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Hedge Weakness Slows Countrywide's Growth

Countrywide Financial Corp. had a pretty good year in 2004, but its fourth-quarter results were marred by poor hedging correlation, demonstrating why Countrywide is among the big lenders that would like to shrink the size of the servicing asset on their balance sheets by carrying a lower servicing fee.

Hedging the MSR portfolio is supposed to reduce earnings volatility. But even the experts run into trouble once in a while. Countrywide posted a $278 million pretax loss attributable to the company's loan servicing unit as the value of its financial hedges fell, but MSR values failed to rise as expected to offset the hedging losses. Blame it on an unexpected flattening of the yield curve between Treas-uries and 30-year mortgage rates.

That hedging snafu limited mortgage earnings to $220 million on a pretax basis, down from $680 million in the fourth quarter of 2003.

Overall, Countrywide's loan servicing income fell by $255 million in the fourth quarter as a flattening of the yield curve, a tightening of mortgage-swap spreads and a reduction in interest rate volatility combined to reduce the value of hedge instruments without producing a corresponding increase in the value of its MSR portfolio.

Stanford Kurland, president and chief operating officer of CFC, said in a conference call with investors and analysts the company does not plan to change its hedging strategy, and he urged investors to look at the long-term performance of Countrywide's hedging strategy. One problem with quarterly financial statements is that they give investors a snapshot of hedges and MSR values at the end of the quarter, rather than averaging out performance over the quarter or giving investors a longer-term view into hedging reliability.

What was unique in this quarter for Countrywide was that despite increases in rates affecting Treasuries, mortgage rates were relatively unchanged. The tightening of mortgage rates to Treasury rates "plays a little bit of havoc with the valuation of the MSR asset," Mr. Kurland said.

The economic conditions that unfolded in the fourth quarter led to less recovery in MSR values than the company's models would have predicted, he acknowledged.

In heavy trading volume on the day earnings were released, Countrywide's stock price declined by $2.12, or 5.6%.

Countrywide has assiduously grown its "diversified" businesses that are not directly tied to mortgage banking activity, but the company remains very much anchored in the mortgage business, so a hedging setback catches the attention of investors quickly.

The company serviced $838 billion of home loans at the end of the year, up $52 billion from Sept. 30. Countrywide services the largest mortgage portfolio in the industry. Its size, now approaching $1 trillion, would have seemed unthinkable even a few years ago.

Despite the poor servicing performance, Countrywide produced $363 billion of home loans last year, down 17% from the 2003 record. But 2004 volume was still the second best annual total in the company's history, and Countrywide has demonstrated an ability to make the transition from a refinancing to a home purchase environment. Home purchase loans, as opposed to refinancing, accounted for $176 billion of Countrywide's 2004 total, a company record.

Loan production income fell by $155 million in the fourth quarter from the third, despite an increase in lending volume to $95 billion in the quarter. Countrywide attributed this decline to lower gain on sale from home-equity lending and lower net interest income.

Countrywide chairman and CEO Angelo Mozilo said during the company's conference call that rising income from the company's bank, capital markets and insurance groups helped keep the company's earnings almost flat from 2003 to 2004. As diversified businesses grow, they may one day dwarf the size of the MSR asset and mitigate the volatility of servicing values.

"A very important factor in the fourth-quarter earnings is that diversification earnings rose 55%," Mr. Mozilo said. "This is evidence of continued success in diversifying the company's earnings base."

He also reiterated his support for a lower minimum servicing fee, which would have the result of shrinking the value of the MSR asset on the company's balance sheet going forward.

Mr. Mozilo said he believes the move to reduce the minimum fee is "getting some traction" with Fannie Mae and Freddie Mac.

"We're working very hard on it with both Freddie and Fannie. I think at this point we have a 50-50 chance of getting it done."

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