Update Appended: June 5, 2009
When is keeping up with the competition illegal?
The answer is central to the charges filed by the Securities and Exchange Commission against Angelo Mozilo and two other former officers at Countrywide Financial, the mortgage company that you might say underwrote the real estate bubble. The three, who include former chief operating officer David Sambol and former chief financial officer Eric Sieracki, are accused of misleading investors about the company's "increasingly dark prospects for the future ... by falsely assuring investors that Countrywide was primarily a prime-quality mortgage lender which had avoided the excesses of its competitors," said Robert Khuzami, head of the SEC's Enforcement Division. In reality, says the SEC, Countrywide had become a mortgage bazaar whose underwriting standards were cheapened to meet competitive offerings. The SEC says that at the same time the company was painting a false picture of prosperity, Mozilo was dumping his shares. And it's some dump: the SEC is seeking to reel back some $140 million in profits he earned from stock sales. Mozilo's attorney denied the charges. "The SEC's allegations are baseless; Mr. Mozilo acted properly and lawfully at all times as the CEO of Countrywide" said David Siegel in a statement, adding that "the SEC's challenge of certain stock sales by Mr. Mozilo is without merit. Those sales were entirely lawful." He also denied that Mozilo withheld information about the company's deteriorating loan portfolio. (See 25 people to blame for the financial crisis.)
The strange thing is that for most of its history, Countrywide had actually avoided the excesses of the competition, or at least the excesses of bad lending. Countrywide started as a plain, vanilla mortgage company that Mozilo painstakingly built up to the point that it originated nearly $500 billion in loans in 2005. The majority of its mortgages until that point were prime paper and with good reason. That's what the mortgage-securities market wanted too.
But the period of low interest rates in the early part of the decade (thanks, Alan Greenspan) attracted low-rent lenders into the mortgage business like seagulls on a garbage scow. As lending standards headed south, Wall Street's securitization machine moved into high gear, packaging vast amounts of "liar loans" and other junk mortgages into securities such as collateralized debt obligations (CDOs) that investors gobbled up. The feeding frenzy was on. The SEC says that Countrywide, desperate to protect its market share, gradually loosened its mortgage guidelines to match anything marketed by any competitors, a so-called supermarket approach. (See the 10 worst business deals of the past year.)
Countrywide, in other words, was not going to be undersold. In most industries, like supermarkets, that's a basic if expensive way to protect your business. It's also legal. You can even sell below cost. But the SEC alleges that as Mozilo and Co. were lowering Countrywide's standards, they were still selling investors, in boilerplate SEC filings and in public presentations, on what a prudent lender it was. Countrywide's risk managers and Mozilo were seeing something else in its portfolio of Pay-Option ARM loans. The SEC says that in one internal e-mail, Mozilo said the company was "flying blind," and that he "repeatedly urged that Countrywide sell its entire portfolio of those [Pay-Option ARM] loans."
The second part of the SEC's case will work only if it proves the first. Mozilo, like many top executives, entered into agreements called 105b-1s to sell shares on a scheduled basis. It's pretty standard, and the transactions are filed with the SEC. So the stock sales were no mystery to anyone, as Mozilo's defense is almost sure to point out. But the government alleges he filed the plans "while he was aware of the company's increasing credit risk and the expected poor performance of Countrywide-originated loans," according to the SEC's Khuzami.
That may well be true. But where were the regulators while Countrywide and others were churning out loans that many observers had already flagged as trouble? Certainly the federal agency had no jurisdiction over state mortgage regulators in states like California, where Pay-Option ARM and other such loans were popular. That's not the case in securitization. As the underwriting of CDOs mushroomed securities held AAA-rated tranches of what were essentially junk mortgages the Bush Administration's SEC was in no mood to throw a spanner in the works. The market would determine the appropriate risks and rewards. So Countrywide played the game. And lost. Or rather, we did.
An earlier version of this story did not have comments from Mozilo's attorney.