The New York Times has a very interesting article about the business practices that resulted in Countrywide’s dramatic spiral into the dirt. Recently, the nation’s largest mortgage lender had to tap $11.5 billion in emergency credit and was the beneficiary of a $2 billion investment bailout from Bank of America.

What happened? Essentially, Countrywide’s operation was set up to squeeze the most amount of money from people who couldn’t afford to get a “conforming” mortgage, either because they were low-income borrowers or because they had poor credit. Subprime mortgages were much more profitable for Countrywide because of the early repayment penalties, fees, and the fact that they were a much more attractive investment for Countrywide to sell on the secondary market.

The NYT spoke to several Countrywide brokers who confessed that the commission structure was set up to encourage brokers to get as many subprime mortgages as possible—even if the borrowers could qualify for a much more attractive loan. From the NYT:

Regulatory filings show how much more profitable subprime loans are for Countrywide than higher-quality prime loans. Last year, for example, the profit margins Countrywide generated on subprime loans that it sold to investors were 1.84 percent, versus 1.07 percent on prime loans. A year earlier, when the subprime machine was really cranking, sales of these mortgages produced profits of 2 percent, versus 0.82 percent from prime mortgages. And in 2004, subprime loans produced gains of 3.64 percent, versus 0.93 percent for prime loans.

One reason these loans were so lucrative for Countrywide is that investors who bought securities backed by the mortgages were willing to pay more for loans with prepayment penalties and those whose interest rates were going to reset at higher levels. Investors ponied up because pools of subprime loans were likely to generate a larger cash flow than prime loans that carried lower fixed rates.

As a result, former employees said, the company’s commission structure rewarded sales representatives for making risky, high-cost loans. For example, according to another mortgage sales representative affiliated with Countrywide, adding a three-year prepayment penalty to a loan would generate an extra 1 percent of the loan’s value in a commission. While mortgage brokers’ commissions would vary on loans that reset after a short period with a low teaser rate, the higher the rate at reset, the greater the commission earned, these people said.

Persuading someone to add a home equity line of credit to a loan carried extra commissions of 0.25 percent, according to a former sales representative.

“The whole commission structure in both prime and subprime was designed to reward salespeople for pushing whatever programs Countrywide made the most money on in the secondary market,” the former sales representative said.

CONSIDER an example provided by a former mortgage broker. Say that a borrower was persuaded to take on a $1 million adjustable-rate loan that required the person to pay only a tiny fraction of the real interest rate and no principal during the first year — a loan known in the trade as a pay option adjustable-rate mortgage. If the loan carried a three-year prepayment penalty requiring the borrower to pay six months’ worth of interest at the much higher reset rate of 3 percentage points over the prevailing market rate, Countrywide would pay the broker a $30,000 commission.

When borrowers tried to reduce their mortgage debt, Countrywide cashed in: prepayment penalties generated significant revenue for the company — $268 million last year, up from $212 million in 2005. When borrowers had difficulty making payments, Countrywide cashed in again: late charges produced even more in 2006 — some $285 million.

The company’s incentive system also encouraged brokers and sales representatives to move borrowers into the subprime category, even if their financial position meant that they belonged higher up the loan spectrum. Brokers who peddled subprime loans received commissions of 0.50 percent of the loan’s value, versus 0.20 percent on loans one step up the quality ladder, known as Alternate-A, former brokers said. For years, a software system in Countrywide’s subprime unit that sales representatives used to calculate the loan type that a borrower qualified for did not allow the input of a borrower’s cash reserves, a former employee said.

A borrower who has more assets poses less risk to a lender, and will typically get a better rate on a loan as a result. But, this sales representative said, Countrywide’s software prevented the input of cash reserves so borrowers would have to be pitched on pricier loans.

This article should be required reading for anyone who is currently in the market for a mortgage. You cannot blindly trust your mortgage broker. You just can’t.

Inside the Countrywide Lending Spree [NYT]
(Photo:Chika)

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