Countrywide Seeks to End Volatile Cycle.

How can a company in a cyclical industry transform itself into a steady earningsgrowth performer?

It's a puzzle that Countrywide Credit Industries Inc. has been trying to solve for 15 years. Now that mortgage rates have turned upward, the Calabasas-based mortgage lender is preparing to test its mettle again in an environment that historically has been hostile.

Like most mortgage companies, Countrywide earns its biggest chunk of income by originating loans and then selling them to investors, booking a profit on the sale of each loan. (The investors are the ones who actually collect monthly payments.) When interest rates fall, like they did for most of this year, origination volume soars as homeowners refinance and new buyers are enticed into the housing market.

When interest rates rise, though -- and they have begun to in the past few weeks -- the opposite can happen. Refinancings slow, and the prospect of high monthly payments scares off would-be home purchasers. If the recent trend toward higher rates holds, origination volumes will suffer, as they did in 1999 and 2000, after the last refinance boom in 1998.

This makes for a volatile earnings stream, and a correspondingly volatile stock price for mortgage lenders -- of which Countrywide is the largest pure-play in the nation. "The stock price tends to go up when rates go down, and tends to go down when rates go up," said Makiko Coakley, an analyst with Lehman Bros.

'Macro-hedge'

The Sept. 11 attacks accelerated a trend toward lower interest rates, and Countrywide was one of the few local stock-market winners in the aftermath. Rates for a 30-year mortgage bottomed at 6.37 percent in the week ended Nov. 9, according to the Mortgage Bankers Association of America. That was the same week the Federal Reserve cut interest rates for the tenth time this year, and Countrywide's stock hit a near-term high of $46.50. Rates have since risen to 7.23 percent, and Countrywide's stock has correspondingly fallen, to a recent price of $41.15.

Since the late 1980s, Countrywide has tried to lower its vulnerability to interest-rate swings by using what it calls a "macro-hedge," a strategy of balancing the origination business with a growing loan-servicing portfolio. The loan-servicing portfolio throws off an annuity-like earnings stream and tends to perform counter-cyclically to the loan origination business, said Stan Kurland, Countrywide's chief operating officer, who is credited with developing the macro-hedge strategy.

"We were looking to create a profile for mortgage banking that would be viewed as a stable earnings-growth strategy, as opposed to the way investors perceived mortgage banking as being highly cyclical," Kurland said.

Countrywide has grown its servicing portfolio to $325 billion as of Oct. 31, from $24.3 billion at the end of 1991, moving up industry rankings to No. 4 from No. 9, according to the industry newsletter Inside Mortgage Finance. Originations also have grown sharply, although Countrywide has remained No. 4 in that area.

The macro-hedge isn't a classic hedge like a call or put option. "You should think of it as a diversification strategy, because the earnings contribution from servicing and (loan) production tend to move in opposite direction when interest rates rise," said Kenneth Posner, a Morgan Stanley Dean Witter analyst.

Countrywide can't quickly alter the size of its servicing portfolio or its loan-origination business, if one is perceived to be too large or too small relative to the other. Nevertheless, it works pretty well, said Posner. "The macro hedge is not perfect, but that said, a company with a macro-hedge would have much more stable earnings than one without it."

Countrywide has also sought to diversify in other ways, including Internet banking, a mortgage-backed securities unit, credit reporting, appraisal and title insurance. Some of these are vulnerable to the same cyclical trends as mortgage origination, but Countrywide has emphasized new businesses that can stand on their own, Kurland said.

"Coming out of the last refinance boom, our income may have dropped 5 percent year over year," he said. "But if you went back to earlier points in the history of the company, you would see enormous changes in income coming out of a refinance market."

Still cyclical threats

Countrywide's results in past years have been encouraging, but not immune to cyclical trends. The plain truth is that mortgage transactions are more lucrative, in good times, than the steady earnings thrown off by the servicing portfolio when new deals fall off.

After the last refinance boom in 1998, for example, Countrywide's earnings continued to rise in the year ended Feb. 29, 2000. But they dipped in the year ended Feb. 28, 2001, to $374 million, or $3.14 a share, from $410 million ($3.52) in the like year-earlier period.

This is shaping up to be a record year, for both Countrywide and for mortgage loan originations in general, which are expected to eclipse 1998's record $1.5 trillion nationwide.

The Wall Street consensus is for Countrywide to reap net income of $4.52 a share in the current year ending in February 2002, but the challenge lies in what happens next.

"Countrywide is desperately trying to change its image but in my opinion they have to show us the money first," Conkley said. "They have to show us they can grow earnings in a year after a refinance boom. If they can't do that then 2002 is not going to be a fun year."

[Graph omitted]

Countrywide Credit Industries Inc.

Stock Prices

YEAR (Feb. 28)                  2001    2000

Revenue (billions)              $2.1    $1.9
Operating Expenses (billions)    1.5     1.2
Operating Income (billions)      586   631.2
Net Income (millions)          374.2   410.2
Earnings PerShare              $3.14   $3.52
Nov. 28, 2000  $36.00
Nov. 28, 2001  $41.26

Note: Table made from line graph

SUMMARY

Business: Mortgage banking and financial services

Headquarters: Calabasas

CEO: Angelo R. Mozilo

Market Cap: $5 billion

Dividend Yield: 0.95%

Total Liabilities: $27.2 billion

P/E Ratio: 11

Long-Term Debt: $500 million