Rumors Send Countrywide to the Chopping Block

If the first week of 2008 is any indication of how the rest of the year will shape up, we're in for some exciting times. And I ain't talking about Britney Spears' custody disputes.

After shedding about 80% of its value in 2007, Countrywide Financial (NYSE: CFC  ) cratered 25% on Tuesday when rumors of imminent bankruptcy spread. The rumor stemmed from fabricated documents related to a bankruptcy case of a Pennsylvania homeowner -- and caused investors to cast a wary eye on the troubled mortgage company's future.

Countrywide was quick to deny the rumors, insisting it could remain solvent during these troubling times. The assurance did little, if anything, to soothe investors' nerves. Shares continued to plunge Wednesday, declining another 10% toward the end of trading today. Tough love these days, boys.

Your words mean nothing to me
Investors are now super-paranoid about leveraged financials and the treacherous waters they navigate, and CWF's massive declines -- while trying to dispel bankruptcy rumors -- illustrate why.

In the wake of the weakest real estate market in recent memory, the once-lucrative business of mortgage lending appears to be teetering on the brink of collapse. Market giants such as Countrywide have lost nearly all respect in the financial community. And then there are the more than 212 lending companies that have met their end since late 2006.

The question for the remaining mortgage companies isn't about when the industry will turn the corner; it's more along the lines of, "Will you still open your doors tomorrow?"

In a monthly operating report, Countrywide announced a 1% increase in loan fundings over November, to $23.4 billion. OK, that's an improvement, but it represents a 44% decline from December 2006 -- not exactly reason to celebrate. On top of the decline in business, foreclosures more than doubled to 1.44% from the same period last year, showing how bleak the real estate market is.

Some investors think the price plunge at Countrywide is far too extreme. They point to the business model of selling mortgages and collecting fees from servicing them down the road. This is true -- when it works. But the market for mortgage-backed securities has frozen in place, as investors fear further fallout from overstretched homeowners falling into foreclosure. If loans can't be sold on the secondary market, Countrywide is left holding the bag when those loans turn sour -- and that could lead to more writeoffs and hits to shareholders' equity.

Desperate measures
Another aspect of the situation that's slowing business and adding a layer of uncertainty is Countrywide's access to the cash it needs to fund new loans. As banks deal with their own liquidity problems and scale back lines of credit given to mortgage issuers, new sources of capital need to be tapped to attract more cash. Countrywide has turned to its banking unit, luring in clients with rates as high as 5.45% on a six-month CD. With the average 30-year fixed mortgage rate at 5.55%, according to bankrate.com, this is indeed an incredibly high price for Countrywide to pay, especially in light of a Federal Reserve that is all but certain to continue cutting interest rates.

While the high rates have certainly attracted more bank deposits and infused Countrywide with much-needed cash, they also highlight how desperate the industry is to stay afloat. Rates this high lead me to believe Countrywide isn't asking for cash to use for profitable business ventures -- it needs the cash to keep the lights on and the bankruptcy police away.

The continued plunge of Countrywide could have aftershocks that investors won't discuss. Back in August, Bank of America (NYSE: BAC  ) dropped in $2 billion in convertible notes to help the ailing company. These notes can be converted into shares of stock at $18 per share -- 261% higher than today's share price. With a current market cap of $2.89 billion, such a conversion would wipe out a substantial amount of current shareholders' stake.

Plug your nose
Countrywide isn't the only one facing boos from investors. E*Trade (Nasdaq: ETFC  ) , which has dealt with exposure to subprime securities and investors fearing a liquidity crisis, also dropped more than 20% on Tuesday to an all-time low. Savings and loan giant Washington Mutual (NYSE: WM  ) slipped 13% at one point Wednesday as investors feared the company would default on debt issued to fund its once-coveted mortgage market. Larger banks such as Citigroup (NYSE: C  ) have seen shares whittled down as much as 50% in the past year. No doubt about it, it's ugly all around.

Going forward, keep an eye out for continued writedowns and sources of capital raised for financial companies like Countrywide. A complete collapse seems unlikely, given its colossal size, but further injections are needed to resuscitate Countrywide -- and this could leave shareholders with little to show even after the industry gets back on its feet.

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