This is our most desperate hour...

Many mortgage originators have declared bankruptcy in the last 6 months. The market is now placing a fair probability that Countrywide may be forced into liquidation in the coming months. A couple days ago, Countrywide bonds maturing in December 2007 could be bought with a 20% yield. Now they are a little better, around 13%, but obviously the market is concerned.

Corporate bond guys use the term "jump to default" to describe what might happen to Countrywide. On August 1, Countrywide's credit rating was a strong A-/A3, how could the company be so close to default so quickly? There is, not surprisingly, a lot of confusion in the main-stream media about Countrywide and their troubles. Below is a simple model for how specialty finance companies (like Countrywide) operate. I don't have intricate details about how Countrywide specifically finances their business, but this example should give the reader a fairly accurate idea of how things work.

Countrywide takes most of the mortgages it underwrites and sells them to investors in the secondary market. But they can't sell anything to the public until they have actual loans actually closed. Of course, at closing they have to actually write a check to the borrower, so somehow they have to come up with some cash.

One way firms like Countrywide can secure attractive financing, at least until recently, was by pledging some of their investment portfolio. This could be to back a credit line at a bank or to back a commercial paper program. Historically banks have always liked having specific assets pledged to secure a loan, because that prevents the borrower from taking on more loans and diluting the bank's recovery in liquidation or similarly selling off assets which could prove valuable in liquidation.

Let's assume that Countrywide wanted to make $30 billion in loans (which was their July production.) In order to raise that cash, let's say they pledge $30 billion of their investment portfolio (mostly mortgages) to an Asset-Backed CP program. Let's say that the term of the CP is 30 days. Then when the loans close, they sell those loans into the secondary market for $30 billion, and repay the CP. Their assets are then free and clear to do the whole thing over again next month.

But what happens if they can't sell the loans into the secondary market? The $30 billion they lent to home owners goes out the door, but they still have to pay off the CP. They might like to just roll over the CP, but now the value of their assets is in question. If the lenders can't value the assets being pledged, they are unlikely to make the loan.

Because of the long lead time in the mortgage business (you commit to a loan as much as 90 days ahead of actually paying out the cash), if Countrywide has $30 billion in CP outstanding, that's probably already being used to pay for loans originated in May and June. The $30 billion they committed to in July is yet to be funded. By that calculation, they would have something like $60 billion in cash needs. This is the figure estimated by Kenneth Bruce of Merrill Lynch in his August 15 report on CFC. Suddenly Countrywide is in desperate need of $60 billion but no one wants to lend them money. Maybe the only route they have left is to sell their investment portfolio. But even if the portfolio is relatively high-quality, the odds are good that any non-prime MBS will have at least a 5-10% discount from their par value. At least. And their liquid investment portfolio is only about $50 billion, again according to Merrill Lynch. So there is probably a $10 billion shortfall even before you assume any discount on their liquid assets.

So notice that the problem has nothing to do with suffering losses on bad loans, or insane leverage, or any of the other ills that have plagued the mortgage industry. Its simply that they cannot sell mortgages.

Now, Countrywide may be able to sell some of their mortgages, and they have been able to tap existing bank credit lines to avoid an imminent cash crunch. They could choose to drastically reduce production and slowly sell off assets, but if they get rid of all their assets, what's left for lenders? If they go down the asset sale road, they may have trouble getting their credit lines re-approved even if the market for mortgage loans recovers.

So while Countrywide's core business is weak, it's the sort of weakness most companies could weather. We know that mortgage underwriting is a long-term viable business. But because Countrywide faces this constant need to refinance itself, the liquidity crunch could cause a jump to default.

Enter Warren Buffett. Consider the scenario I just described: long-term Countrywide is a powerful player in a long-term viable business who is getting squeezed due to short-term problems. Someone who is looking to buy a nice asset on the cheap and who has adequate access to capital to ride out the liquidity crunch. That means that Countrywide, at a certain price, is a
very attractive takeover candidate. Hence the Buffett rumors. His history of getting involved (or trying to) in Salomon Brothers and Long-Term Capital Management has a lot of parallels. If he is willing to suffer a little short-term pain, he could own a dominant player in the mortgage business when things finally improve.

Help us, Oracle of Omaha... You're our only hope.

UPDATE: No... there is another... Bank of America Invests $2 billion in Countrywide