loans generally are pooled into private-label
asset-backed securities. We generally securitize these loans
with limited recourse for credit losses through retention of a
residual interest, which usually ranges from 0.5% to 3.0% of the
principal balance of the loans. In some cases, such limited
recourse securitizations have contained mortgage pool insurance
as the primary form of credit enhancement, coupled with a
limited corporate guarantee from us and/or a retained residual
interest. When mortgage pool insurance is used, we pay the
associated premiums. We also have pooled a portion of our
Nonprime Mortgage 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.
76
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, 2004 are as follows:
Corporate guarantees in excess of recorded liability
$
419,264
The carrying value of the residual securities is net of expected
future credit losses. The total credit losses incurred for 2004
and 2003 related to all of our mortgage securitization
activities are summarized as follows:
Nonprime securitizations with retained residual interest
$
43,021
$
36,699
Repurchased or indemnified loans
42,063
35,426
Prime home equity securitizations with retained residual interest
29,370
15,196
Nonprime securitizations with corporate guarantee
20,039
40,891
Prime home equity securitizations with corporate guarantee
6,930
2,763
VA losses in excess of VA guarantee
1,658
2,824
$
143,081
$
133,799
Mortgage Reinsurance
We provide mortgage reinsurance on mortgage loans included in
our servicing portfolio through contracts with several primary
mortgage insurance companies. 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. As of December 31, 2004, approximately
$71.9 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, 2004, the maximum aggregate losses
under the reinsurance contracts were $419.1 million. We are
required to pledge securities to cover this potential liability.
We recorded provisions for losses related to this activity of
$41.5 million in 2004.
Mortgage Loans Held for Sale
At December 31, 2004, mortgage loans held for sale amounted
to $37.4 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.
77
Portfolio Lending Activities
We have a portfolio of mortgage loans held for investment,
consisting primarily of Prime Mortgage and Prime Home Equity
Loans, which amounted to $34.6 billion at December 31,2004. This portfolio is held primarily in our Bank. Prime Home
Equity Loans held in the Bank with combined loan-to-value ratios
equal-to or above 90% are covered by a pool insurance policy
that provides partial protection against credit losses.
Otherwise, we generally retain full credit exposure on these
loans.
We also provide short-term secured mortgage-loan warehouse
advances to various lending institutions, which totaled
$3.7 billion at December 31, 2004.
Our total allowance for credit losses for mortgage loans held
for investment amounted to $125.0 million at
December 31, 2004. Related net charge-offs during 2004
totaled $25.2 million.
Counterparty Credit Risk
We have exposure to credit loss in the event of contractual
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 extended to
any single counterparty.
The aggregate amount of counterparty credit exposure at
December 31, 2004, before and after collateral held by us,
was as follows:
For the year ended December 31, 2004, we incurred no credit
losses due to non-performance of any of our 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, loans held for investment
and loans serviced under subservicing agreements, for the
periods indicated.
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 number of loans in the conventional and Prime Home Equity
portfolios, which carry lower delinquency rates than the
government and nonprime portfolios. Also contributing to the
decline in the overall delinquency rate is a reduction in the
delinquency rate of our nonprime portfolio. We believe the
delinquency rates in our servicing portfolio are consistent with
industry experience for similar mortgage loan portfolios.
Inflation
Our operations that would be most significantly impacted by an
increase in inflation are 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
79
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 periods 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 manage our long-term debt maturities (which
we define for this purpose as debt maturing after six months),
and credit facility expirations to minimize 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 their
reliability, recognizing that certain financing programs are
sensitive to temporary market disruptions.
We regularly forecast our potential funding needs over
three-month and longer horizons, taking into account debt
maturities and potential peak balance sheet levels. Available
reliable sources of liquidity are appropriately established and
sized to meet potential future funding requirements. We
currently have $72.5 billion in reliable sources of
short-term liquidity, including secured and unsecured committed
bank lines of credit and reusable mortgage purchase commitments
totaling $55.7 billion. Our long-term debt typically
consists of unsecured debt issued in the public corporate debt
markets. At December 31, 2004, we had $21.5 billion in
unsecured long-term debt outstanding. See
“Note 16 — 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, 2004, we had a total of $26.5 billion in
public corporate debt outstanding.
80
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 12 years. Given
our current ratings, we generally have deep access to the public
corporate debt markets. Current credit ratings are as follows:
Countrywide
Home Loans
Countrywide
Short-Term
Financial Corporation
Ratings(1)
Long-Term Ratings
Standard and Poors
A-1
A
Moody’s Investors Service
P-2
A3
Fitch
F1
A
(1)
The Company expects to receive short-term credit ratings for CFC
consistent with those currently in place at Countrywide Home
Loans in the near future.
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.
Minimum required to qualify as “well capitalized.”
Our primary source of equity capital is retained earnings. We
also have $1.0 billion outstanding in junior subordinated
debentures that receive varying degrees of “equity
treatment” from rating agencies, bank lenders and
regulators. In addition, we currently have a $2.7 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 agencies in the
past have included our significant investment in MSRs and other
retained interests, our involvement in nonprime 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 could 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. We analyze contingent
81
liquidity scenarios of varying duration and severity for our
mortgage company, bank and broker-dealer to ensure that
sufficient highly reliable sources of committed liquidity are in
place and available to finance the Company during a temporary
market disruption.
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 or market value swaps.
Investors that purchase secured debt, typically commercial
paper, issued by these conduits look primarily to the asset
value to ensure repayment, rather than to the credit standing of
the company that utilizes 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 has been well
received by asset-backed commercial paper investors. We utilize
such programs as a cost-effective means to expand and diversify
our sources of liquidity. At December 31, 2004, we had a
borrowed a total of $7.4 billion through such asset-backed
financing programs.
Secondary Mortgage Market
We rely substantially on the secondary mortgage market as a
source of long-term capital to support our mortgage banking
operations. 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 (“ABS”). Significant portions 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 ABS. Private-label MBS and
ABS are registered with the SEC and have separate credit
ratings. Generally, private-label MBS and ABS require some form
of credit enhancement, such as over-collateralization,
senior-subordinated structures, primary mortgage insurance,
Countrywide guarantees and/or private surety guarantees.
The Agency MBS market is extremely liquid. The private-label MBS
and ABS market, particularly the nonprime ABS 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 primary
means of financing securities and mortgage loans pending sale.
Although this method of financing is uncommitted and short-term
in nature, it has proven to be a reliable and cost-effective
financing alternative for us.
Funding Bank Growth
Our goal is to increase the total assets of our Bank from
$41.0 billion as of December 31, 2004 to
$200 billion in five years. We intend to accomplish this
goal primarily 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.
82
Cash Flow
Cash flow provided by operating activities was $3.3 billion
for 2004, compared to net cash used in operating activities of
$3.3 billion for 2003. The increase in cash flow from
operations for 2004 compared to 2003 was primarily due to a
$6.4 billion net decrease in cash used to fund Mortgage
Loan Inventory.
Net cash used by investing activities was $18.0 billion for
2004, compared to $32.7 billion for 2003. The decrease in
net cash used in investing activities was primarily attributable
to a $7.0 billion decrease in cash used to fund loans held
for investment, combined with a $4.3 billion decrease in
cash used to fund investments in other financial instruments.
Net cash provided by financing activities for 2004 totaled
$14.8 billion, compared to $36.1 billion for 2003. The
decrease in cash provided by financing activities was comprised
of a $27.7 billion net decrease in short-term (primarily
secured) borrowings, offset by a $4.5 billion increase in
deposit liabilities and a $2.6 billion net increase in
long-term debt.
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, to 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 becomes burdensome in relation to the
benefits of servicing.
Our Prime Mortgage Loans generally are securitized on a
non-recourse basis, while Prime Home Equity and Nonprime Loans
generally are securitized with limited recourse for credit
losses. During 2004, we securitized $57.8 billion in
Nonprime Mortgage and Prime 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.”
We do not believe that any of our off-balance sheet arrangements
have had 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
2004 and additional information with respect to securitization
activities are included in the financial statements section of
this Report (Note 11 —
“Securitizations”).
83
Contractual Obligations
The following table summarizes our significant contractual
obligations at December 31, 2004, with the exception of
short-term borrowing arrangements and pension and
post-retirement benefit plans.
Less than
More than
Note(1)
1 Year
1-3 Years
3-5 Years
5 Years
Total
(In thousands)
Obligations:
Notes payable
16
$
26,595,868
$
18,613,268
$
10,539,849
$
3,492,548
$
59,241,533
Time deposits
17
$
3,918,980
$
3,407,888
$
2,347,493
$
695,402
$
10,369,763
Operating leases
29
$
114,856
$
182,865
$
93,783
$
34,722
$
426,226
Purchase obligations
—
$
163,804
$
11,066
$
5,295
$
—
$
180,165
(1)
See respective notes to the financial statements included in
this Report.
As of December 31, 2004, the Company had undisbursed home
equity lines of credit and construction loan commitments of
$5.4 billion and $936.9 million, respectively. As of
December 31, 2004, outstanding commitments to fund mortgage
loans in process totaled $29.8 billion.
In connection with the Company’s underwriting activities,
the Company had commitments to purchase and sell new issues of
securities aggregating $666.7 million at December 31,2004.
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 9%. 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 30 mortgage lenders
combined have a 84% share of the mortgage origination market, up
from 61% five years ago.
84
Following is a year-over-year comparison of loan volume for the
top five originators, according to Inside Mortgage
Finance:
Years Ended
December 31,
Institution
2004
2003
(In billions)
Countrywide
$
363
$
435
Wells Fargo Home Mortgage
298
470
Washington Mutual
255
435
Chase Home Finance
197
308
Bank of America Mortgage
144
152
Total for Top Five
$
1,257
$
1,800
This consolidation trend has naturally carried over to the loan
servicing side of the mortgage business. Today, the top 30
mortgage servicers combined have a 70% share of the total
mortgages outstanding, up from 58% five years ago. Following is
a year-over-year comparison of loan volume for the top five
servicers, according to Inside Mortgage Finance:
Years Ended
December 31,
Institution
2004
2003
(In billions)
Countrywide
$
838
$
645
Wells Fargo Home Mortgage
782
664
Washington Mutual
728
726
Chase Home Finance
563
470
CitiMortgage Corp.(1)
364
—
Bank of America Mortgage(1)
—
246
Total for Top Five
$
3,275
$
2,751
(1)
Comparative data not included for year in which the institution
was not in the top five originators.
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
industry consolidation should lessen irrational price
competition — which from time to time has affected the
industry.
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 continues, the secondary mortgage market does not
continue to provide a competitive outlet for these loans, and we
are unable to develop an adequate portfolio lending capacity.
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 monetize 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. Although there may be some markets that
experience housing price depreciation, we believe that price
depreciation will not occur nationwide. Over the long term, we
expect that
85
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 nonprime lending
opportunities. Similarly, certain proposed state and federal
privacy legislation requiring notice to consumers of a potential
compromise of the security of personal information, if passed,
could have an adverse impact on our reputation in the event
notice is required.
Mortgage Originations
Following is the estimated total United States mortgage
originations market for each of the last five years:
United States
Mortgage
Calendar Year
Originations
(In billions)
2004
$
2,854
2003
$
3,810
2002
$
2,852
2001
$
2,243
2000
$
1,139
Source: Mortgage Bankers Association
Forecasters currently put the market for 2005 at between
$2.2 trillion and $2.6 trillion. The forecasted
reduction 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 Segment 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 profitability.
Implementation of New Accounting Standards
In January 2003, the FASB issued FASB Interpretation
No. 46, “Consolidation of Variable Interest
Entities,” which was amended in December 2003
(“FIN 46R”). FIN 46R is an interpretation of
Accounting Research Bulletin No. 51,
“Consolidated Financial Statements.” FIN 46R
requires business enterprises to consolidate variable interest
entities which have one or more of the following characteristics:
•
The equity investment at risk is not sufficient to permit the
entity to finance its activities without additional subordinated
financial support from other parties
•
The equity investors lack one or more of the following essential
characteristics of a controlling financial interest:
•
The direct or indirect ability to make decisions about the
entity’s activities through voting rights or similar rights
•
The obligation to absorb the expected losses of the entity if
they occur
•
The right to receive expected residual returns of the entity if
they occur
86
FIN 46R excludes qualifying special purpose entities
subject to the reporting requirements of SFAS 140.
FIN 46R 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.
As discussed in Note 16 —
Notes Payable — Junior Subordinated
Debentures, the Company has issued trust-preferred
securities. Based on guidance related to FIN 46R, during
the quarter ending March 31, 2004, the Company ceased
consolidating the subsidiaries which issued the trust-preferred
securities. The primary effect of this deconsolidation was for
the Company to reclassify the trust-preferred securities from
mezzanine equity to debt.
In December 2003, the American Institute of Certified Public
Accountants issued Statement of Position 03-3,
“Accounting for Certain Loans or Debt Securities Acquired
in a Transfer” (“SOP 03-3”). SOP 03-3
applies to loans acquired in a transfer if both of the following
apply:
•
it is probable at the acquisition date that the investor will
not be able to collect all of the contractual cash flows of the
loan
•
there has been deterioration of the borrower’s credit
quality.
SOP 03-3 prohibits the carryover or creation of a valuation
allowance or loan allowance in the initial accounting for the
purchase. SOP 03-3 allows recognition of interest income on
these loans if a reasonable estimate of the amount and timing of
cash flows is available. The requirements of SOP 03-3 are
consistent with our existing accounting for purchases of
impaired loans as part of our Capital Markets Segment
activities. Therefore we do not expect the adoption of
SOP 03-3 to have a significant affect our financial
condition or earnings.
In March 2004, the Emerging Issues Task Force (“EITF”)
of the FASB reached consensus opinions regarding the
determination of whether an investment is considered impaired,
whether the identified impairment is considered
other-than-temporary, how to measure other-than-temporary
impairment, and how to disclose unrealized losses on investments
that are not other-than-temporarily impaired. The consensus
opinions, detailed in Emerging Issues Task Force Issue
No. 03-1, “The Meaning of Other-Than-Temporary
Impairment and its Application to Certain Investments
(“EITF 03-1”),” add to the Company’s
impairment assessment requirements detailed in Emerging Issues
Task Force Issue No. 99-20, “Recognition of Interest
Income and Impairment on Purchased and Retained Interests in
Securitized Financial Assets.”
We have included the new disclosure requirements of
EITF 03-1 in our financial statements. Adoption of the new
measurement requirements has been delayed by the FASB pending
reconsideration of implementation guidance relating to debt
securities that are impaired solely due to interest rates and/or
sector spreads.
Late in 2004, the Emerging Issues Task Force reached a consensus
on Issue No. 04-8, “The Effect of Contingently
Convertible Instruments on Diluted Earnings per Share”
(“EITF 04-8”). The consensus requires that all
instruments that have embedded conversion features that are
contingent on market conditions indexed to an issuer’s
share price should be included in diluted earnings per share
computations (if dilutive) regardless of whether the market
conditions have been met.
The consensus includes instruments that have more than one
contingency if one of the contingencies is based on market
conditions indexed to the issuer’s share price and that
instrument can be converted to shares based on achieving a
market condition — that is, the conversion is not
dependent on a substantive non-market-based contingency. The
application of this consensus is required beginning with the
December 31, 2004 reporting period. Countrywide’s
Liquid Yield Option Notes and Convertible Securities, described
in Note 16 — “Notes Payable,” meet the
criteria of EITF 04-8. Therefore, earnings per share
amounts have been recalculated and restated as appropriate for
all periods presented.
In December 2004, the FASB issued Statement of Financial
Accounting Standards No. 123R, “Share-Based
Payment” (“SFAS 123R”), an amendment of FASB
Statement No. 123” (“SFAS 123”),
“Accounting for Stock-Based Compensation.”
SFAS 123R is focused primarily on accounting for
share-based compensation. This statement requires companies to
measure the cost of employee services received in exchange for
an award of equity instruments based on the grant date fair
value of the awards. SFAS 123R
87
requires measurement of the fair value of the options using an
option pricing model that takes into account the awarded
options’ unique characteristics. SFAS 123R requires
charging the recognized cost to expense over the period the
employee provides services to earn the award —
generally the vesting period for the award.
SFAS 123R’s measurement requirements are similar to
those of SFAS 123, which is the basis for the pro forma
stock-based compensation disclosure contained in
Note 2 — “Summary of Significant Accounting
Policies” in the financial section of this report. However,
SFAS 123R requires:
•
initial and ongoing estimates of the amount of shares that will
vest — SFAS 123 provided entities the alternative
of assuming that all shares would vest and then
“truing-up” compensation cost and expense as shares
were forfeited
•
adjusting the cost of a modified award with reference to the
difference in the fair value of the modified award to the
initial award at the date of modification of the award
SFAS 123R also provides for the use of alternative models
to determine compensation cost related to stock option grants.
The model we will use to value our employee stock options has
not yet been selected, and therefore any financial impacts of a
model change cannot be determined. However, we do not expect the
adoption of SFAS 123R to have a significant impact on our
financial position or earnings. The provisions of SFAS 123R
are applicable to us in the quarter ending September 30,2005.
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
may 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. 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, as well as 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
88
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. There are many
market factors that impact the performance of our interest rate
risk management activities including interest rate volatility,
the shape of the yield curve and the spread between mortgage
interest rates and Treasury or Swap rates. 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
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, 2004. 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
89
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 nonprime 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 limit our liability 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 in 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 Government Sponsored Enterprises (GSEs)
•
Changes in regulations or the occurrence of other events that
impact the business, operation or prospects of GSEs
90
•
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 could also cause results to differ from
our expectations may not be described in any such report or
document. 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.
Quantitative and Qualitative Disclosures About Market
Risk
In response to this Item, the information set forth on
pages 69 to 74 and Note 12 of this Form 10-K is
incorporated herein by reference.
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 F-1
of this Form 10-K.
Item 9.
Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure
Not Applicable.
Item 9A.
Controls and Procedures
(1)
Evaluation of Disclosure 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, solely because of the material weakness in our
internal control over financial reporting described below under
the heading “Management’s Report on Internal Control
Over Financial Reporting,” our disclosure controls and
procedures were ineffective 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, 2004 that
has materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting.
(2)
Management’s Report on Internal Control Over
Financial Reporting
The Company’s management is responsible for establishing
and maintaining adequate internal control over financial
reporting. The Company’s internal control system was
designed to provide reasonable assurance regarding the
preparation and fair presentation of published financial
statements.
A material weakness is a significant deficiency, or combination
of significant deficiencies, that results in more than a remote
likelihood that a material misstatement of the annual or interim
financial statements will not be prevented or detected. A
significant deficiency is a control deficiency, or combination
of control deficiencies, that adversely affects the
Company’s ability to initiate, authorize, record, process,
or report external financial information reliably in accordance
with generally accepted accounting principles such that
91
there is more than a remote likelihood that a misstatement of
the Company’s annual or interim financial statements that
is more than inconsequential will not be prevented or detected.
The Company’s management assessed the effectiveness of the
Company’s internal control over financial reporting as of
December 31, 2004, and this assessment identified the
following material weakness in the Company’s internal
control over financial reporting:
The Company’s internal controls intended to ensure the
proper accounting treatment of certain securitization
transactions were not properly designed as of December 31,2004. Specifically, these controls were intended to facilitate
the proper sale accounting treatment pursuant to the provisions
of Statement of Financial Accounting Standards No. 140,
“Accounting For Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities”
(“SFAS 140”). These internal controls were not
designed to address all relevant provisions of SFAS 140,
specifically those relating to derivatives and retained
interests, that require evaluation when concluding on the
propriety of sale accounting treatment for a securitization
transaction. As a result of these ineffectively designed
controls, the Company recorded certain gains on the sales of
mortgage loans in improper periods during 2004 and 2003. The
Company will restate its quarterly financial information for
each of the first three quarters in 2004 and the second and
third quarters of 2003 to correct these accounting errors.
In making its assessment of internal control over financial
reporting, management used the criteria established in
“Internal Control — Integrated Framework”
issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO). Because of the material weakness
described in the preceding paragraph, management concludes that
it did not maintain effective internal control over financial
reporting as of December 31, 2004 based on the criteria
established in COSO.
KPMG LLP, the independent registered public accounting firm that
audited the Company’s financial statements included in this
Annual Report on Form 10-K for the period ended
December 31, 2004, has issued an audit report on
management’s assessment of the Company’s internal
control over financial reporting. This report appears on
page 93.
(3)
Remediation Efforts Related to the Material Weakness in
Internal Control over Financial Reporting
The Company created certain mortgage-backed securities
containing embedded derivatives which were underwritten by a
Countrywide affiliate. At the end of each quarter in 2004 and at
the end of the second quarter in 2003, a small amount of these
securities had not yet been sold, but in all cases the remaining
securities were sold shortly after quarter end. The securities
held at each quarter end ranged from 0.1 percent to
2.2 percent of the principal balance of the related loans
securitized. Such unsold securities containing embedded
derivatives needed to be sold prior to the Company recording any
gain on sale. These securities were not identified by the
existing internal controls and resulted in the Company having to
revise the timing of the gain on sale for such transactions, and
ultimately, the identification of a material weakness in
internal control over financial reporting. This has been
remediated in 2005 by implementing the following:
1)
Accounting policies relating to new or modified activities will
be reviewed prior to the end of the first quarter in which such
policies are effective.
2)
Each securitization transaction will be reviewed as it occurs to
identify whether it involves securities containing embedded
derivatives, and if so, a plan will be developed for disposition
of such securities.
3)
Procedures will be implemented to identify any such securities
containing embedded derivatives that are held at each quarter
end.
92
Report of Independent Registered Public Accounting
Firm
The Board of Directors and Stockholders
Countrywide Financial Corporation:
We have audited management’s assessment, included in the
accompanying Management’s Report on Internal Control
Over Financial Reporting, included in Item 9A(2), that
Countrywide Financial Corporation (the Company) did not maintain
effective internal control over financial reporting as of
December 31, 2004, because of the effect of the material
weakness identified in management’s assessment, based on
criteria established in Internal Control — Integrated
Framework issued by the Committee of Sponsoring Organizations of
the Treadway Commission (COSO). The Company’s management is
responsible for maintaining effective internal control over
financial reporting and for its assessment of the effectiveness
of internal control over financial reporting. Our responsibility
is to express an opinion on management’s assessment and an
opinion on the effectiveness of the Company’s internal
control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain
reasonable assurance about whether effective internal control
over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of
internal control over financial reporting, evaluating
management’s assessment, testing and evaluating the design
and operating effectiveness of internal control, and performing
such other procedures as we considered necessary in the
circumstances. We believe that our audit provides a reasonable
basis for our opinion.
A company’s internal control over financial reporting is a
process designed to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with
generally accepted accounting principles. A company’s
internal control over financial reporting includes those
policies and procedures that (1) pertain to the maintenance
of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the
company; (2) provide reasonable assurance that transactions
are recorded as necessary to permit preparation of financial
statements in accordance with generally accepted accounting
principles, and that receipts and expenditures of the company
are being made only in accordance with authorizations of
management and directors of the company; and (3) provide
reasonable assurance regarding prevention or timely detection of
unauthorized acquisition, use, or disposition of the
company’s assets that could have a material effect on the
financial statements.
Because of its inherent limitations, internal control over
financial reporting may not prevent or detect misstatements.
Also, projections of any evaluation of effectiveness to future
periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree
of compliance with the policies or procedures may deteriorate.
A material weakness is a control deficiency, or combination of
control deficiencies, that results in more than a remote
likelihood that a material misstatement of the annual or interim
financial statements will not be prevented or detected. The
following material weakness has been identified and included in
management’s assessment:
The Company’s internal controls intended to ensure the
proper accounting treatment of certain securitization
transactions were not properly designed as of December 31,2004. Specifically, these controls were intended to facilitate
the proper sale accounting treatment pursuant to the provisions
of Statement of Financial Accounting Standards No. 140,
“Accounting For Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities”
(“SFAS 140”). These internal controls were not
designed to address all relevant provisions of SFAS 140,
specifically those relating to derivatives and retained
interests, that require evaluation when concluding on the
propriety of sale accounting treatment for a securitization
transaction. As a result of these ineffectively designed
controls, the Company recorded certain gains on the sales of
mortgage loans in improper periods during 2004 and 2003. The
Company will restate its quarterly financial information for
each of the first three quarters in 2004 and the second and
third quarters of 2003 to correct these accounting errors.
93
We also have audited, in accordance with the standards of the
Public Company Accounting Oversight Board (United States), the
consolidated balance sheet of Countrywide Financial Corporation
and subsidiaries as of December 31, 2004, and the related
consolidated statements of earnings, stockholders’ equity,
cash flows and comprehensive income for the year then ended. The
aforementioned material weakness was considered in determining
the nature, timing, and extent of audit tests applied in our
audit of the 2004 consolidated financial statements, and this
report does not affect our report dated March 11, 2005,
which expressed an unqualified opinion on those consolidated
financial statements.
In our opinion, management’s assessment that the Company
did not maintain effective internal control over financial
reporting as of December 31, 2004, is fairly stated, in all
material respects, based on criteria established in Internal
Control—Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO).
Also, in our opinion, because of the effect of the material
weakness described above on the achievement of the objectives of
the control criteria, the Company has not maintained effective
internal control over financial reporting as of
December 31, 2004, based on criteria established in
Internal Control—Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission
(COSO).
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.
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.
Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters
Equity Compensation Plan Information
The following table shows aggregate information, as of
December 31, 2004, with respect to compensation plans under
which equity securities of Countrywide are authorized for
issuance.
Number of Securities
Remaining Available for
Future Issuance Under
Number of Securities to be
Weighted-Average
Equity Compensation Plans
Issued Upon Exercise of
Exercise Price of
(Excluding Securities
Outstanding Options,
Outstanding Options,
Reflected in
Plan Category
Warrants and Rights
Warrants and Rights
Column(a))(1)
Equity Compensation Plans Approved by Security Holders
59,109,336
$
15.35
40,859,635
Equity Compensation Plans Not Approved by Security Holders
N/A
N/A
N/A
Total
59,109,336
$
15.35
40,859,635
(1)
Countrywide’s 2000 Equity Incentive Plan also provides for
awards of Restricted Stock. Of the securities available for
issuance under this plan, 4,986,516 shares of our Common
Stock are available for issuance in the form of Restricted Stock.
The other information required by this Item 12 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 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.
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.
95
PART IV
Item 15.
Exhibits and Financial Statement Schedules
(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 F-2 of this Form 10-K. The index to
Financial Statements and Schedules is set forth at page F-1 of
this Form 10-K.
Bylaws of the Company, as amended and restated (incorporated by
reference to Exhibit 3 to the Company’s Current Report
on Form 8-K, dated February 10, 1988).
Specimen Certificate of the Company’s Common Stock
(incorporated by reference to Exhibit 4.2 to the Current
Company’s Report on Form 8-K, dated February 6,
1987).
Indenture dated as of January 1, 1992 among CHL, the
Company and The Bank of New York, as trustee (incorporated by
reference to Exhibit 4.1 to the registration statement on
Form S-3 of CHL and the Company (File Nos. 33-50661 and
33-50661-01), filed with the SEC on October 19, 1993).
Form of Medium-Term Notes, Series B (fixed-rate) of CHL
(incorporated by reference to Exhibit 4.2 to the
Company’s registration statement on Form S-3 (File
No. 33-51816), filed with the SEC on September 9,1992).
4
.7*
Form of Medium-Term Notes, Series B (floating-rate) of CHL
(incorporated by reference to Exhibit 4.3 to the
Company’s registration statement on Form S-3 (File
No. 33-51816), filed with the SEC on September 9,1992).
Form of Medium-Term Notes, Series D (fixed-rate) of CHL
(incorporated by reference to Exhibit 4.10 to Amendment
No. 2 to the registration statement on Form S-3 of the
Company and CHL (File Nos. 33-59559 and 33-59559-01), filed with
the SEC on June 16, 1995).
4
.11*
Form of Medium-Term Notes, Series D (floating-rate) of CHL
(incorporated by reference to Exhibit 4.11 to Amendment
No. 2 to the registration statement on Form S-3 of the
Company and CHL (File Nos. 33-59559 and 33-59559-01), filed with
the SEC on June 16, 1995).
Form of Medium-Term Notes, Series E (floating rate) of CHL
(incorporated by reference to Exhibit 4.4 to Post-Effective
Amendment No. 1 to the registration statement on
Form S-3 of the Company and CHL (File Nos. 333-3835
and 333-3835-01), filed with the SEC on August 2, 1996).
Indenture, dated as of December 1, 2001 among CHL, the
Company and The Bank of New York, as trustee (incorporated by
reference to Exhibit 4.25 to the Company’s Annual
Report on Form 10-K, for the year ended December 31,2003).
Trust Deed dated 1st May, 1998 among CHL, the Company
and Bankers Trustee Company Limited, as Trustee for Euro Medium
Notes of CHL (incorporated by reference to Exhibit 4.15 to
the Company’s Quarterly Report on Form 10-Q, for the
quarter ended May 31, 1998).
4
.34*
Second Supplemental Trust Deed dated 23rd day of
December, 1999, further modifying the provisions of a
Trust Deed dated 1st May, 1998 among CHL, the Company
and Bankers Trustee Company Limited, as Trustee for Euro Medium
Notes of CHL (incorporated by reference to Exhibit 4.16.3
to the Company’s Annual Report on Form 10-K, for the
fiscal year ended February 28, 2001).
4
.35*
Third Supplemental Trust Deed dated 12th day of January,
2001, further modifying the provisions of a Trust Deed
dated 1st May, 1998 among CHL, the Company and Bankers
Trustee Company Limited, as Trustee for Euro Medium Notes of CHL
(incorporated by reference to Exhibit 4.16.4 to the
Company’s Annual Report on Form 10-K, for the fiscal
year ended February 28, 2001).
4
.36*
Fourth Supplemental Trust Deed, dated January 29,2002, further modifying the provisions of a Trust Deed,
dated May 1, 1998 among CHL, the Company and Bankers
Trustee Company Limited, as trustee for Euro medium term notes
of CHL (incorporated by reference to Exhibit 4.46 of the
Company’s Quarterly Report on Form 10-Q, for the
quarter ended March 31, 2002).
Supplemental Note Deed Poll, dated April 23, 2004,
modifying the terms of a Note Deed Poll, dated
October 11, 2001, by CHL in favor of each person who is
from time to time an Australian Dollar denominated Noteholder
(incorporated by reference to Exhibit 4.49 to the
Company’s Quarterly Report on Form 10-Q, for the
quarter ended September 30, 2004).
98
Exhibit
No.
Description
4
.39*
Indenture, dated as of December 16, 1996 among CHL, the
Company and the Bank of New York, as trustee (incorporated by
reference to Exhibit 4.34 to the Company’s Annual
Report on Form 10-K, for the year ended December 31,2003).
Amended and Restated Declaration of Trust, dated as of
December 16, 1996 for Countrywide Capital I by and among
Eric P. Sieracki, Sandor E. Samuels and Carlos M. Garcia as
Regular Trustees, The Bank of New York, as Institutional
Trustee, and the Company (incorporated by reference to
Exhibit 4.36 to the Company’s Annual Report on
Form 10-K, for the year ended December 31, 2003).
Amended and Restated Declaration of Trust of Countrywide
Capital III, dated as of June 4, 1997, by and among
the Company, The Bank of New York (Delaware) as Delaware
Trustee, Eric P. Sieracki, Sandor E. Samuels, and Thomas Keith
McLaughlin, as Regular Trustees (incorporated by reference to
Exhibit 4.3 to the registration statement on Form S-4
of CHL and the Company (File Nos. 333-37047, 333-37047-01, and
333-37047-02), filed with the SEC October 2, 1997).
Amended and Restated Declaration of Trust of Countrywide Capital
IV, dated as of April 11, 2003, by and among Sandor E.
Samuels, Thomas K. McLaughlin and Jennifer Sandefur, as Regular
Trustees, The Bank of New York (Delaware), as Delaware Trustee,
The Bank of New York, as Institutional Trustee, the Company, as
Sponsor and Debenture Issuer, and CHL., as Debenture Guarantor
(incorporated by reference to Exhibit 4.28 to the
Company’s Current Report on Form 8-K, dated
April 15, 2003).
First Supplemental Trust Deed dated 16th December, 1998,
modifying the provisions of a Trust Deed dated
1st May, 1998 among CHL, the Company and Bankers Trustee
Company Limited, as Trustee for Euro Medium Notes of CHL
(incorporated by reference to Exhibit 4.16 to the
Company’s Annual Report on Form 10-K, for the fiscal
year ended February 28, 1999).
First Amendment to Employment Agreement, dated March 1,2002, by and between the Company and Angelo Mozilo (incorporated
by reference to Exhibit 10.63 of the Company’s
Quarterly Report on Form 10-Q, for the quarter ended
June 30, 2002).
Restated Employment Agreement, dated as of March 1, 2003,
by and between the Company and Thomas H. Boone (incorporated by
reference to Exhibit 10.80 to the Company’s Quarterly
Report on Form 10-Q, for the period ended March 31,2003).
+ 10
.7*
Restated Employment Agreement, dated as of March 1, 2003,
by and between the Company and Carlos M. Garcia (incorporated by
reference to Exhibit 10.81 to the Company’s Quarterly
Report on Form 10-Q, for the period ended March 31,2003).
First Amendment to Second Restated Employment Agreement, dated
as of January 1, 2004, by and between the Company and David
Sambol.
+ 10
.10*
Restated Employment Agreement, dated as of March 1, 2003,
by and between the Company and Sandor E. Samuels (incorporated
by reference to Exhibit 10.82 to the Company’s
Quarterly Report on Form 10-Q, for the period ended
March 31, 2003).
The Company’s Deferred Compensation Agreement for
Non-Employee Directors (incorporated by reference to
Exhibit 5.2 to the Company’s Quarterly Report on
Form 10-Q, for the quarter ended August 31, 1987).
The Company’s Executive Deferred Compensation Plan Amended
and Restated effective March 1, 2000 (incorporated by
reference to Exhibit 10.7.3 to the Company’s Quarterly
Report on Form 10-Q, for the quarter ended May 31,2000).
Third Amendment to Company’s Deferred Compensation Plan
(incorporated by reference to Exhibit 10.86 to the
Company’s Quarterly Report on Forms 10-Q and 10-Q/ A,
for the quarter ended June 30, 2003).
+ 10
.18*
1987 Stock Option Plan, as Amended and Restated on May 15,
1989 (incorporated by reference to Exhibit 10.7 to the
Company’s Annual Report on Form 10-K for the fiscal
year ended February 28, 1989).
Fourth Amendment to the 1987 Stock Option Plan as Amended and
Restated (incorporated by reference to Exhibit 10.11.4 to
the Company’s Quarterly Report on Form 10-Q, for the
quarter ended May 31, 1998).
Amended and Restated Stock Option Financing Plan (incorporated
by reference to Exhibit 10.12 to Post-Effective Amendment
No. 2 to the Company’s registration statement on
Form S-8 (File No. 33-9231), filed with the SEC on
December 20, 1988).
First Amendment to the 1991 Stock Option Plan (incorporated by
reference to Exhibit 10.19.1 to the Company’s Annual
Report on Form 10-K, for the fiscal year ended
February 28, 1993).
+ 10
.30*
Second Amendment to the 1991 Stock Option Plan (incorporated by
reference to Exhibit 10.19.2 to the Company’s Annual
Report on Form 10-K, for the fiscal year ended
February 28, 1993).
+ 10
.31*
Third Amendment to the 1991 Stock Option Plan (incorporated by
reference to Exhibit 10.19.3 to the Company’s Annual
Report on Form 10-K, for the fiscal year ended
February 28, 1993).
+ 10
.32*
Fourth Amendment to the 1991 Stock Option Plan (incorporated by
reference to Exhibit 10.19.4 to the Company’s Annual
Report on Form 10-K, for the fiscal year ended
February 28, 1993).
+ 10
.33*
Fifth Amendment to the 1991 Stock Option Plan (incorporated by
reference to Exhibit 10.19.5 to the Company’s Annual
Report on Form 10-K, for the fiscal year ended
February 28, 1995).
+ 10
.34*
Sixth Amendment to the 1991 Stock Option Plan (incorporated by
reference to Exhibit 10.20.6 to the Company’s Annual
Report on Form 10-Q, for the quarter ended
November 30, 1997).
+ 10
.35*
Seventh Amendment to the 1991 Stock Option Plan (incorporated by
reference to Exhibit 10.20.7 to the Company’s Annual
Report on Form 10-Q, for the quarter ended
November 30, 1997).
+ 10
.36*
Eighth Amendment to the 1991 Stock Option Plan (incorporated by
reference to Exhibit 10.20.8 to the Company’s
Quarterly Report on Form 10-Q, for the quarter ended
May 31, 1998).
First Amendment to the 1992 Stock Option Plan (incorporated by
reference to Exhibit 10.21.1 to the Company’s
Quarterly Report on Form 10-Q, for the quarter ended
November 30, 1997).
+ 10
.42*
Second Amendment to the 1992 Stock Option Plan (incorporated by
reference to Exhibit 10.21.2 to the Company’s
Quarterly Report on Form 10-Q, for the quarter ended
November 30, 1997).
+ 10
.43*
Third Amendment to the 1992 Stock Option Plan (incorporated by
reference to Exhibit 10.21.3 to the Company’s
Quarterly Report on Form 10-Q, for the quarter ended
May 31, 1998).
Amended and Restated 1993 Stock Option Plan (incorporated by
reference to Exhibit 10.5 to the Company’s Quarterly
Report on Form 10-Q, for the quarter ended August 31,1996).
+ 10
.47*
First Amendment to the Amended and Restated 1993 Stock Option
Plan (incorporated by reference to Exhibit 10.5.1 to the
Company’s Quarterly Report on Form 10-Q, for the
quarter ended August 31, 1996).
+ 10
.48*
Second Amendment to the Amended and Restated 1993 Stock Option
Plan. (incorporated by reference to Exhibit 10.22.2 to the
Company’s Quarterly Report on Form 10-Q, for the
quarter ended November 30, 1997).
+ 10
.49*
Third Amendment to the Amended and Restated 1993 Stock Option
Plan (incorporated by reference to Exhibit 10.22.3 to the
Company’s Annual Report on Form 10-K, for the fiscal
year ended February 28, 1998).
+ 10
.50*
Fourth Amendment to the Amended and Restated 1993 Stock Option
Plan (incorporated by reference to Exhibit 10.22.4 to the
Company’s Quarterly Report on Form 10-Q, for the
quarter ended May 31, 1998).
+ 10
.51*
Fifth Amendment to the Amended and Restated 1993 Stock Option
Plan (incorporated by reference to Exhibit 10.22.5 to the
Company’s Quarterly Report on Form 10-Q, for the
quarter ended August 31, 1998).
First Amendment to the Company’s 2000 Equity Incentive
Plan, as amended on November 12, 2003 (incorporated by
reference to Exhibit 10.97 to the Company’s Quarterly
Report on Form 10-Q, for the quarter ended June 30,2004).
+ 10
.59*
Amendment Number Two to the Company’s 2000 Equity Incentive
Plan, as amended on November 12, 2003 (incorporated by
reference to Exhibit 10.98 to the Company’s Quarterly
Report on Form 10-Q, for the quarter ended June 30,2004).
First Amendment to 2000 Equity Incentive Plan of the Company, as
amended and restated on June 16, 2004.
+ 10
.62*
Amended and Restated Supplemental Executive Retirement Plan
(incorporated by reference to Exhibit 10.23.1 to the
Company’s Annual Report on Form 10-K, for the
fiscal year ended February 28, 1998).
Second Amendment, effective as of June 30, 1999, to the
Company’s Supplemental Executive Retirement Plan
(incorporated by reference to Exhibit 10.23.3 to the
Company’s Quarterly Report on Form 10-Q, for the
quarter ended August 31, 1999).
+ 10
.65*
Third Amendment, effective January 1, 2002, to the
Company’s Supplemental Executive Retirement Plan
(incorporated by reference to Exhibit 10.23.4 to the
Company’s Quarterly Report on Form 10-Q, for the
quarter ended November 30, 2001).
Amended and Restated Split-Dollar Life Insurance Agreement
(incorporated by reference to Exhibit 10.24.1 to the
Company’s Quarterly Report on Form 10-Q, for the
quarter ended November 30, 1998).
Form of Restricted Stock Award Agreement with non-employee
directors dated as of March 1, 2000 (incorporated by
reference to Exhibit 10.30 to the Company’s Annual
Report on Form 10-K, for the fiscal year ended
February 28, 2001).
Form of Restricted Stock Award Agreement with non-employee
directors dated as of March 1, 2001 (incorporated by
reference to Exhibit 10.31 to the Company’s Annual
Report on Form 10-K, for the fiscal year ended
February 28, 2001).
Amendment One to the Employee Stock Purchase Plan (incorporated
by reference to Exhibit 10.71 to the Company’s Annual
Report on Form 10-K, for the year ended December 31,2002).
Company Selected Employee Deferred Compensation Plan, Master
Plan Document, dated December 23, 2003 (incorporated by
reference to Exhibit 10.71 to the Company’s Annual
Report on Form 10-K, for the year ended December 31,2003).
Revolving Credit Agreement, dated as of December 17, 2001,
by and among CHL and Bank Of America, N.A., as Managing
Administrative Agent, Bank of America, N.A. and JP Morgan Chase
Bank, as the Administrative Agents, The Bank Of New York, as the
Documentation Agent, Bank One, N.A. and Deutsche Bank AG, as the
Co-Syndication Agents, the lenders party thereto and Banc of
America Securities LLC and JP Morgan Securities, Inc., as
Co-Arrangers (incorporated by reference to Exhibit 10.8.11
to the Company’s Quarterly Report on Form 10-Q, for
the quarter ended November 30, 2001).
10
.98*
First Amendment to Credit Agreement, dated as of
September 30, 2002, by and among CHL, the Lenders thereto,
Bank of America, N.A. as the Managing Administrative Agent and
as a co-administrative agent and JP Morgan Chase Bank as a
co-administrative agent (incorporated by reference to
Exhibit 10.74 to the Company’s Annual Report on
Form 10-K, for the year ended December 31, 2002).
10
.99*
Second Amendment to Revolving Credit Agreement, dated as of
December 16, 2002, by and among CHL, the Lenders thereto
and Bank of America, N.A. as the Managing Administrative Agent
(incorporated by reference to Exhibit 10.75 to the
Company’s Annual Report on Form 10-K, for the year
ended December 31, 2002).
10
.100*
Third Amendment to Credit Agreement, dated as of June 13,2003, by and among CHL, the Lenders thereto, Bank of America,
N.A. as the Managing Administrative Agent and the
co-administrative agent and JPMorgan Chase Bank as
co-administrative agent (incorporated by reference to
Exhibit 10.86 to the Company’s Quarterly Report on
Form 10-Q, for the period ended June 30, 2003).
10
.101*
Fourth Amendment to Credit Agreement, dated as of
December 15, 2003, by and among CHL, the Lenders thereto,
Bank of America, N.A. as the Managing Administrative Agent and
the co-administrative agent and JPMorgan Chase Bank as
co-administrative agent. (incorporated by reference to
Exhibit 10.79 to the Company’s Annual Report on
Form 10-K, for the year ended December 31, 2003).
10
.102*
Five-Year Credit Agreement, dated as of May 12, 2004, among
CHL, the Comapny, ABN AMRO Bank N.V. and Deutsche Bank
Securities Inc., as Documentation Agents, Citicorp USA, Inc., as
Syndication Agent, the Lenders party hereto, Bank of America,
N.A., as Administrative Agent, and JPMorgan Chase Bank, as
Managing Administrative Agent (incorporated by reference to
Exhibit 10.103 to the Company’s Quarterly Report on
Form 10-Q, for the quarter ended June 30, 2004).
10
.103*
364-Day Credit Agreement, dated as of May 12, 2004, among
CHL, the Company ABN AMRO Bank N.V. and Deutsche Bank Securities
Inc., as Documentation Agents, Citicorp USA, Inc., as
Syndication Agent, the Lenders party hereto, Bank of America,
N.A., as Administrative Agent, and JPMorgan Chase Bank, as
Managing Administrative Agent (incorporated by reference to
Exhibit 10.101 to the Company’s Quarterly Report on
Form 10-Q, for the quarter ended June 30, 2004).
105
Exhibit
No.
Description
10
.104*
Amended and Restated Credit Agreement as of the 27th day of
February, 2002 by and among CHL, Royal Bank of Canada, Lloyds
TSB Bank PLC, Credit Lyonnais New York Branch, Commerzbank AG
New York Branch, and the Lenders Party thereto (incorporated by
reference to Exhibit 10.59 of the Company’s Annual
Report on Form 10-K, for the transition period from
March 1, 2001 to December 31, 2001).
10
.105*
First Amendment to Credit Agreement, dated as of June 14,2002, by and among CHL, the Lenders party thereto, and the Royal
Bank of Canada, as the Lead Administrative Agent for the
Lenders. (incorporated by reference to Exhibit 10.64 of the
Company’s Quarterly Report on Form 10-Q, for the
quarter ended June 30, 2002).
10
.106*
Second Amendment to Credit Agreement, dated as of
September 30, 2002, by and among CHL, the Lenders thereto
and Royal Bank of Canada as lead administrative agent
(incorporated by reference to Exhibit 10.73 to the
Company’s Annual Report on Form 10-K, for the year
ended December 31, 2002).
10
.107*
Third Amendment to Credit Agreement, dated as of June 13,2003, by and among CHL, the Lenders thereto and Royal Bank of
Canada, as lead administrative agent (incorporated by reference
to Exhibit 10.85 to the Company’s Quarterly Report on
Form 10-Q, for the quarter ended June 30, 2003).
10
.108*
364-Day Credit Agreement, dated as of May 12, 2004, among
CHL, the Company, Commerzbank AG, New York and Grand Cayman
Branches and Societe Generale, as Documentation Agents, BNP
Paribas, as Syndication Agent, the Lenders party hereto,
Barclays Bank PLC, as Administrative Agent, and Royal Bank of
Canada, as Managing Administrative Agent (incorporated by
reference to Exhibit 10.102 to the Company’s Quarterly
Report on Form 10-Q, for the quarter ended June 30,2004).
10
.109*
Termination and Replacement Agreement, dated as of
November 19, 2004, among the Company, CHL, the Lenders
thereto and Royal Bank of Canada, as managing administrative
agent (incorporated by reference to Exhibit 10.1 to the
Company’s Current Report on Form 8-K, dated
November 19, 2004).
12
.1
Computation of the Ratio of Earnings to Fixed Charges.
+ Constitutes a management contract or compensatory plan or
arrangement.
106
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.
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.
Consolidated Statements of Comprehensive Income for the years
ended December 31, 2004, 2003, and 2002
F-8
Notes to Consolidated Financial Statements
F-9
Schedules:
Schedule I — Condensed Financial Information of
Registrant
F-73
Schedule II — Valuation and Qualifying Accounts
F-77
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.
F-1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
Countrywide Financial Corporation:
We have audited the accompanying consolidated balance sheet of
Countrywide Financial Corporation and subsidiaries as of
December 31, 2004 and the related consolidated statements
of earnings, changes in shareholders’ equity, cash flows
and comprehensive income for the year ended December 31,2004. In connection with our audit of the consolidated financial
statements, we have also audited financial statement
schedules I and II. These consolidated financial statements
and financial statement schedules are the responsibility of the
Company’s management. Our responsibility is to express an
opinion on these consolidated financial statements and financial
statement schedules based on our audit.
We conducted our audit in accordance with the standards of the
Public Company Accounting Oversight Board (United States). 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 audit provides a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred
to above present fairly, in all material respects, the financial
position of Countrywide Financial Corporation and subsidiaries
as of December 31, 2004, and the results of their
operations and their cash flows for the year ended
December 31, 2004, in conformity with U.S. generally
accepted accounting principles. Also in our opinion, the related
financial statement schedules, when considered in relation to
the basic consolidated financial statements taken as a whole,
present fairly, in all material respects, the information set
forth therein.
We have also audited, in accordance with the standards of the
Public Company Accounting Oversight Board (United States), the
effectiveness of the Company’s internal control over
financial reporting as of December 31, 2004, based on
criteria established in Internal Control—Integrated
Framework issued by the Committee of Sponsoring Organizations of
the Treadway Commission (COSO), and our report dated
March 11, 2005 expressed an unqualified opinion on
management’s assessment of, and an adverse opinion on the
effective operation of, internal control over financial
reporting.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
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 the related consolidated statements
of earnings, changes in shareholders’ equity, cash flows
and comprehensive income for the years ended December 31,2003 and 2002. 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 the standards of the
Public Company Accounting Oversight Board (United States). 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 consideration
of internal control over financial reporting as a basis for
designing audit procedures that are appropriate in the
circumstances, but not for the purpose of expressing an opinion
on the effectiveness of the Company’s internal control over
financial reporting. Accordingly, we express no such opinion. An
audit also includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial
statements, 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 the consolidated
results of their operations and their consolidated cash flows
for the years ended December 31, 2003 and 2002, in
conformity with accounting principles generally accepted in the
United States of America.
We have also audited Schedule I (restated) and
Schedule II for the years ended December 31, 2003 and
2002. 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, except for Note 2, the caption
titled “Financial Statement Reclassifications and
Restatements” and Schedule I as to which the date is
March 11, 2005.
F-3
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
Mortgage loans and mortgage-backed securities held for sale
37,350,149
24,103,625
Trading securities owned, at market value
10,499,711
6,996,699
Trading securities pledged as collateral, at market value
1,303,007
4,118,012
Securities purchased under agreements to resell and securities
borrowed
13,231,448
10,348,102
Loans held for investment, net
39,660,086
26,368,055
Investments in other financial instruments
10,091,057
12,761,764
Mortgage servicing rights, net
8,729,929
6,863,625
Premises and equipment, net
985,350
755,276
Other assets
5,891,551
5,029,048
Total assets
$
128,495,705
$
97,977,673
LIABILITIES
Notes payable
$
66,613,671
$
39,948,461
Securities sold under agreements to repurchase
20,465,123
32,013,412
Deposit liabilities
20,013,208
9,327,671
Accounts payable and accrued liabilities
8,507,384
6,248,624
Income taxes payable
2,586,243
2,354,789
Total liabilities
118,185,629
89,892,957
Commitments and contingencies
—
—
SHAREHOLDERS’ EQUITY
Preferred stock — authorized, 1,500,000 shares of
$0.05 par value; none issued and outstanding
—
—
Common stock — authorized, 1,000,000,000 shares
of $0.05 par value; issued, 581,706,836 shares and
553,471,779 shares at December 31, 2004 and 2003,
respectively; outstanding, 581,648,881 shares and
553,460,528 shares at December 31, 2004 and 2003,
respectively
29,085
27,674
Additional paid-in capital
2,570,402
2,289,082
Accumulated other comprehensive income
118,943
164,526
Retained earnings
7,591,646
5,603,434
Total shareholders’ equity
10,310,076
8,084,716
Total liabilities and shareholders’ equity
$
128,495,705
$
97,977,673
The accompanying notes are an integral part of these
consolidated financial statements.
F-4
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
Net unrealized (losses) gains on available-for-sale securities,
net of reclassification adjustment
(88,277
)
(53,634
)
140,200
Net unrealized gains (losses) from cash flow hedging instruments
29,101
16,088
(9,654
)
Foreign currency translation adjustments
13,593
15,273
6,786
Other comprehensive (loss) income, net of tax
(45,583
)
(22,273
)
137,332
Comprehensive income
$
2,151,991
$
2,350,677
$
979,111
The accompanying notes are an integral part of these
consolidated financial statements.
F-8
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 —
Organization
Countrywide Financial Corporation (“Countrywide”) is a
holding company which, through its principal subsidiary,
Countrywide Home Loans, Inc. (“CHL”) and other
subsidiaries (collectively, the “Company”), 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. The Company’s
business activities fall into the following general categories:
residential mortgage banking, securities dealer, retail banking
and mortgage warehouse lending, insurance underwriting and
agency, and international mortgage loan processing and
subservicing.
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.
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. For operating entities, the consolidated financial
statements include the accounts of Countrywide Financial
Corporation, all majority-owned subsidiaries and all joint
ventures where its has operational control. The Company has
whole or majority ownership of all of its subsidiaries, and has
operational control of its joint ventures. Therefore Countrywide
has no equity method or cost-basis investees.
Special purpose entities are evaluated first for classification
as “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”). Special
purpose entities that are classified as QSPEs are excluded from
the consolidated financial statements of the Company. Special
purpose entities that are not classified as QSPEs are further
evaluated for classification as variable interest entities as
specified by FASB Interpretation No. 46,
“Consolidation of Variable Interest Entities.” Special
purpose entities that meet the definition of variable interest
entities where the Company is identified as the primary
beneficiary of the entity are included in Countrywide’s
consolidated financial statements.
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 consolidated balance
sheets and minority interests in the Company’s earnings are
charged to other operating expenses, net of applicable income
taxes, on the Company’s consolidated statements of earnings.
Financial Statement Reclassifications and
Restatements
Certain amounts reflected in the consolidated financial
statements for the years ended December 31, 2003 and 2002,
have been reclassified to conform to the presentation for the
year ended December 31, 2004.
As more fully discussed under the caption
“Implementation of New Accounting Standards,”to this note, the Company implemented an amendment to
Financial Accounting Standards Board (“FASB”)
Interpretation No. 46, “Consolidation of Variable
Interest Entities” (“FIN 46R”) during 2004.
FIN 46R requires that
F-9
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
companies no longer include certain subsidiary trusts in its
consolidated reporting group. The effects of this pronouncement
on the financial statements are that the consolidated balance
sheets:
•
Exclude the trust preferred securities issued by the subsidiary
trusts, formerly reflected in a separate mezzanine category on
the consolidated balance sheets,
•
Include the junior subordinated debentures issued by CHL and the
Company to the subsidiary trusts, in notes payable, and
•
Include CHL’s and the Company’s investments in the
subsidiary trusts, currently reflected in other assets.
The consolidated balance sheet at December 31, 2003, has
been restated to reflect the changes in consolidation accounting
required by FIN 46R.
During the periods presented, the Company completed stock splits
on the dates indicated:
In addition, in the fourth quarter of 2004 the Emerging Issues
Task Force (“EITF”) reached a consensus on Issue
No. 04-8 (“EITF 04-08”), which required the
Company to include the assumed conversion of its convertible
debentures in diluted earnings per share.
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 these stock
splits and the implementation of EITF 04-08.
Derivative Financial Instruments
The Company uses derivative financial instruments extensively as
part of its interest rate and foreign currency risk management
activities. (See Note 12 — “Financial
Instruments,” for further discussion about the
Company’s risk management activities.) All derivative
financial instruments are recognized on the balance sheet at
fair value.
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 accumulated other comprehensive income within
shareholders’ equity and subsequently reclassified to
earnings in the same period(s) that the hedged transaction
impacts net earnings on the same income statement line item as
the hedged item. Any ineffective portion of a cash flow hedge is
reported in current-period earnings on the same income statement
line item as the hedged item.
For free-standing derivative instruments, changes in the fair
values are reported in current-period earnings.
At the inception of a hedge, the Company formally documents the
relationship between hedging instruments and hedged items, as
well as the risk management objective and strategy for
undertaking various
F-10
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
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 with
changes in fair value recognized in current-period earnings.
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
accumulated 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 accumulated other comprehensive income to the date
of sale or termination is reported in accumulated other
comprehensive income until the forecasted transaction impacts
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 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 sells substantially all of the mortgage loans it
produces in the secondary mortgage market, primarily in the form
of securities, and to a lesser extent as whole loans. 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 11 —
“Securitizations,” for a description of MSRs.)
When the Company securitizes mortgage loans, it allocates the
cost of the mortgage loans between the security sold and the
retained interests, based on their relative fair values.
Note 11 — “Securitizations,” describes
how the Company estimates fair value. The reported gain is the
difference between the cash proceeds from the sale of the
security or loan, the cost allocated to the security or portion
of the loan sold and the fair value of any recourse retained or
guarantee issued by the Company. 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.
F-11
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
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 50 basis points for note rates between
5% and 8% and single pools for note rates above 8% and less than
or equal to 5%. 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 write-down of the MSRs in the stratum to its estimated
recoverable value is charged to the valuation allowance. MSRs
cannot be carried above their amortized cost.
Other retained interests created before July 1, 2004, are
classified as available-for-sale securities and are carried at
estimated fair value in the consolidated balance sheets. Other
retained interests created on or after July 1, 2004 are
classified as trading securities.
Other retained interests classified as trading securities are
recorded at fair value with changes in value included in
current-period earnings as a component of impairment of retained
interests.
If other retained interests classified as available-for-sale are
impaired, impairment is recognized as a reduction to
shareholders’ equity (net of tax). If the impairment is
deemed to be other than temporary, the Company writes down the
retained interest through a charge to current-period earnings.
Once impairment of other retained interests classified as
available-for-sale is charged to earnings, subsequent increases
in value are recognized in earnings over the estimated remaining
life of the investment through a higher effective yield.
Recourse retained in loan sales and securitization activities is
discussed in Note 28 — “Credit Losses
Related to Securitized Loans.”
Countrywide Securities Corporation (“CSC”), a
broker-dealer subsidiary of Countrywide, may reacquire
beneficial interests previously sold to outside third parties in
the Company’s securitization transactions. In the event
that such securities include protection by a derivative
financial instrument held by an SPE, that SPE no longer meets
the conditions as a QSPE under SFAS 140. As a result
mortgage loans held for sale and asset-backed secured financings
are included on the Company’s consolidated balance sheets
for the period of time such securities are held by CSC. The
assets and liabilities are initially recorded at fair value.
Once the securities that include protection by a derivative
financial instrument are sold, typically in less than
90 days, the conditions necessary for QSPE status under
SFAS 140 are again met and the related assets and
liabilities are removed from the Company’s consolidated
balance sheet. See Note 16 — “Notes
Payable — Asset-Backed Secured Financing.”
Loans
Mortgage Loans and Mortgage-Backed Securities
(“MBS”) Held for Sale
Mortgage loans held for sale includes mortgage loans originated
or purchased for resale together with mortgage loans held in
SPEs used in the Company’s securitization transactions, net
of related retained interests which temporarily do not meet the
conditions necessary for QSPE status under SFAS 140
(“Mortgage Loans held in SPEs”). Mortgage loans
originated or purchased for resale 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 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
F-12
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
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.
Mortgage Loans Held in SPEs used in the Company’s
securitization transactions are initially recorded at fair value
upon reconsolidation.
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 Company provides for losses on impaired loans with an
allowance for loan losses. 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. A loan is considered impaired when,
based on current information and events, it is probable that the
Company will be unable to collect the scheduled payments of
principal or interest when due according to the contractual
terms of the loan agreement.
The Company’s loan portfolio is comprised primarily of
large groups of homogeneous loans made to consumers that are
secured by residential real estate. Accordingly, the Company
does not evaluate individual homogenous loans for impairment.
These loans are generally identified as impaired when they
become 90 days delinquent, at which time the loans are
placed on nonaccrual status. Loans in the Company’s
warehouse lending and commercial real estate lending portfolios
are individually monitored for impairment on a regular basis.
Loan losses are charged against the allowance when management
believes the loss is confirmed. Subsequent recoveries, if any,
are credited to the allowance.
The allowance for loan losses is evaluated on a periodic basis
by management and is determined by applying expected loss
factors to outstanding loans, based on historical default rates
and loss percentages for similar loans originated by the
Company, estimates of collateral value for individually
evaluated loans, and judgmental components such as economic
considerations. This evaluation is inherently subjective as it
requires estimates that are susceptible to significant revision
as factors change or more information becomes available.
Interest Income Recognition
Interest income is accrued as earned. Loans are placed on
nonaccrual status when any portion of principal or interest is
90 days past due, or earlier when concern exists as to the
ultimate collection of principal or interest. When a loan is
placed on nonaccrual status the accrued and unpaid interest is
reversed and interest income is recorded as collected. Loans
return to accrual status when principal and interest become
current and are anticipated to be fully collectible.
Trading Securities
Trading securities consist of 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
F-13
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
the trade date basis, and gains and losses, both realized and
unrealized, are included in gain on sale of loans and securities
in the consolidated statements of earnings.
Investments in Other Financial Instruments
Investments in other financial instruments include
mortgage-backed securities, obligations of
U.S. Government-sponsored enterprises, municipal bonds,
U.S. Treasury securities, derivative financial 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:
•
Changes in the fair value of financial instruments classified as
trading securities 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 a component of accumulated other comprehensive income, which
is included in shareholders’ equity. Realized gains and
losses on sales of these assets are computed by the specific
identification method and are recorded in earnings at the time
of disposition. 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,
Securities Borrowed and Securities Sold Under Agreements to
Repurchase
Transactions involving purchases of securities under agreements
to resell, borrowing of securities or sales of securities under
agreements to repurchase are recorded at their contractual
amounts plus accrued interest and are 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. Transactions that do not provide for the
Company to sell (or purchase) substantially the same securities
before maturity at a fixed or determinable price are accounted
for as purchases and sales of securities.
Certain of the Company’s securities lending arrangements
include master netting agreements that entitle the
counterparties to settle their positions “net.” Where
such arrangements are in place, and where the Company or its
counterparty intends to settle its positions “net,”the Company includes the net asset or liability in its balance
sheet. At December 31, 2004 and 2003, $8.1 billion and
$12.6 billion of securities sold under agreements to
repurchase were offset against securities purchased under
agreements to resell under master netting arrangements,
respectively.
Deferred Acquisition Costs
The Company’s insurance carrier subsidiary, Balboa Life and
Casualty (“Balboa”), incurs acquisition costs that
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 $91.2 million and $82.2 million were
included in other assets at December 31, 2004 and 2003,
respectively. Amortization of policy acquisition costs totaling
$138.1 million, $184.2 million and $98.8 million
were included in other operating expenses for the years ended
December 31, 2004, 2003 and 2002, respectively.
F-14
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Liability for Insurance Losses
For Balboa’s property and casualty policies, the liability
for losses and loss adjustment expenses consists of an accrual
for the unpaid portion of estimated ultimate losses and loss
adjustment expenses on claims reported through the end of the
accounting period and an accrual 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
projected defaults, losses and prepayments.
Collateral Pledged and Collateral Received
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.
Premises and Equipment
Premises and equipment 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 and of salary costs relating to employees’ time
spent on the software project during the application development
stage. Internally developed software is amortized over six to
10 years using the straight-line method.
Capitalized software costs are evaluated for impairment annually
or when changing circumstances indicate that amounts capitalized
may be impaired. Impaired items are written down to their
estimated fair values at the date of evaluation.
F-15
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
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 to the lessor of the
vehicle. 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 has both stock option and restricted stock award
programs for its employees. Details of these plans are included
in Note 21 — “Employee Benefits.”
The Company generally grants to eligible employees, stock
options 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 presently 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.
The Company recognizes compensation expense relating to its
restricted stock grants based on the fair value of the shares
awarded as of the date of the award. Compensation expense for
restricted stock grants is recognized over the shares’
vesting period.
As more fully discussed under the caption
“Implementation of New Accounting Standards”to
this note, the Company will adopt Statement of Financial
Accounting Standards No. 123R, “Share-Based
Payment” (“SFAS 123R”) beginning in the
third quarter of 2005. As a result of adopting SFAS 123R,
the Company will be required to charge stock-based compensation
to its consolidated statement of earnings. Amounts to be charged
to earnings include the unamortized grants plus the value of
grants awarded after June 30, 2005. Management has not yet
determined the effect of implementation of SFAS 123R.
F-16
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
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:
Add: Stock-based compensation included in net earnings, net of
taxes
3,292
1,329
—
Deduct: Stock-based employee compensation, net of taxes
(41,317
)
(29,515
)
(25,926
)
Pro forma
$
2,159,549
$
2,344,764
$
815,853
Basic Earnings Per Share:
As reported
$
3.90
$
4.44
$
1.69
Pro forma
$
3.83
$
4.39
$
1.64
Diluted Earnings Per Share:
As reported
$
3.63
$
4.18
$
1.62
Pro forma
$
3.57
$
4.13
$
1.57
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. The fair value
of each option grant is amortized to periodic compensation
expense, over the options’ vesting period for purposes of
this pro-forma disclosure.
The weighted-average assumptions used to value the option grants
and the resulting average estimated values were as follows:
The Company utilizes a balance sheet method in its accounting
for income taxes. Under this method, the net deferred tax asset
or liability is based on the tax effects of the differences
between the book and tax basis of assets and liabilities, and
recognizes enacted changes in tax rates and laws. A valuation
allowance is recognized if, based on the weight of available
evidence, it is more likely than not that some portion of a
deferred tax asset will not be realized.
F-17
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Implementation of New Accounting Standards
In January 2003, the FASB issued FASB Interpretation
No. 46, “Consolidation of Variable Interest
Entities,” which was amended in December 2003
(“FIN 46R”). FIN 46R is an interpretation of
Accounting Research Bulletin No. 51,
“Consolidated Financial Statements.” FIN 46R
requires business enterprises to consolidate variable interest
entities which have one or more of the following characteristics:
•
The equity investment at risk is not sufficient to permit the
entity to finance its activities without additional subordinated
financial support from other parties.
•
The equity investors lack one or more of the following essential
characteristics of a controlling financial interest:
•
The direct or indirect ability to make decisions about the
entity’s activities through voting rights or similar rights
•
The obligation to absorb the expected losses of the entity if
they occur
•
The right to receive expected residual returns of the entity if
they occur.
FIN 46R excludes qualifying special purpose entities
subject to the reporting requirements of SFAS 140.
FIN 46R 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.
As discussed in Note 16 —
“Notes Payable — Junior Subordinated
Debentures,”the Company has issued trust-preferred
securities. Based on guidance related to FIN 46R, during
the quarter ending March 31, 2004, the Company ceased
consolidating the subsidiaries which issued the trust-preferred
securities. The primary effect of this de-consolidation was for
the Company to reclassify the trust-preferred securities from
mezzanine equity to debt.
In December 2003, the American Institute of Certified Public
Accountants issued Statement of Position 03-3, “Accounting
for Certain Loans or Debt Securities Acquired in a
Transfer” (“SOP 03-3”). SOP 03-3 applies to loans
acquired in a transfer if both of the following apply:
•
it is probable at the acquisition date that the investor will
not be able to collect all of the contractual cash flows of the
loan
•
there has been deterioration of the borrower’s credit
quality.
SOP 03-3 prohibits the carryover or creation of a valuation
allowance or loan allowance in the initial accounting for the
purchase. SOP 03-3 allows recognition of interest income on
these loans if a reasonable estimate of the amount and timing of
cash flows is available. The requirements of SOP 03-3 are
consistent with the Company’s existing accounting for
purchases of impaired loans as part of its Capital Markets
Segment activities. Therefore the Company does not expect the
adoption of SOP 03-3 to have a significant affect the
Company’s consolidated financial condition or earnings.
In March 2004, the EITF of the FASB reached consensus opinions
regarding the determination of whether an investment is
considered impaired, whether the identified impairment is
considered other-than-temporary, how to measure
other-than-temporary impairment, and how to disclose unrealized
losses on investments that are not other-than-temporarily
impaired. The consensus opinions, detailed in EITF Issue
No. 03-1 (“EITF 03-1”), “The Meaning of
Other-Than-Temporary Impairment and its Application to Certain
Investments,” add to the Company’s impairment
assessment requirements detailed in EITF Issue No. 99-20,
“Recognition of Interest Income and Impairment on Purchased
and Retained Interests in Securitized Financial Assets.”
F-18
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The Company has included the new disclosure requirements of
EITF 03-1 in its consolidated financial statements.
Adoption of the new measurement requirements has been delayed by
the FASB pending reconsideration of implementation guidance
relating to debt securities that are impaired solely due to
interest rates and/or sector spreads.
Late in 2004, the Emerging Issues Task Force reached a consensus
on Issue No. 04-8, “The Effect of Contingently
Convertible Instruments on Diluted Earnings per Share”
(“EITF 04-8”). The consensus requires that all
instruments that have embedded conversion features that are
contingent on market conditions indexed to an issuer’s
share price should be included in diluted earnings per share
computations (if dilutive) regardless of whether the market
conditions have been met.
The consensus includes instruments that have more than one
contingency if one of the contingencies is based on market
conditions indexed to the issuer’s share price and that
instrument can be converted to shares based on achieving a
market condition — that is, the conversion is not
dependent on a substantive non-market-based contingency. The
application of this consensus is required beginning with the
December 31, 2004 reporting period. Countrywide’s
Liquid Yield Option Notes and Convertible Securities, described
in Note 16 — “Notes Payable,” meet
the criteria of EITF 04-8. Therefore, earnings per share
amounts have been recalculated and restated as appropriate for
all periods presented.
In December 2004, the FASB issued Statement of Financial
Accounting Standards No. 123R, “Share-Based
Payment” (“SFAS 123R”), an amendment of FASB
Statement No. 123 (“SFAS 123”),
“Accounting for Stock-Based Compensation.”
SFAS 123R is focused primarily on accounting for
share-based compensation. This statement requires companies to
measure the cost of employee services received in exchange for
an award of equity instruments based on the grant date fair
value of the award. SFAS 123R requires measurement of fair
value of employee stock options using an option pricing model
that takes into account the awarded options’ unique
characteristics. SFAS 123R requires charging the recognized
cost to expense over the period the employee provides services
to earn the award, generally the vesting period for the award.
SFAS 123R’s measurement requirements for employee
stock options are similar to those of SFAS 123, which is
the basis for the pro forma stock-based compensation disclosure
contained in the preceding caption “Stock Based
Compensation” of this note. However, SFAS 123R
requires:
•
initial and ongoing estimates of the amount of shares that will
vest — SFAS 123 provided entities the option of
assuming that all shares would vest and then
“truing-up” compensation cost and expense as shares
were forfeited
•
adjusting the cost of a modified award with reference to the
difference in the fair value of the modified award to the
initial award at the date of modification of the award.
SFAS 123R also provides for the use of alternative models
to determine compensation cost related to stock option grants.
The model the Company will use to value its employee stock
options has not yet been selected, and therefore any financial
impacts of a model change cannot be determined. However,
adoption of SFAS 123R is not expected to have a significant
impact on the consolidated financial position or earnings of the
Company. The provisions of SFAS 123R are applicable to the
Company in the quarter ended September 30, 2005.
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 potentially
dilutive common shares were issued.
F-19
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The following table summarizes the basic and diluted earnings
per share calculations for the periods indicated:
During the years ended December 31, 2004, 2003 and 2002,
options to purchase 0.1 million shares, 4.3 million
shares and 3.6 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 2 — “Summary
of Significant Accounting Policies — Implementation
of New Accounting Standards,” the Company has restated
the shares and per share amounts of earnings per share for the
assumed conversion of its convertible debentures for all periods
presented as the result of adopting EITF 04-8 and for stock
splits effected during the period.
Note 4 —
Supplemental Cash Flow Information
The following table presents supplemental cash flow information:
At December 31, 2004, the Company had pledged
$6.7 billion of mortgage loans originated or purchased for
resale and $10.6 billion of Mortgage Loans Held in SPEs as
collateral for asset-backed secured financings.
At December 31, 2004, the Company had pledged
$7.6 billion in mortgage loan inventory to secure
asset-backed commercial paper.
F-22
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Note 7 —
Trading Securities
Trading securities, which consist of trading securities owned
and trading securities pledged as collateral, include the
following:
Obligations of U.S. Government-sponsored enterprises
560,163
243,790
Asset-backed securities
340,684
99,774
Interest-only stripped securities
318,110
190,331
Negotiable certificates of deposits
30,871
26,243
Corporate debt securities
21,659
—
Other
6,669
—
$
11,802,718
$
11,114,711
As of December 31, 2004, $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 $1.3 billion. For
the year ended December 31, 2004, 2003 and 2002, the
Company recorded $1.7 million in losses and
$26.2 million and $34.0 million in gains,
respectively, on trading securities that related to trading
securities still held at the respective period-end reporting
dates.
Note 8 —
Securities Purchased Under Agreements to Resell and
Securities Borrowed
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 securities purchased under
agreements to resell and securities borrowed. Collateral is
valued daily, and the Company may require counterparties to
deposit additional collateral or may return collateral pledged
when appropriate. Securities borrowed transactions require the
Company to deposit cash, letters of credit or other collateral
with the lender in an amount generally in excess of the market
value of the securities borrowed.
As of December 31, 2004, the Company had accepted
collateral with a fair value of $22.2 billion that it had
the contractual ability to sell or re-pledge. As of
December 31, 2004, the Company had re-pledged
$18.7 billion of such collateral for financing purposes, of
which $8.2 billion related to amounts offset against
securities purchased under agreements to resell under master
netting arrangements.
As of December 31, 2003, the Company had accepted
collateral with a fair value of $11.8 billion that 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.
F-23
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Note 9 —
Mortgage Servicing Rights
The activity in Mortgage Servicing Rights (“MSRs”) is
as follows:
Application of valuation allowance to write down impaired MSRs
(390,809
)
(2,161,205
)
(2,178,648
)
Balance before valuation allowance at end of period
9,820,511
8,065,174
7,420,946
Valuation Allowance for Impairment of Mortgage Servicing
Rights
Balance at beginning of period
(1,201,549
)
(2,036,013
)
(935,480
)
Additions
(279,842
)
(1,326,741
)
(3,304,991
)
Application of valuation allowance to securitization of MSRs
—
—
25,810
Application of valuation allowance to write down impaired MSRs
390,809
2,161,205
2,178,648
Balance at end of period
(1,090,582
)
(1,201,549
)
(2,036,013
)
Mortgage Servicing Rights, net
$
8,729,929
$
6,863,625
$
5,384,933
The estimated fair values of mortgage servicing rights were
$8.9 billion, $6.9 billion and $5.4 billion as of
December 31, 2004, 2003 and 2002, respectively. (See
Note 11 — “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, 2009. This projection was developed
using the assumptions made by management in its
December 31, 2004, valuation of MSRs. The assumptions
underlying the following estimate will be affected 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.
Estimated MSR
Year Ending December 31,
Amortization
(In thousands)
2005
$
1,702,751
2006
1,370,287
2007
1,110,443
2008
905,963
2009
743,925
Five year total
$
5,833,369
F-24
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Note 10 —
Investments in Other Financial Instruments
Investments in other financial instruments include the following:
Total other interests retained in securitization classified as
available-for-sale securities
1,166,469
1,457,905
Total available-for-sale securities
7,734,233
11,953,854
Other interests retained in securitization classified as trading
securities:
Prime home equity residual securities
533,554
—
Nonprime residual securities
187,926
—
Nonconforming residual securities
20,555
—
Total other interests retained in securitization classified as
trading securities
742,035
—
Servicing hedge derivative instruments
1,024,977
642,019
Debt hedge instruments — Interest rate and foreign
currency swaps
589,812
165,891
Total investments in other financial instruments
$
10,091,057
$
12,761,764
At December 31, 2004, the Company had pledged
$1.8 billion of mortgage-backed securities to secure
securities sold under agreements to repurchase. The
Company’s insurance subsidiaries have deposited
$18.1 million of mortgage-backed securities to meet state
statutory deposit requirements.
F-25
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Amortized cost and fair value of available-for-sale securities
are as follows:
Obligations of U.S. Government-sponsored enterprises
1,225,117
(10,370
)
1,225,117
(10,370
)
Other interests retained in securitization
10,698
(1,313
)
—
—
10,698
(1,313
)
Total impaired securities
$
3,809,177
$
(58,949
)
$
7,666
$
(53
)
$
3,816,843
$
(59,002
)
The impairment reflected in mortgage-backed securities is a
result of the change in market interest rates and is not
indicative of the underlying issuers’ ability to repay.
Accordingly, we have not recognized other-than-temporary
impairment related to these securities as of December 31,2004 or December 31, 2003.
Gross gains and losses realized on the sales of
available-for-sale securities are as follows:
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. However, the Company generally has limited recourse
on the Prime Home Equity and Nonprime 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 has
potential liability under representations and warranties it
makes to purchasers and insurers of the loans. At
December 31, 2004, the Company had a liability for losses
relating to representations and warranties included in other
liabilities totaling $139.9 million. The Company recognized
gains of $4.3 billion from sales of mortgage loans in
securitizations in the year ended December 31, 2004.
F-29
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
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,
subordinated securities and residual interests.
MSRs arise from contractual agreements between the Company and
investors (or their agents) in mortgage securities and mortgage
loans. The value of MSRs is derived from the net positive cash
flows associated with the servicing contracts. 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.
Our MSR valuation process combines the use of a sophisticated
discounted cash flow model and extensive analysis of current
market data to arrive at an estimate of fair value at each
balance sheet date. Senior financial management exercises
extensive and active oversight of this process. 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 key 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 — both at initial recognition and on an
ongoing basis — 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. The Company has
incorporated cash flow and prepayment assumptions based on its
own empirical data drawn from the historical performance of the
loans underlying its other retained interests, which management
believes is consistent with assumptions other major market
participants would use in determining the assets’ fair
value.
F-30
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Key economic assumptions used in determining the fair value of
MSRs at the time of securitization are as follows:
Proceeds from collections reinvested in securitizations
1,836,796
1,844,332
1,431,896
Service fees received
1,586,166
1,461,747
1,179,137
Purchases of delinquent loans
(3,387,739
)
(3,715,193
)
(3,712,399
)
Servicing advances
(3,334,357
)
(2,519,583
)
(1,520,422
)
Repayment of servicing advances
3,576,598
2,124,564
1,376,068
Other cash flows received on retained interests(a)
704,813
1,237,183
974,892
(a)
Represents cash flows received on retained interests other than
servicing fees.
F-31
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Key economic assumptions used in measuring the period-end fair
value of the Company’s MSRs at December 31, 2004 and
2003 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, 2004 and 2003, 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 compound or counteract
the sensitivities.
F-32
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The following table presents information about delinquencies and
components of prime home equity and nonprime mortgage loans for
which the Company has retained some level of credit risk:
Loans and securities held for or available-for sale
6,706,663
15,033,767
Mortgages Loans held in SPEs
9,692,776
—
$
67,421,267
$
30,860,647
The Company incurred credit losses of $99.4 million and
$95.5 million related to the mortgage loans above during
the years ended December 31, 2004 and 2003, respectively.
Note 12 —
Financial Instruments
Derivative Financial Instruments
The primary market risk facing the Company is interest rate
risk. Interest rate risk includes the risk that the value of our
assets or liabilities will change due to changes in interest
rates. 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 interest rate 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 the values of its interest
rate lock commitments, mortgage loan inventory and MBS held for
sale, MSRs, trading securities and other retained interests, as
well as a portion of its debt and deposit liabilities. 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 Interest Rate Lock Commitments
Description of Risk Management Activities
The Company is exposed to interest rate risk relative to its
Mortgage Loan Inventory and its interest rate lock commitments
(“IRLC”). The Mortgage Loan Inventory is comprised of
mortgage loans and MBS held by the Company pending sale, and is
presently held for an average of 30 days. IRLCs guarantee
the rate and points on the underlying mortgage or group of
mortgages for a specified period, generally from seven to
60 days.
The Company is exposed to interest rate 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 interest rate 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.)
F-33
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The interest rate risk management of the IRLCs 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, this probability
increases if mortgage rates rise, and decreases if mortgage
rates fall, 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 calculate the quantity of loans that
will fund within the terms of IRLCs.
To manage the interest rate risk associated with the IRLCs, 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 IRLCs 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 interest rate 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 actively manages its IRLCs and Mortgage Loan Inventory
risk profiles on a daily basis.
The Company uses the following derivative instruments in its
risk management activities related to the IRLCs and Mortgage
Loan Inventory:
•
Forward Sales of MBS: represents an obligation to sell an
MBS at a specified price in the future. Its value increases as
mortgage rates rise.
•
Forward Purchases of MBS: represents an obligation to buy
an MBS at a specified price in the future. Its value increases
as mortgage rates fall.
•
Long Call Options on MBS: represents a right to buy an
MBS at a specified price in the future. Its value increases as
mortgage rates fall.
•
Long Put Options on MBS: represents a right to sell an
MBS at a specified price in the future. Its value increases as
mortgage rates rise.
•
Long Call Options on Treasury Futures: represents a right
to acquire a Treasury futures contract at a specified price in
the future. 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 specified price in the
future. Its value increases as the benchmark Treasury rate rises.
•
Short Interest Rate 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.
•
Total Return Swaps: represents a mutual agreement to pay
or receive the performance return on a particular market index
or asset in exchange for receipt or payment of floating rate
interest tied to a reference interest rate (e.g. USD LIBOR). For
use in commercial mortgage real estate loan inventory, we
generally receive the floating rate index and pay the
performance return on a market index (e.g. Lehman index).
F-34
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The following table summarizes the balance or notional amounts,
as applicable, of Mortgage Loan Inventory, IRLCs and the related
derivative instruments at December 31, 2004:
(In billions)
Mortgage Loan Inventory:(1)
Fixed rate
$
9.8
Adjustable rate
10.3
Total
$
20.1
Interest Rate Lock Commitments
Fixed rate
$
13.7
Adjustable rate
14.4
Total
$
28.1
Mandatory Forward Trades
Sales
$
(41.6
)
Buys
18.1
Net mandatory positions
$
(23.5
)
Long MBS Options
Calls
$
—
Puts
(8.5
)
Net long MBS options
$
(8.5
)
Long Treasury Options
Calls
$
46.2
Puts
(30.0
)
Net long Treasury Options
$
16.2
Short Interest Rate Futures
$
(84.9
)
Total Return Swaps
$
0.5
(1)
The interest rate risk related to the mortgage loan inventory
pledged to secure asset-backed secured financings has been
mitigated by the corresponding debt. Therefore, such amounts,
which amounted to $17.3 billion at December 31, 2004,
are excluded from the mortgage loan inventory in this table.
Accounting for Risk Management Activities
During 2004, the interest rate risk management activities
connected with 76% of the fixed-rate mortgage inventory and 14%
of the adjustable-rate mortgage inventory were accounted for as
“fair value” hedges under SFAS 133. The Company
recognized pre-tax losses of $139.4 million and
$72.8 million, representing the ineffective portion of such
fair value hedges of its mortgage loan inventory, for the years
ended December 31, 2004 and 2003, respectively. These
amounts, 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 and securities in the consolidated statements of earnings.
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 and
F-35
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
securities). 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 date we issue the IRLC. 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 do not
qualify for hedge accounting under SFAS 133. The
“freestanding” derivative instruments that are used to
manage the interest rate risk associated with the IRLCs are
marked to fair value and recorded as a component of gain on sale
of loans and securities in the consolidated statements 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 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
generally increase in aggregate value when interest rates
decline. This portfolio of financial instruments is collectively
referred to herein as the “Servicing Hedge”.
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. 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.
•
Long Treasury Futures: represents an agreement to
purchase a Treasury security at a specified price in the future.
Its value increases as the benchmark Treasury rate falls.
•
Long Call Options on Interest Rate Futures: represents a
right to acquire a Treasury or Eurodollar futures contract at a
specified price in the future. Its value increases as the
benchmark Treasury or Eurodollar deposit rate falls.
•
Long Put Options on Interest Rate Futures: represents a
right to sell a Treasury or Eurodollar futures contract at a
specified price in the future. Its value increases as the
benchmark Treasury or Eurodollar deposit rate rises.
•
Forward Purchases of MBS: represents an obligation to buy
an MBS at a specified price in the future. Its value increases
as mortgage rates fall.
•
Interest Rate Caps: represents a contract that requires
the issuer to make a payment to the holder when an underlying
interest rate exceeds a specified level. Interest rate caps
increase in value as interest rates rise.
F-36
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
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. Such contracts increase in value as interest rates decline.
•
Receiver Swaptions: represents a right to enter into a
predetermined Interest Rate Swap at a future date upon exercise
of its right, the Company receives the fixed rate and pays the
floating rate. 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 upon exercise
of its right, the Company pays the fixed rate and receives the
floating rate. The contract generally increases in value as
interest rates rise.
These instruments are used to manage the overall risk portfolio
of the MSRs and other retained interests. The Company actively
manages 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 interests impairment that
generally results from a decline in mortgage rates. Should
mortgage rates increase, the value of the MSRs and other
retained interests is 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 futures
contracts included in the Servicing Hedge as of
December 31, 2004, the Company estimates that its maximum
exposure to loss over the contractual terms is $255 million.
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 consolidated statements 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 consolidated statements of
earnings.
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 $2.6 billion as of
F-37
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
December 31, 2004) and to enable the Company to convert a
portion of its foreign currency-denominated fixed and
floating-rate, long-term debt to U.S. dollar LIBOR-based
floating-rate debt (notional amount of $2.5 billion as of
December 31, 2004). These transactions are designated as
fair value hedges under SFAS 133. For the years ended
December 31, 2004 and 2003, the Company recognized a
pre-tax loss of $3.8 million and a pre-tax gain of
$0.02 million, respectively, representing the ineffective
portion of such fair value hedges of debt. These amounts are
included in interest expense in the consolidated statements 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
$1.7 billion as of December 31, 2004) 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 $1.3 billion as of December 31, 2004). These
transactions are designated as cash flow hedges under
SFAS 133. For the years ended December 31, 2004 and
2003, the Company recognized a pre-tax gain of
$0.04 million and pre-tax loss of $0.05 million,
representing the ineffective portion of such cash flow hedges.
As of December 31, 2004, deferred net gains or losses on
derivative instruments included in accumulated 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 (“Payor Swap”).
The following summarizes the notional amounts of and the average
interest rates on the swaps as of December 31, 2004:
Notional
Fixed
Floating
Amount
Rate
Rate
(Dollar amounts in millions)
Receiver swaps
$
5,094
3.88
%
2.66
%
Payor swaps
$
2,968
3.27
%
3.09
%
Payments are due periodically through the termination date of
each contract. The swap contracts expire between March, 2005 and
July, 2029.
Risk Management Activities Related to Deposit
Liabilities
The Company acquires interest rate swap contracts which have the
effect of converting a portion of its fixed-rate deposits to
variable-rate deposits. During 2004, certain of the swaps with a
notional value totaling $752 million, were accounted for as
free-standing derivatives, with changes in the swaps’ fair
value and cash flow from the swaps recorded in interest expense.
The Company recorded no ineffectiveness relating to these swaps
during 2004. Effective January 1, 2005, these swaps were
designated and will be accounted for as fair value hedges of
certain fixed-rate deposits.
The following summarizes the notional amounts of and the average
interest rates on the swaps and swaptions as of
December 31, 2004:
Notional
Fixed
Floating
Amount
Rate
Rate
(Dollar amounts in millions)
Receiver swaps
$
407
3.74
%
2.35
%
Receiver swaptions
$
751
4.86
%
2.32
%
F-38
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Payments are due periodically through the termination date of
each swap contract. The contracts expire between September,
2007, and January, 2025.
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
have not yet been issued at a specified price and at a specified
date in the future. 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 specified price at a specified date in the future. Its
value increases as mortgage rates fall.
•
Short Futures Contracts: represents standardized
exchange-traded contracts, 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.
•
Long Futures Contracts: represents standardized
exchange-traded contracts, the value of which is tied to the
spot Fed Funds or Eurodollar rates at specified future dates.
The value of these contracts increases when Fed Funds or
Eurodollar rates fall.
•
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. Such contracts increase in value as
rates rise.
•
Long Put Options on Futures Contracts: represents a right
to sell futures contracts, 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.
•
Long Call Options on Futures Contracts: represents a
right to purchase futures contracts, the value of which is tied
to spot Fed Funds or Eurodollar rates at specific future dates.
The value of these contracts increases when Fed Funds or
Eurodollar rates fall.
The following summarizes the notional amounts of the derivative
contracts included in the broker-dealer’s trading portfolio
at December 31, 2004:
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Accounting for Risk Management Activities
The changes in fair value of derivative contracts used in the
interest rate management activities related to trading
activities are recorded as a component of the gain on sale of
loans and securities in the consolidated statements of earnings.
Fair Value of Financial Instruments
The following disclosure of the estimated fair value of
financial instruments as of December 31, 2004 and 2003, 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.
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The fair value estimates as of December 31, 2004 and 2003,
were based on pertinent information that was available to
management as of the respective dates. Although management is
not aware of any factors that 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 generally based on quoted market prices. If quoted
market prices are not available, fair value is determined based
on other relevant factors, including dealer price quotations,
prices available for similar instruments, and valuation pricing
models intended to approximate the amounts that would be
received from or paid to a third party in settlement of the
contracts.
Securities Purchased Under Agreements to Resell and
Securities Borrowed
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. If quoted
market prices are not available, fair value is determined based
on other relevant factors, including dealer price quotations,
prices available for similar instruments, and valuation pricing
models intended to approximate the amounts that would be
received from or paid to a third party in settlement of the
contracts.
F-41
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Collateralized Mortgage Obligations
Fair value is estimated using quoted market prices. If quoted
market prices are not available, fair value is determined based
on other relevant factors, including dealer price quotations,
prices available for similar instruments, and valuation pricing
models intended to approximate the amounts that would be
received from or paid to a third party in settlement of the
contracts.
U.S. Treasury Securities and Obligations of
U.S. Government-Sponsored Enterprises
Fair value is estimated using quoted market prices.
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.
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 date the IRLC is
issued. 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.
F-42
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
contractual 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 extended to 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, 2004, before and after applicable collateral
held, is as follows:
(In millions)
Total credit exposure before collateral held
$
1,681
Less: collateral held
(1,088
)
Net unsecured credit exposure
$
593
Note 13 —
Premises and Equipment
Premises and equipment consist of the following:
Useful
December 31,
Lives
(Years)
2004
2003
(In thousands)
Buildings
19-40
$
377,481
$
274,153
Equipment
3-10
923,514
756,843
Leasehold improvements
2-10
125,099
94,736
1,426,094
1,125,732
Less: accumulated depreciation and amortization
(511,283
)
(416,526
)
914,811
709,206
Land
70,539
46,070
$
985,350
$
755,276
Depreciation and amortization expense amounted to
$111.7 million, $82.1 million and $59.9 million
for the years ended December 31, 2004, 2003 and 2002,
respectively.
F-43
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Warehouse lending advances secured by mortgage loans
3,681,830
1,886,169
Defaulted FHA-insured and VA-guaranteed mortgage loans
repurchased from securities
1,518,642
2,560,454
39,395,102
26,197,242
Deferred loan origination costs
390,030
249,262
Allowance for loan losses
(125,046
)
(78,449
)
Loans held for investment, net
$
39,660,086
$
26,368,055
At December 31, 2004, mortgage loans held for investment
totaling $28.8 billion were pledged to secure Federal Home
Loan Bank advances.
At December 31, 2004, the Company had accepted collateral
with a fair value of $3.8 billion securing warehouse
lending advances for which it had the contractual ability to
sell or re-pledge. As of December 31, 2004, no such
mortgage loan collateral had been re-pledged.
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.
Impaired loans — loans which the Company has placed on
non-accrual status — totaled $1.3 billion and
$2.3 billion at December 31, 2004 and 2003,
respectively. Included in total impaired loans were Government
insured or guaranteed loans totaling $0.9 billion at
December 31, 2004, and $1.7 billion at
December 31, 2003.
Changes in the allowance for the loan losses were as follows:
As of December 31, 2004, outstanding medium-term notes
issued by 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:
Outstanding Balance
Interest Rate
Maturity Date
Floating-Rate
Fixed-Rate
Total
From
To
From
To
(In thousands)
Series B
$
—
$
50,000
$
50,000
6.81
%
6.81
%
August, 2005
August, 2005
Series D
—
150,000
150,000
6.88
%
6.88
%
September, 2005
September, 2005
Series E
—
275,000
275,000
6.94
%
7.23
%
October, 2006
October, 2008
Series F
85,000
333,685
418,685
2.88
%
6.73
%
February, 2005
April, 2013
Series H
—
600,000
600,000
6.25
%
6.25
%
April, 2009
April, 2009
Series J
35,000
1,625,000
1,660,000
2.80
%
5.50
%
August, 2006
October, 2006
Series K
275,000
4,430,525
4,705,525
2.77
%
7.05
%
March, 2005
June, 2022
Series L
4,821,000
2,874,970
7,695,970
2.14
%
6.00
%
January, 2005
May, 2023
Series M
3,928,000
1,300,500
5,228,500
2.42
%
6.20
%
May, 2005
July, 2029
Euro Notes
2,596,293
1,247,994
3,844,287
2.24
%
6.57
%
March, 2005
January, 2009
Australian Notes
105,975
—
105,975
2.81
%
2.81
%
September, 2007
September, 2007
Sub-total
11,846,268
12,887,674
24,733,942
Basis adjustment through application of hedge accounting
—
631,820
631,820
Total
$
11,846,268
$
13,519,494
$
25,365,762
As of December 31, 2004, $3.8 billion of foreign
currency-denominated medium-term notes were outstanding. Such
notes are denominated in Japanese Yen, Pounds Sterling, Canadian
Dollars, Australian Dollars, and Euros. These notes have been
effectively converted to U.S. dollars through currency
swaps.
Asset-Backed Secured Financings
The Company has recorded certain securitization transactions as
secured borrowings as of December 31, 2004 because they do
not qualify for sales treatment under SFAS 140 at that
date. These secured borrowings amounted to $6.7 billion at
December 31, 2004. The Company had pledged
$6.7 billion of mortgage loans held for sale to secure such
borrowings.
In addition, CSC may reacquire beneficial interests previously
sold to outside third parties in the Company’s
securitization transactions. In the event that such securities
include protection by a derivative financial instrument held by
an SPE, that SPE no longer meets the conditions as a QSPE under
SFAS 140. As a result, the mortgage loans held for sale and
asset-backed secured financings are included on the
Company’s consolidated balance sheets and are initially
recorded at fair value. Once the securities that include
protection by a derivative financial instrument are sold,
typically in less than 90 days, the conditions necessary
F-46
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
for QSPE status under SFAS 140 are again met and the
related assets and liabilities are removed from the
Company’s consolidated balance sheet. At December 31,2004, such asset-backed secured financings in the amount of
$10.6 billion had been recorded because some of the related
beneficial interests that included protection by a derivative
financial instrument had been reacquired. The Company had
pledged the related $10.6 billion of mortgage loans held
for sale to secure such borrowings.
Federal Home Loan Bank Advances
As of December 31, 2004, Federal Home Loan Bank
advances totaled $15.5 billion, with a weighted-average
interest rate of 2.97%. Of the total advances,
$11.3 billion were fixed-rate and $4.2 billion were
adjustable-rate. The advances are secured by $28.8 billion
of mortgage loans.
Asset-Backed Commercial Paper
The Company has formed special purpose entities for the purpose
of financing certain of its mortgage loan inventory. These
entities issue commercial paper in the form of short-term
secured liquidity notes (“SLNs”) with initial
maturities of up to 180 days. The SLNs bear interest at
prevailing money market rates approximating LIBOR. The SLN
programs’ capacity, based on aggregate commitments from
underlying credit enhancers, was $18.2 billion at
December 31, 2004. For the year ended December 31,2004, the average borrowings under these facilities totaled
$13.0 billion, and the weighted-average interest rate borne
by the SLNs was 1.59%. At December 31, 2004, the
weighted-average interest rate borne by the SLNs was 2.35%, and
the Company had pledged $7.6 billion in mortgage loan
inventory to secure such SLNs.
Junior Subordinated Debentures
As more fully discussed in Note 2 — “Summary
of Significant Accounting Policies — Implementation
of New Accounting Standards,”the FASB issued
FIN 46R in December 2003. As a result of the adoption of
FIN 46R, the company-obligated capital securities of
subsidiary trusts are no longer reflected on the Company’s
consolidated balance sheets, but have been replaced on the
Company’s balance sheet by the junior subordinated
debentures issued to the subsidiary trusts by CHL and the
Company.
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 the 6.75% Securities, the
Company issued to Countrywide Capital IV $500 million
of its 6.75% Junior
F-47
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
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 respect to, or redeem, purchase or acquire, or
make a liquidation payment with respect to, any of its capital
stock.
The Company guarantees CHL’s indebtedness to two of the
subsidiary trusts, Countrywide Capital I and Countrywide
Capital III, which are excluded from the Company’s
consolidated financial statements. Following is summarized
information for those trusts:
Convertible Securities and LYONs Convertible
Debentures
In February 2001, the Company issued zero-coupon Liquid Yield
Option Notes (“LYONs”) with an aggregate face value of
$675 million, or $1,000 per note, due February 8,2031. The LYONs were issued at a discount to yield 1.0% to
maturity, or 8.25% to the first call date. Under certain
conditions, the LYONs are convertible into the Company’s
common stock at the rate of 46.3 shares per $1,000 note.
In September 2004, the Company completed an exchange offer,
through which LYONs were exchanged for convertible securities
with terms similar to the LYONs, except for a provision to allow
settlement in cash and stock upon the debentures’
conversion. As a result of the exchange offer,
$637.2 million or 94.7% of the outstanding LYONs were
exchanged for convertible securities. During the year ended
December 31, 2004, LYONs and convertible securities with a
face value totaling. $574.0 million were surrendered for
conversion by the security holders.
F-49
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Maturities of Notes Payable
Maturities of notes payable are as follows:
Hedge Basis
Year ending December 31,
Principal
Adjustment
Total
(In thousands)
2005(1)
$
33,813,261
$
154,745
$
33,968,006
2006
7,476,513
105,127
7,581,640
2007
10,957,414
74,214
11,031,628
2008
4,428,618
227,908
4,656,526
2009
5,875,259
8,064
5,883,323
Thereafter
3,430,786
61,762
3,492,548
Total
$
65,981,851
$
631,820
$
66,613,671
(1)
Asset-backed secured financings are generally included in the
Company’s consolidated financial statements for less than
90 days. Therefore, the amount outstanding at
December 31, 2004 of $17.3 billion is included with
2005 maturities.
Commercial Paper and Backup Credit Facilities
As of December 31, 2004, CHL had unsecured credit
agreements (revolving credit facilities) with a group of
commercial banks permitting CHL to borrow an aggregate maximum
amount of $7.6 billion. The composition of the facilities
was as follows:
As consideration for these facilities, CHL pays annual
commitment fees of $6.7 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, 2004. 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, 2004, the
average commercial paper outstanding was $3.2 billion and
the weighted-average borrowing rate was 1.62%. For the year
ended December 31, 2003, the weighted-average borrowing
rate was 1.22%.
Pre-Sale Funding Facilities
As of December 31, 2004, CHL had uncommitted revolving
credit facilities that are secured by conforming mortgage loans
held for sale. As of December 31, 2004, the Company had no
outstanding borrowings under any of these facilities.
F-50
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The total of time certificates of deposit and other time
deposits issued and outstanding were $10.4 billion and
$3.3 billion at December 31, 2004 and 2003,
respectively. Substantially all of those deposits were interest
bearing. The contractual maturities of those deposits as of
December 31, 2004, are shown in the following table:
Time Deposit
Year Ending December 31,
Maturities
(In thousands)
2005
$
3,918,980
2006
2,289,103
2007
1,118,785
2008
1,169,241
2009
1,178,252
Thereafter
695,402
$
10,369,763
The amount of time deposits with a denomination of $100,000 or
more was approximately $6.6 billion and $1.7 billion
at December 31, 2004 and 2003, respectively.
The contractual maturities of time deposits with denominations
of $100,000 or more are shown in the following table:
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Note 18 —
Committed Reusable Purchase Facilities
As of December 31, 2004, the Company had in place a
reusable $7.2 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 $7.2 million.
This multi-seller commercial paper conduit was established and
is owned by several major, third-party financial institutions.
Using funds raised through 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 19 —
Securities Sold Under Agreements to Repurchase
The Company routinely enters short-term financing arrangements
to sell securities under agreements to repurchase
(“repurchase agreements”). 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, 2004 was 1.33%. The
weighted-average borrowing rate on repurchase agreements
outstanding as of December 31, 2004 was 2.02%. The
repurchase agreements had a weighted-average maturity of
12 days at December 31, 2004.
At December 31, 2004, repurchase agreements were secured by
$10.0 billion of trading securities, $18.7 billion of
securities purchased under agreements to resell and securities
borrowed, $1.8 billion in investments in other financial
instruments, and $0.3 billion of other assets.
Note 20 — Shareholders’ Equity
In February 1988, the Company’s Board of Directors 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 10 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
F-52
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
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 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.
The Company declared a 4-for-3, a 3-for-2 and a 2-for-1 split of
the Company’s $0.05 par value common stock, which were
effected as stock dividends on December 18, 2003,
April 12, 2004, and August 30, 2004, respectively. The
effects of these stock splits are detailed in the consolidated
statement of changes in shareholders’ equity. 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 splits.
Note 21 — Employee Benefits
Stock Compensation Plans
The Company has stock compensation plans (the “Plans”)
that provide for the granting of both qualified and
non-qualified stock options and shares of restricted stock to
employees and directors. Stock 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 10 years from the date
of grant. Stock options vest over a period of three to
four-and-a-half years.
Stock option transactions under the Plans were as follows:
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Outstanding stock options under the Plans as of
December 31, 2004 are summarized below.
Outstanding Options
Exercisable Options
Weighted
Average
Weighted
Weighted
Remaining
Average
Average
Exercise
Contractual
Exercise
Exercise
Price Range
Life (Years)
Number
Price
Number
Price
$ 3.79-$7.57
1.5
9,078,120
$
6.00
9,078,120
$
6.00
$ 7.58-$11.36
6.6
18,600,377
9.93
11,816,496
9.91
$11.37-$15.14
7.6
15,555,849
13.78
5,421,070
13.21
$15.15-$18.93
8.3
58,004
17.83
35,500
18.01
$18.94-$22.71
8.4
3,928,246
18.98
866,302
18.98
$22.72-$26.50
8.9
89,004
24.81
11,000
24.76
$26.51-$30.28
6.3
31,000
28.33
2,500
26.93
$30.29-$34.07
4.8
11,682,780
31.86
—
—
$34.08-$37.85
4.5
85,956
34.87
—
—
5.9
59,109,336
$
15.35
27,230,988
$
9.57
Restricted stock is awarded to employees and directors at no
cost and generally vests over a one- or three-year period.
Unvested restricted shares may not be sold by the grantee.
However, share grantees are entitled to vote on shareholder
proposals and receive dividends on their unvested shares. The
Company granted 286,483, 621,744, and 144,682 shares in the
years ended December 31, 2004, 2003 and 2002, respectively.
The weighted-average grant date fair value of these awards was
$31.85, $15.21, and $12.00, respectively. The Company recorded
compensation expense relating to restricted stock totaling
$5.4 million and $2.2 million for the years ended
December 31, 2004 and 2003, respectively. No expense was
recorded in the year ended December 2002. The balance of
unamortized restricted stock awards was $9.6 million and
$8.9 million at December 31, 2004 and 2003,
respectively.
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, 2004, the Company made the maximum
tax-deductible contribution to the Plan.
In the year ended December 31, 2004, the Company changed
certain of its actuarial assumptions. Specifically, the discount
rate was lowered from 6.0% to 5.75% and the expected return on
Plan assets was reduced from 7.5% to 7.0%. The decrease in
discount rate resulted in an increase of $9.0 million to
the accumulated benefit obligation at December 31, 2004,
and the decrease in expected return on Plan assets resulted in a
$0.6 million increase in 2004 net periodic pension
cost. Certain other demographic assumptions, relating to
mortality, termination of employment and retirement, were
changed for 2004 to more closely reflect the Company’s
experience and more recently published mortality data. The net
effect of these changes was to reduce 2004 net periodic pension
cost by $6.2 million.
F-54
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The following table sets forth the Plan’s funded status and
amounts recognized in the Company’s financial statements:
The weighted-average assumptions used in calculating the net
periodic benefit costs were as follows:
2004
2003
2002
Discount rate
6.00
%
6.50
%
7.25
%
Expected long-term return on plan assets
7.00
%
7.50
%
8.00
%
Rate of compensation increase
5.00
%
5.00
%
4.00
%
Pension expense for the years ended December 31, 2004, 2003
and 2002 was $55.5 million, $41.9 million and
$20.0 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 7.0% over the long term. The assumed rate of return is
based on historical as well as forecasted returns for the asset
categories into which the Plan’s assets will be invested,
given the targeted asset allocation levels. 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 by asset category are as follows:
Plan Assets
at
Target
December 31,
Allocation
Asset Category
2005
2004
2003
Domestic equity securities
55%-65%
61
%
71
%
International equity securities
5%-15%
11
%
0
%
Debt securities
25%-35%
28
%
28
%
Other
0%-5%
0
%
1
%
Total
100
%
100
%
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. U.S. equity securities are
diversified among growth strategies, as well as small and large
capitalization strategies. Equity securities do not include any
Company stock. 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.
F-56
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The following benefit payments, which reflect expected future
service, as appropriate, are expected to be paid:
Year ending December 31,
Pension Benefits
(In thousands)
2005
$
1,002
2006
1,379
2007
1,892
2008
2,583
2009
3,501
2010-2014
43,169
$
53,526
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%
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%
of the participant contributions up to a maximum contribution of
6% 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 $27.4 million,
$21.0 million, and $14.6 million in expense for
matching contributions for the years ended December 31,2004, 2003 and 2002, respectively.
Note 22 —
Income Taxes
Components of the provision for income taxes are as follows:
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
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:
Investment in net interest margin fixed-rate notes
101,433
—
Allowance for losses
86,503
65,064
Tax gain on loan sales accounted for as financings under
SFAS 140
54,626
—
Other
122,765
109,437
533,642
288,537
Deferred income tax liabilities:
Mortgage servicing rights
2,722,641
2,190,185
Gain on available-for-sale securities
177,619
68,113
Depreciation and amortization
158,652
91,100
Mortgage guaranty insurance tax and loss bonds
94,444
66,825
Other
72,446
102,259
3,225,802
2,518,482
Deferred income taxes payable
$
2,692,160
$
2,229,945
Foreign pre-tax earnings approximated $44.9 million in
2004, $28.2 million in 2003 and $9.0 million in 2002.
Earnings of a foreign subsidiary are subject to U.S. taxation
when effectively repatriated. The Company is required to provide
U.S. income taxes on the undistributed earnings of non-U.S.
subsidiaries except to the
F-58
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
extent such earnings are indefinitely invested outside the U.S.
At December 31, 2004, $66.1 million of accumulated
undistributed earnings on non-U.S. subsidiaries was indefinitely
invested outside the U.S. It is not practicable at this time to
determine the income tax liability that would result upon
repatriation of these earnings. No income tax is provided
against other comprehensive income for the translation
adjustments for such unremitted earnings of a subsidiary that
are indefinitely invested outside of the U.S.
The Company may elect to repatriate qualifying earnings under
the American Jobs Creation Act (the “AJCA”) which was
signed into law on October 22, 2004. The AJCA includes a
deduction of 85% of certain foreign earnings that are
repatriated, as defined in the AJCA. The Company expects to
complete an evaluation of the effects of repatriation under the
AJCA in 2005. The range of possible amounts of undistributed
earnings at December 31, 2004 that may be repatriated in
2005 under this provision is between $0 and $35.0 million.
The related potential range of income tax is between $0 and
$1.9 million.
Note 23 — Regulatory and Agency Capital
Requirements
In connection with the acquisition of Treasury Bank (the
“Bank”), the Company became a bank holding company.
Both the Company and the Bank are subject to regulatory capital
requirements imposed by the Board of Governors of the Federal
Reserve System (the “Federal Reserve”). The Company is
also subject to U.S. Department of Housing and Urban
Development, Fannie Mae, Freddie Mac and Government National
Mortgage Association (“Ginnie Mae”) net worth
requirements, which are lower than those of the Federal Reserve.
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 (MSRs includable in regulatory capital is
limited to the lesser of the carrying value of MSRs, 100% of
Tier 1 capital, or 90% of the fair value of the MSRs, net
of associated deferred taxes) and other adjustments. Tier 1
Leverage Capital is measured with respect to average assets
during the quarter. The Company and the Bank are 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 and the Bank are 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 and the Bank are 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.
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. The amount of dividends that the Bank may distribute in a
calendar year without OCC approval is limited to the sum of
Bank’s net income for the calendar year-to date plus the
net income of the preceding two years, all reduced by the
dividends declared in the period. For 2005, the Bank can declare
dividends totaling $463.8 million plus its net profits for
2005 up to the date of dividend declaration.
F-59
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
At December 31, 2004 and 2003, CFC and the Bank’s
regulatory capital ratios and amounts, and minimum required
capital ratios for the Company and the Bank to maintain a
“well capitalized” status were as follows:
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, Ginnie Mae and the
U.S. Department of Housing and Urban Development. Such
equity requirements generally are tied to the size of CHL’s
servicing portfolio. At December 31, 2004, the Company and
CHL’s equity requirements for these agencies ranged up to
$820 million. The Company had agency capital of
$10.3 billion and CHL had agency capital ranging from
$2.8 billion to $3.6 billion at December 31, 2004.
Note 24 — Segments and Related Information
The Company has five business segments: Mortgage Banking,
Banking, Capital Markets, 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 originates prime and nonprime loans
through a variety of channels on a national scale. Through the
Company’s retail branch network, which consists of the
Consumer Markets and Full Spectrum Lending Divisions, 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 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 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 Banking Segment’s operations are comprised primarily of
the Bank, and of Countrywide Warehouse Lending. Treasury Bank
invests primarily in mortgage loans sourced from the Loan
Production Sector.
F-60
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Countrywide Warehouse Lending provides temporary financing
secured by mortgage loans to third-party mortgage lenders.
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 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 Operations Segment includes Global Home Loans
Limited, a provider of loan origination processing and loan
subservicing 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 fulfillment fees paid by the
Bank to the Production Sector for origination costs incurred on
mortgage loans funded by the Bank are determined on an
incremental cost basis, which is less than the fees that the
Bank would pay to a third party.
F-61
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Included in the tables below labeled “Other” are the
holding company activities and certain reclassifications to
conform management reporting to the consolidated financial
statements:
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.
(2)
Throughout 2004 and 2003, Countrywide created certain
mortgage-backed securities which were underwritten by a
Countrywide affiliate, Countrywide Securities Corporation
(“CSC”). Some of these securities contained embedded
derivatives designed to protect rated security holders from
extreme changes in short-term interest rates and/or to enhance
the credit rating of the securities. At the end of each quarter
in 2004 and at June 30, 2003, a small amount of these
securities had not yet been sold by CSC. The securities held at
each quarter and during the year ranged from 0.1% to 2.2% of the
principal balance of the related loans securitized. In all
cases, the remaining securities were sold shortly after quarter
end. Countrywide believed that recording these transactions as
sales fully complied with all applicable accounting principles.
Subsequently it was determined that all securities that
contained embedded derivatives needed to have been completely
sold before any portion of the sale could be recognized. In
light of this information, the Company revised its recognition
of gain on sale accordingly.
F-63
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
This resulted in revised timing of gain on sale recognized
during 2004 and the quarters ended June 30, 2003 and
September 30, 2003.
The following table summarizes the change in net earnings from
amounts previously reported in the Company’s Quarterly
Reports on Form 10-Q or Annual Report on Form 10-K:
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
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, loans held
for investment and loans subserviced for others:
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.
F-67
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
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 5% of the servicing portfolio (as measured by unpaid
principal balance) at December 31, 2004:
Unpaid Principal
% Total
State
Balance
Balance
(In millions)
California
$
238,335
28%
Florida
47,918
6%
Texas
39,955
5%
All other states
512,114
61%
Total
$
838,322
100%
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, 2004, the
weighted-average service fee, net of applicable guarantee fees,
of the Company’s portfolio of loans serviced for others was
0.34% 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, 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 $1.4 billion of such
advances outstanding at December 31, 2004 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.
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. As
of December 2004 and 2003, the Company managed
$20.6 billion and $14.4 billion of borrower and
investor custodian cash accounts. These accounts are not
F-68
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
included in the Company’s consolidated balance sheets
except for $7.9 billion and $5.9 billion of the
borrower and investor custodial accounts placed as deposits in
Treasury Bank that are included in Bank deposit liabilities.
Note 28 — Credit Losses Related to Securitized
Loans
Substantially all of the mortgage loans produced by the Company
are sold into the secondary mortgage market, primarily in the
form of securities, and to a lesser extent as whole loans. While
the Company generally sells prime mortgage loans on a
non-recourse basis, either in the form of securities or whole
loans, it has potential liability under the representations and
warranties made to purchasers and insurers of the loans or
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, the Company bears any subsequent credit loss on the
mortgage loans.
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
mortgage loans generally are securitized on a non-recourse
basis, while prime home equity and nonprime 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 or Freddie
Mac. A small portion of these loans also has been sold to 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 compensates
the 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 has 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.
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, over collateralization 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
F-69
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
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.
Nonprime Mortgage Loans
Nonprime mortgage loans generally are pooled into private-label
asset-backed securities. The Company generally securitizes these
loans with limited recourse for credit losses through the
retention of a residual interest. Such limited recourse
securitizations may contain 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 nonprime mortgage 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.
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, 2004, are as follows:
Corporate guarantees in excess of recorded liabilities
$
419,264
F-70
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The carrying value of the residual securities is net of expected
future credit losses. The total credit losses incurred by the
Company on securitized loans for the years ended
December 31, 2004 and 2003, are summarized as follows:
Nonprime securitizations with retained residual interest
$
43,021
$
36,699
Repurchased or indemnified loans
42,063
35,426
Prime home equity securitizations with retained residual interest
29,370
15,196
Nonprime securitizations with corporate guarantee
20,039
40,891
Prime home equity securitizations with corporate guarantee
6,930
2,763
VA losses in excess of VA guarantee
1,658
2,824
$
143,081
$
133,799
Note 29 — Commitments and Contingencies
Legal Proceedings
Countrywide and certain subsidiaries are defendants in various
legal proceedings involving matters generally incidental to
their businesses. 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.
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, 2004,
was $99.8 million.
Lease Commitments
The Company leases office facilities under operating lease
agreements extending through January 14, 2015. Future
minimum annual rental commitments under these non-cancelable
operating leases with initial or remaining terms of one year or
more are as follows:
Lease
Year Ending December 31,
Commitments
(In thousands)
2005
$
114,856
2006
101,208
2007
81,657
2008
59,240
2009
34,543
Thereafter
34,722
$
426,226
F-71
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Rent expense was $160.7 million, $109.7 million and
$80.0 million for the years ended December 31, 2004,
2003 and 2002, 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, 2004, the Company and
CHL are required to maintain minimum consolidated net worth of
$5.6 billion and $1.8 billion, respectively.
FHLB and FRB Stock
The Bank is required to purchase stock in the Federal Reserve
Bank (FRB) at an amount equal to 6% of its capital, one-half of
which must be paid currently with the balance due upon demand.
The Bank is also a member of the Federal Home Loan Bank (FHLB)
and, therefore, is required to purchase FHLB stock in an amount
equal to the lesser of 1% of the Bank’s real estate loans
that are secured by residential properties, or 4.5% of total
advances for the year ended December 31, 2004. For the year
ended December 31, 2003, the amount of FHLB stock required
was equal to the lesser of 1% of the Bank’s real estate
loans that are secured by residential properties, or 5.0% of
total advances. The Company records its FRB and FHLB stock at
cost and evaluates it periodically for impairment.
Mortgage Reinsurance
Countrywide has entered into 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 $71.9 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.
Securities Underwriting
In connection with the Company’s underwriting activities,
the Company had commitments to purchase and sell new issues of
securities aggregating $666.7 million at December 31, 2004.
Note 30 — Loan Commitments
As of December 31, 2004 and 2003, the Company had
undisbursed home equity lines of credit commitments of
$5.4 billion and $4.8 billion, respectively, as well
as undisbursed construction loan commitments of
$936.9 million and $509.0 million, respectively. As of
December 31, 2004, outstanding commitments to fund mortgage
loans in process totaled $29.8 billion.
A special purpose entity formed for the purpose of issuing
asset-backed commercial paper, in the form of secured liquidity
notes for the purpose of financing mortgage loan inventory began
issuing secured liquidity notes in January, 2005. The
program’s capacity, based on aggregate commitments from
underlying credit enhancers, was $9.9 billion at
January 31, 2005.
F-72
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE I — CONDENSED FINANCIAL INFORMATION OF
REGISTRANT
Income, net of tax, in the amount of $37.0 million and
$8.3 million in 2003 and 2002, respectively, previously
reported as other income has been determined to be attributable
to a subsidiary. Accordingly, the 2003 and 2002 amounts have
been restated to reflect this income as equity in net earnings
of subsidiaries. The recharacterization of such income had no
impact on the consolidated results of operations of the Company.
F-74
COUNTRYWIDE FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE I — CONDENSED FINANCIAL INFORMATION OF
REGISTRANT — (Continued)
