Insights from the Failure of the Countrywide Financial Corporation

Abstract

This paper evaluates the business activities, financial reports, and management compensation practices of Countrywide Financial Corporation (Countrywide) in the period preceding the company’s financial distress and leading to its eventual takeover by Bank of America in 2008. This analysis provides a number of insights into the risks that Countrywide was exposed to which may guide future research and financial management. First, Countrywide was heavily reliant upon the securitization of mortgage loans to finance its activities, which was apparent from the financial report disclosures. Second, these securitization transactions exposed Countrywide to significant financial risk because of retained interests and the poor quality of many underlying mortgages. However, the risk was not reflected transparently in the financial reports, as evidenced by the timing of stock price responses. Untimely market responses suggest the equity market was not aware of Countrywide’s risk exposure until shortly before the company’s solvency crisis. Third, the design of CEO compensation at Countrywide encouraged and rewarded management for exposing the firm to significant risk. The analysis and supporting evidence in this paper contributes insights into financial management that is relevant for researchers and professionals.

Keywords: Mortgage Loan Securitization, Financial Reporting, Executive compensation

JEL Classification: M41, M48, G01, G21