The question was all over Wall Street last week: Was the credit crunch threatening the survival of Countrywide Financial (CFC) (see BusinessWeek, 8/15/07, “Mortgage Lenders: Close to the Edge?”)? A bankruptcy filing by the largest U.S. mortgage lender would have jolted the economy, squeezing Countrywide’s many creditors and tormenting the already wounded mortgage and housing markets.

Then the Federal Reserve acted on Aug. 17, temporarily cutting the primary discount-window rate by 50 basis points. The move let banks know that the Fed was willing to add liquidity to the financial system, loosening up increasingly tight credit conditions. That eased, at least for now, some of the worries about mortgage lenders that have been stung by deteriorating conditions in the housing market.

Was the Fed action on Aug. 17 effectively a Countrywide bailout, saving a company many saw as too big to fail? Fed watchers and banking experts say far more is at work here. The Fed wasn’t reacting to Countrywide’s plight as much as the conditions that put the lender in such deep trouble.

“What happened with [Countrywide] is just a reflection of how quickly markets seized up,” says Nancy Vanden Houten, an economist at Stone & McCarthy Research Associates.
Fears of a Failure

Despite the worries and rumors, many thought a Countrywide bankruptcy remained quite unlikely.

Until recently, Countrywide was seen as one of the strongest and most durable of players in an industry stretched by rising delinquencies on subprime and other risky mortgages. Even as a Merrill Lynch (MER) analyst warned last week that Countrywide could be approaching bankruptcy, several other analysts were saying the firm would survive even a bad credit crisis.

“We thought they were overblown,” Morningstar (MORN) equities analyst Erin Swanson says of bankruptcy fears.

True, Countrywide’s creditors were getting nervous. Many mortgage lenders have been a victim of the freezing-up of certain parts of the credit market. Lenders raise cash to fund operations by reselling mortgages to investors on secondary markets. But many investors were simply refusing to buy up riskier debt.

With fewer chances to resell mortgages and nervous creditors, Countrywide had to call on an $11.5 billion credit line. Ratings agencies downgraded Countrywide debt. But Countrywide’s finances and earning prospects still looked good to many analysts. Deposits in Countrywide’s bank gave it stability lacking in other stand-alone mortgage lenders (several now bankrupt).
Dysfunction in Lending

Though Countrywide made its share of risky loans, it also handles billions of dollars in conventional and prime loans. It’s not as if the market was punishing Countrywide for “bad choices,” Vanden Houten says. Rather, the credit markets seemed to be panicking, punishing all mortgage lenders.

“While the housing and mortgage markets are severely challenged,” Piper Jaffray (PJC) analyst Robert Napoli wrote Aug. 17, “we believe the prevailing fear in the credit markets eclipses the actual credit and housing problems.” (Piper Jaffray makes a market in Countrywide stock.)

Countrywide’s problems were the latest signs of real dysfunction on credit markets, the so-called credit crunch, which threatens to crimp lending by banks and the issuance of commercial paper. Those are key foundations of the U.S. financial system, and threats to those foundations caused the Fed to act, experts say.

The Fed lowered the rate on borrowing from its discount window. That money is available to banks who need cash short-term. Lowering the rate “gives the banks another place to go to get liquidity,” says Donald Dutkowsky, a professor of economics at Syracuse University who has studied the discount window.
Fed Soothing

The direct effect on Countrywide is limited. However, as a bank, it could also use the discount window if it wanted.

The indirect effect, however, is to defuse the panic that has gripped credit and stock markets.

“Overall, it’s having a calming effect,” Swanson says. “That’s probably the biggest benefit right now.”

The Fed made clear it’s willing to intervene to deal with credit issues, and it hinted it is changing its stance on interest rate cuts. The fact that the Fed is more willing to lend itself “may lend a sense of calm that allows other institutions to feel more comfortable to borrow and lend from one another again,” Vanden Houten says.

Countrywide shares were up almost 12% by midday on Aug. 17.

But plenty of worries remain about Countrywide. The stock is still being punished by the last week of credit problems and bankruptcy worries. Before Aug. 17, it had fallen more than 33% in a week.
Countrywide Concerns

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Tags: Bankruptcy, Countrywide, Discount, Federal Reserve, financial, housing market, mortgage lenders