美國銀行 (BAC) 2004 Q2 法說會逐字稿

Good morning, good afternoon, good evening and welcome to the Countrywide Financial Corporation's second quarter earnings conference call.

At this time, all of your phone lines are muted or in a listen-only mode mode.

However, after today's presentation, there will be opportunities for questions and we certainly encourage your participation at that time. [Caller Instructions] As a reminder, today's call is being recorded for replay purposes.

We do ask that you would stay online at the conclusion of our conference to receive that replay information.

With that being said, I would now like to introduce our host, Countrywide's Chairman and Chief Executive Officer, Mr. Angelo Mozilo.

Please go ahead, sir.

Thank you.

Good morning and welcome to Countrywide's earnings teleconference call for the second quarter of 2004.

I strongly recommend that all of our listeners view the presentation which accompanies this discussion.

The presentation can be found on our website, www.Countrywide.com in the investor relations section, under presentations.

Turning to Page 2 of the presentation, you will see today's agenda.

First I will give you an overview of our recently completed second quarter and first half of 2004, including operational and earnings highlights.

Next I'll discuss our mortgage banking segment and key diversified businesses.

We will conclude the presentation with a look at earnings guidance for 2004.

This section will include key assumptions behind our earnings guidance.

Let's begin with a discussion of our operational earnings highlights for the second quarter and first half of 2004.

Turning to Page 4 of the presentation, you will see a list of our key operational highlights.

For the second quarter, total fundings were $100 billion, bringing the first half total to 176 billion.

This included record purchase volume of 46 billion for the quarter and 78 billion through the six-month period.

The value of adjustable rate fundings was 49 billion for the quarter and 82 billion for six months.

Adjustable rate loans comprised 49% of total volume in the second quarter and 47% for the first half.

As of June 30th, our pipeline of applications was $47 billion.

Our total servicing portfolio reached 726 billion and bank assets were 27.1 billion.

The chart on Page 5 shows our consolidated earnings highlights for the same periods.

Net earnings in the quarter with 700 million, up 83% over last year's second quarter.

For the first half, earnings of roughly 1.4 billion were 96% higher than last year's first half.

Earnings per diluted share were $2.24, which is 64% higher than the second quarter of 2003.

First half earnings were $4.46, up 72% from the first half of 2003.

Return on average equity was 31%, substantially higher than the 25% return for the second quarter of 2003.

While first half ROE of 32% also topped last year's comparable period ROE.

Page 6 shows the breakout of earnings between mortgage banking and our diversified businesses.

Mortgage banking pretax earnings rose 118% from the second quarter of last year, while six-month mortgage banking earnings were up 122%.

Second quarter diversification earnings were up 22% from last year's second quarter.

For the first half, the increase was 51% for the same period last year.

Diversification accounted for 23% of consolidated earnings in the second quarter and 26% in the first half.

Both numbers down from the prior year as mortgage banking growth outpaced diversification.

Let's take a closer look at Countrywide's mortgage banking sector on Page 7.

Production pretax profits for the quarter were 828 million, down 32% from the second quarter of last year.

This decline was primarily attributable to changing market conditions as the mortgage origination market was smaller than the peak refinance boom conditions seen in the second quarter of 2003.

As a result of the reduction in overall refinance activity, Countrywide's funding volume declined 23% compared to last year's second quarter.

Six-month production earnings were down 15% from the same period last year, also attributable to the decreased volume in the overall origination market.

Increased profitability on the servicing side more than offset the decline in productions earnings.

Servicing pretax earnings were 25 billion, an improvement of 861 million from last year's second quarter.

This resulted from rising interest rates which, in turn, generated net impairment recovery of 30 million in contrast to an 804 million in net impairment in last year's second quarter.

For the six-month period pretax servicing earnings approved by more than $1.2 billion.

On--the table on Page 8 shows the performance of diversification segments.

During the second quarter banking emerged as the most profitable of these segments.

Pretax banking earnings for the quarter was 119 million, up 77% over the second quarter of 2003.

For the first half, banking earnings were up 103% over last year's first half.

Bank growth is the vehicle for pursuing our strategic objective of redirecting a portion of current period gain on sale income into a stable long-term stream of spread income.

Capital markets experienced a 22% decline in pretax earnings as a result of an overall decline in mortgage market activity from last year's second quarter period, which was obviously a boom period.

For the first half, pretax earnings for capital markets were up 15% from prior year's first half.

The insurance segment made a pretax contribution of $49 million, up 31% for the prior year second quarter while first half earnings were up 63%.

Global operations, also recorded pretax earnings growth in the second quarter and first half compared to the same period last year.

Now, let's--now that I've provided you with the highlights of our second quarter and first half, let's look at our key business segments in more detail.

Within the mortgage banking segment, overall pretax profits increased by 74 million over the last quarter, in the midst of a 77-basis points rise in the 10-year treasury rates.

A more detailed look at the segment is shown on Page 10.

Despite the rise in interest rates during the quarter, production volume increased substantially.

This resulted from a large pipeline at the beginning of the period in the wake of a sharp drop in rates late in the first quarter.

Even with the surge in volume, pretax production profits decreased from the first half by 114 million as pretax margins declined from the last quarter's record level.

The primary driver was a decrease in the sub prime margin.

The sub prime gain on sale margin based on loans sold fell to 290 basis points from 555 basis points in the first quarter as a result of increased price competition and less favorable secondary market execution.

Looking forward, the sub prime gain on sale margin is expected to return to a level of 350-400 basis points.

Pretax servicing earnings increased 183 million, more than offsetting the decrease on the production side.

Rising interest rates resulted in net MSR impairment recovery of 30 million compared to 323 million in net impairment expense in the first quarter.

It is important to note, however, that the MSR recovery recorded during the second quarter does not fully reflect the estimated increase in fair value of the MSRs.

The graph on Page 11 shows this more clearly by tracking the changes in book value and fair value of the MSRs.

Countrywide accounts for its MSRs on the basis of lower cost or market, in accordance with GAAP.

Driven by rising interest rates during the second quarter, the MSRs appreciated in value by 2.2 billion.

Recovery of previous MSR impairment of 1.4 billion was recorded, largely offset by a decline in the MSR hedge position of 1.2 billion, and impairment of other retained interests resulting in net recovery of $30 million.

The difference between the appreciation in value, 2.2 billion, and the recognized MSR recovery of 1.4 billion, was an unrecognized increase in MSR value of 810 million for the second quarter.

In total, the estimated fair value of MSRs in-- as of June 30th, 2004 was 856 million above their book value.

During the quarter, the MSR capitalization rates on loan service for others was 126 basis points compared to 103 basis points last quarter.

Based upon recent public disclosures by our major competitors, we believe our MSR capitalization rate compares favorably to our peer group and in fact is substantially more conservative today than our peer group.

On Page 12, we discuss growth in the banking segment.

Total banking segment assets reached 30.4 billion at the quarter end, of which 27.1 billion were on the balance sheet of Countrywide Bank and the remainder of assets of Countrywide Warehouse Lending.

Bank segment assets were up 88% from the second quarter last year and 15% from the last quarter.

Growth in the banking segments profitability has followed the same trend, with total segment pretax profits reaching $119 million.

As we have previously stated our goal for the bank is to grow total assets to 120 billion by 2008.

Our strategy for achieving this goal is to continue leveraging our strengths of our mortgage banking operations such as asset generation capabilities, servicing-related escrow balances, intellectual capabilities and its physical locations.

The bank now has 45 financial centers located within Countrywide's retail branches nationwide.

Within our capital market segment discussed on Page 13, pretax profits decreased 22% from last year's second quarter.

This was a result of changing market conditions, specifically an increase in interest rates, rising rates and the market's expectation of future increase in interest rates had a negative effect on the overall fixed income securities market.

This reduced profitable trading opportunities resulting in reduced securities trading margins.

Although securities trading volume increased quarter-over-quarter, securities trading revenues were down 36% from the second quarter of 2003 and 45% from the last quarter.

Furthermore, capital markets loan conduit revenues were reduced by 2% from the same quarter last year and 35% from the first quarter of 2004.

This was due to increased competition which resulted in a lower volume of loan conduit purchases and a reduction of the interest rate spread earned on conduit loan balances.

In the near term, overall market activity will remain an important driver in the profitability of this segment.

Over the longer term, growth in newer business lines within this segment, trading in U.S. securities and commercial real estate refinance is expected to moderate the impact of rising rates.

Let's turn to the--next to our earnings guidance for 2004.

As you can see on Page 15,the new guidance indicates diluted earnings per share of $7.50 to $8.50 for 2004.

There's an increase over the range of $7 to $8.25 per diluted share, which provided as guidance at the conclusion of the first quarter.

Please note that the new guidance does not contemplate the effects of the pending two for one stock split to be effected as a stock dividend which was previously announced by Countrywide.

We believe the average 10 year U.S. treasury rate for the remainder of the year will be within a range of 4-6% consist with our prior guidance.

With this range in mind, we believe the relevant range for the size of the mortgage origination market should be 2.3 trillion to 2.7 trillion.

This range is higher than in our previous guidance, largely due to the result of a strong mortgage origination market in the second quarter.

In our forecast, mortgage banking pretax profits are expected to range from 2.8 billion to 3.2 billion.

The the first five businesses are expected to make pretax earnings contributions of 1 billion to 1.2 billion.

Assumptions for the production in the servicing sectors are shown on Page 16.

Average production market share is expected to be within range of 13-14%, implying volume for Countrywide of 300 billion to 375 billion.

The range for pretax production margins is 95-105 basis points compared to the 75-100 basis point range underlying the guidance we provided last quarter.

We have once again increased the range as a result of the strong production margins realized year-to-date.

On the servicing side, the forecasted average servicing portfolio balance remains relatively unchanged at 710-730 billion.

The net pretax servicing margin after impairment, impairment recovery and hedge gains or losses is minus 3 points to plus 6 basis points.

In a normal purchase market, we would expect a range of 12 basis points to 15 basis points for servicing margins, as previously indicated.

Risk factors which could effect the accuracy of these forecasts is shown on page 17.

The first is the level of interest rates, as we saw during the first quarter, average rates outside of the 4-6% range --10 year treasury range, can generate results that are not consistent with our forecast.

A second important factor is volatility of interest rates which can cause a difference in the period in which different rate sensitive elements of raw financials are recognized.

Price competition in the productions markets can also be a significant factor in driving market share margins or both.

Additional factors include, but are not limited to those in the disclaimer in this presentation and those found in Countrywide's SEC filings.

Page 18 shows how this guidance measures up against our recent historical performance.

Last year's record earnings were $8.31.

The high end of our 2004 range, $8.50, now exceeds that level.

The low end of $7.50 represents a 48% compounded annual growth rate since the beginning of this decade.

The final slide on Page 19 contains a disclaimer regarding the forward-looking statements including this presentation, which I encourage all listeners to review.

And before I open the lines for questions, I would like to once again thank the employees and the management of Countrywide for their efforts in delivering another very outstanding quarter.

To our audience, we appreciate your interest in our company and the time you have taken to listen to this conference call.

We will now take your questions.

At this time I would like to ask the operator to explain how question and answer protocol.

Thank you very much.

Indeed.

And thank you, Mr. Mozilo and ladies and gentlemen, as you just heard, if you do have questions or comments we invite you to queue up at this point. [Caller Instructions] Representing Sandler O'Neill, our first question comes from the line of Mike McMahon, please go ahead.

Good morning, Angelo.

Good morning, Michael.

The share price is off today and I'm under the impression that it's because you missed the consensus and although you exceeded my estimate by 6 cents, I have a feeling that there was a general belief that you would have more net recovery than you did and, correct me if I'm wrong, but when I look at your hedging and your impairment over time, generally speaking, that's been about zero; and wouldn't it be correct that you would attempt to minimize that number to, to a modest amount so that, you know, no multiple should be placed on earnings derived from recoveries?

Well, let me-- I'm going to have Keith go more deeply into your question.

Very first of all, relative to consensus, we don't control consensus.

What we control is the operations of this company, and by any standard, at least from my perspective, this was a phenomenal performance on the part of the company, particularly with lower originations and, yet, higher earnings, which has clearly demonstrated that the diversification efforts that we've embarked upon over the last six, seven years is working as we have planned; and that the macro hedge that we talked about for years in terms of the performance of the servicing portfolio as rates rise performed as we expected.

The hedging strategies performed as planned and as expected.

Relative to your specific question concerning the recovery, the impairment recovery, I'm going turn that over to Keith to go through that.

Keith, do you want comment on that?

Sure.

Hi Mike, you know, as Angelo pointed out in his presentation, we had a little over of 800 million of unrecognized appreciation in our MSRs in the second quarter and that would translate to roughly $1.60 of additional earnings per share.

I would like to point out that our major competitors wrote up their assets significantly more than we did and the reason they were able to do that, essentially, is because they applied hedge accounting, which is elective.

We chose not to apply hedge accounting, which means that we were subjected to the lower cost of market constraint.

Had we applied hedge accounting, we could have written our assets up substantially more than we did and we would have had a much bigger earnings than we reported.

The unfortunate part of that would have been though that we'd have had a bigger asset to have to amortize in future periods.

So while we had lower earnings reported this quarter, it will benefit us with greater earnings through less amortization in future periods.

And I think that was the point you were trying to make.

Mike, I just want to point out also that, as I said, we cannot control consensus.

It's a subjective point of view on the part of analysts, but we do control operations and guidance and not only did we meet our guidance, at least the trend of guidance that you can see if you use the proper multiple; we increased our guidance in an atmosphere where the performance by some of our peers has been below standard, and so increasing guidance with lower volumes, I think, is a demonstration that the company is much better balanced than it ever has been in our history.

Yeah, I appreciate that.

That's the way I'm seeing things.

I think that the, what you've been trying to do to some degree is to minimize the growth of that MSR asset on your balance sheet for the reasons that Keith mentioned.

Just compare the cap rates.

Right.

Both of our competitors that you--that put out the cap rate, look at their cap rates versus ours.

You'll see that, by far, ours is much more conservative.

Excellent.

Thank you.

Thank you very much, Mr. McMahon.

Next in queue is Bob Napoli representing Piper Jaffray.

Please go ahead, sir.

Thank you.

Good morning.

Your stock's battling back a little bit, so question, Fannie Mae yesterday in their conference call was, you know, threw out some cautionary comments on the competitive environment that they are seeing in the mortgage market.

Your margins in the production side have held up well and your outlook for margins have held up well.

I was wondering if you can comment on what you are seeing and if you agree with the caution, some of the cautionary statements that Fannie Mae had yesterday, on a competitive front.

To be honest with you, I was not on the call.

I don't know specifically what they said, but I would, you know, with that caveat, you know, not knowing what specifically what they meant that, there clearly is less competition than there was previously.

This consolidation that's going on creates a much more rational environment.

You'll have blips, you know, as rates--if rates rise very rapidly for a while.

You'll have a blip for a while, but you can see, as we see happening in July, the correction comes very quickly.

So if the statement by Fannie Mae was that there is more competition than before, I would disagree with that.

There is less--certainly in numbers, there is substantially less competition than we have faced over the last decade, as you see massive consolidation has taken place both in the banking and mortgage banking sector.

Stan, do you want to comment on that?

Yeah, I think all along we've been very clear that through the refinance boom that we were experiencing, you know, significant abnormally high margins and we've provided all along guidance of where those margins should fall in a normalized market.

So, you know, I think it's--part of the market perception is maybe the, the belief that margins were sustainable at the high levels that we had during the refinance boom.

We have, you know, all along, you know, provided guidance to the marketplace that we expect margins to return to a normalized level and that's the, you know, the guidance that we have given today of 95-105 basis points.

You're not seeing what you think is irrational competition, I was wondering if you could comment at all, probably not, but trajectory of earnings into 2005 and when you might be able to comment on that and if you have any thoughts on that at all at this point that you would want to share?

Stan can comment on this as well.

We-- I think last year when we got to the tail end of the third quarter, beginning of the fourth quarter we then went into--2003, we gave 2004 guidance.

I think it'll probably follow, unless there is a force majeure of some kind, which I don't anticipate, you can expect that towards the end of the third quarter, or at the end of the third quarter, we would be giving you guidance for 2005.

In terms of irrational competition, you know if you've been following this industry for any period of time and you were in this-- you know, you were involved at the time when the thrifts were deeply entrenched in the business; that was irrational competition.

We don't see anything like that today.

Stan, do you want to comment on that?

Yeah, I think that on the prime side and on the home equity lines of credit and fixed rate seconds, we've seen conduct which is, you know, totally rational and within the expectations of where competitive pricing should be.

In terms of the sub prime market, you had a transition to a higher interest rate environment on a product that has very--starts with very, very high revenues to begin with, and so what we saw in the second quarter was an adjustment period for--in the pricing of-- of sub prime mortgages.

So greater competition and a longer adjustment period to the changes, to the change in the interest rate environment.

We believe, and are experiencing, you know, the, you know, change to increasing revenues on that side, you know, and we've seen a start of that in the third quarter.

Then on the other side of, you know, sub prime margins, it's-- there are execution changes that occurred during the second quarter in terms of overcollateral-- OC levels that are required on the sub prime securitization.

Thank you.

You're welcome.

Thank you very much, sir.

Our next question comes from the line of Mike Vinciquerra with Raymond James.

Please go ahead.

Thank you.

Good morning.

Angelo, you pointed out the progress you've made in terms of the return on equity and the impressive improvement you've had there.

I'm just curious if you guys, when you look at your statistics, have come up with, kind of, a range that you would expect through a cycle.

Where does this-- in terms of how much capital you need to hold for your business and your growth opportunities, I mean, where is the bottom and the worst cycle you can imagine and how high could that possibly go, if you can comment at all?

Well, I would say in response to that that, you know, our expectations, returning returns on equity are built into our guidance and we're not really prepared to provide guidance beyond the specific guidance we have given.

And then just one other thing.

On the-- you continue to sign a lot of the joint venture agreements to, kind of, boost your retail production, you've had a lot of success there.

Can you characterize the profitability of those agreements?

Is it somewhere between your core retail operation and the wholesale and should we continue to-- should we continue to expect to see more of those types of announcements, say, over the next 6 to 12 months?

Thank you.

It's comparable to the consumer part of our business.

It's slightly less profitable in the direct consumer business.

And I think your characterization of somewhere between consumer and wholesale is where it is.

It's very profitable and the other aspect of it is, Vincent, is that you-- it lessens the requirement for both marketing and advertising costs as well as field staff to solicit those accounts since the, the transactions are being directed as a result of the joint venture rather than as a result of solicitation.

So there is, you know, when you combine all of that together, it's probably very close to our consumer costs.

Thank you.

And thank you very much, sir.

Next in queue is Mr. Bruce Harting with Lehman Brothers.

Please go ahead, sir.

Yeah, good quarter, you beat us by a couple pennies too.

But can you talk a little bit about on the bank diversified earnings, the outlook for the net interest margin and the provision for loan loss and how you see the, you know, charge-off level developing as you grow the bank.

Thank you.

Good morning, Bruce, but let me just give you the general highlights of it and Stan and Keith will come in.

First of all in terms of loan losses, loan losses were far below what you would expect to experience in a--this type of a bank simply because we, as a de novo institution from both our viewpoint and the regulatory viewpoint, we have focused on FICOs well above the 700.

The average in the portfolio is around 740.

So our delinquencies and foreclosure--I think foreclosures are non-existent, so deliquencies are very, very low in that entity, and I would expect that that, because of the quality of that portfolio and the type of loans that are in there, which are mortgage loans, assets that we understand very well and know how to service, that-- that we can expect the performance that we're seeing today to continue at a very high level.

In terms of profitability, profit-- as rates rise, their profitability-- their margins are increasing.

Simply because they're not facing the prepayment issues that they faced last year.

So--and that trend appears to be continuing, you know, continued through the first quarter-- second quarter and continuing now.

So the profitability levels we can expect if rates either stabilize or rise will-- those spreads will continue to widen.

Let me turn it over to Mike.

Any comment on that?

You know, specifically net interest margins in the second quarter for the bank were 220 basis points and, you know, as Angelo indicates, we would expect that that margin will increase in the upcoming quarters as they go through certain, you know, loan resetting and put on higher rate loans.

Those-- you know, the margins are, have been fair, you know, fairly consistent and our cost structure in a rising rate environment in terms of margins tends to improve as our spread, we look it as spread to LIBOR, tends to decrease in a rising rate environment.

I must say also, just since you focused on the bank, Bruce, that the inflow of deposits into our financial centers is running at record highs now.

It's a very, very successful concept and as we've made public, we're going continue to expand those financial centers.

I think we have another 30 or 40 set for this year and we'll just continue going because we have, you know, substantial number of 600 of these branches, retail branches that we can, that can house the bank.

So it's a very successful concept in terms of its ability to bring in deposits from CD's.

It also now has a very successful money market fund which people are using as they make the decision whether or not they want to-- after a CD matures, whether they want to get another CD or just let it sit in the money market account.

So we're beginning to develop a substantial volume of funds in money market accounts within the bank.

Thank you.

And your next question comes from the line of Brad Ball with Prudential.

Please go ahead.

Thanks.

Stan, you actually touched on this a little bit, but I wonder if you could elaborate.

The production margin outlook, you mentioned that the sub prime margin is going higher.

I wondered if you could talk about your confidence level in that and why you're confident that sub prime gain on sale margins will go up.

Also, did you-- how much did you sell in the way of sub prime and HELOCs during the quarter?

Then with respect to the new guidance, 95-105, you characterize that as normalized.

Or is it appropriate to say that in a more normalized total market environment, the 75-100 that you had previously talked about might be more, quote, unquote normal.

Well, again, the margin levels that we're giving are, you know, averaged for the year, so they have the benefit of the higher margins that we've experienced during, you know, half of the year.

So, you know, that is affecting the annual guidance levels, you know, but we're kind of on the-- you look on the low side of margins or, you know, very-- you know, significant rise in interest rates to the 6% level on the 10-year treasury, we would experience-- expect to experience margins as you're indicating that are on the 75 basis points on incremental production.

So I hope that helps to clarify that.

With regard to sub prime, you know, margins, we're giving you, you know, the best information that we have at this time.

We have a pretty significant history in terms of our experience in terms of sub prime margins and we, you know, we had what I consider to be very significant margins during the, you know, lower rate environment and so we had sub prime margins a little bit abnormally high.

So the execution change, I think, is a more permanent part of-- of the change and in terms of our, the competitive nature of, you know, pricing, we're seeing that adjust and, you know, we've given you the best guesstimate of where we think margins will normalize in that, in-- on sub prime between the 350 and 400 level.

Okay, and how much did you do during the second quarter?

Keith is going to--

In terms of sales?

Yes.

It was about 9 billion?

Yeah, 9 billion of sub prime sales and about 6 billion of home equity sales.

And I would just point out that, you know, in terms of our outlook on sub prime, we've already seen the improvement in our app trends.

Improvement in the what trends?

I'm sorry.

Application trends.

Oh.

Application trends, based on what we've seen in our applications coming through.

Okay.

So just to clarify, Stan, a 75 basis point margin on incremental prime production is what we should be, you know, sort of thinking about as we model into the future?

That would be at the very high end of our rate guidance.

So, you know, we're giving guidance, you know, with rates in between 6 and 4%.

So that would be what you would anticipate at the high end of interest rates.

Sure.

Okay.

Great.

Thank you.

And--

We'll put a financial on that at the end of the third quarter when we give our outlook for '05.

Keith said we'll provide greater granularity on that at the end of the third quarter.

And our next question comes from FBR's Paul Miller.

Please go ahead.

Thank you very much.

Angelo, one of the most significant things you did this quarter was take your dividend up from 15 cents to 20 cents.

Now, a lot of investors who would love to invest in the stock cannot get over the fact on your cash flow position.

For you taking up your dividend must mean you have a lot of confidence in your cash flow position improving over time.

But saying that, as you build up that MSR, it does put pressure on your cash flow position.

Can you address that, you know, for investors and why it shouldn't be such a major concern?

Yeah.

First of all it, shouldn't be a major concern because I wouldn't increase the cash position, I mean the dividend unless I felt confident now and in the future that we have adequate cash to cover that.

Let me just give you an overall goal so you know where we're headed with this and then I'm going to have Keith comment on the cash issue that you've raised.

We believe as a management team that it's important in today's environment that the company address its dividend policy and, even deeper than that, it's dividend velocity.

And just for the moment assume that we have adequate cash to do this, that we-- our goal is to get the dividend to around the 2% level of the stock-- of the price of the stock based upon what we believe the stock of the price will be; and that's over about a two and a half-year period, where the stock will be in two and a half years.

Ad that's the odyssey that we have begun and we-- we believe that it's in the best interest of your shareholders to get the stock to the position where we can open up the marketplace with institutions that have thresholds relative to dividend payouts.

And so that-- I just want to you understand the overriding issue and goal that the company has.

Now, let me turn this over to Keith.

In terms of why you should not be concerned with cash flows as the company goes forward.

Keith?

Yeah, I would say that that has been evolving.

We sit here now with a portfolio of about $730 billion and that's a tremendous generator of cash.

Yes, we do make an investment when we originate a new loan.

That investment, though, has been coming down, as you may have observed.

Our initial capitalization rates are now around the 125 level.

We retaining only around 32, 33 basis points of net servicing.

So the amount of cash that we're investing in new servicing has been declining and that's also as a result of the increased profitability on the origination side.

And then the servicing portfolio, as I pointed out, has grown to over 700 billion and it's going to generate a lot of cash.

I guess on the other side, though, on the production side, it's very difficult to determine how much cash you're really using up.

I mean is it, is it-- I know this is a very tough question.

I don't know if you want to answer it, but is it safe to say around 30-50 basis points off new production is being eaten up into the MSR on the cash basis?

Well, the way to look at it would be to look at our origination margins and then factor what we invest in servicing.

As I pointed out, that's around 125 basis points and our production margins are running about, ran-- well, ran about 94 basis points in the second quarter; so the difference between those numbers would be approximately the cash investment.

Okay.

Thank you very much.

And thank you, Mr. Miller.

Representing J.P.

Morgan, our next question comes from the line of George Sacko.

Please go ahead.

Hi.

With regards to your MSR, now that you have some MSR that appears to have been capped by the low com accounting, as I guess as rates rise, more MSRs should reach their cap, I assume you still have some hedges in place.

So, assuming rates rise, should we expect to see hedging losses come through the income statement that are not offset by revaluation of the MSR?

That, that's a possibility, that although the way that we run our hedge and part of the reason why we were able to generate an $800 million improvement in the economic value versus what's booked is because our hedge is asymmetrical.

We use a lot of optional hedge instruments that have a limitation on loss.

The-- so that it is the case, I think we show that we have about a $385 million impairment reserve and that could be recovered, or we have the ability to move to hedge accounting, which would-- where we would be able to offset, you know, some of the losses in the hedge position against increases in the value of the--of the servicing.

But it is, you know, the case that the-- that-- you know, in any-- when you look at your profile, the economic value in a-- of the servicing asset versus the cost of the hedge go up very dramatically in a rising rate environment, and you can really-- you know, you get a very good snapshot of that in the 10-Q; where we disclose the changes or the shocks that would occur in the value of our hedge positions versus the MSR.

Okay.

Thank you.

And thank you very much, Mr. Sacko.

Next in queue is Mr. Robert Hottenson with Goldman Sachs.

Please go ahead.

Hi.

Just following up on that question a little bit.

As you indicated, Angelo, some of your competitors have elected to go to the voluntary new accounting, which provides more leeway in terms of writing up the servicing asset.

My question is, is that if this becomes a more permanent or requirement, is your guidance in any way taking into account the new policy?

The second thing I wanted to ask is that if you-- the point that I think Keith made is that the servicing, you know, write-up to I think it was around 114 basis points or so, you know, really has another 800 million that is unrealized appreciation and mortgage servicing rights.

Does that-- are you in effect then saying that the, you know, the valuation of the entire servicing portfolio reflects the capitalization rate of the new business that's being on the books?

And my question then is that as you-- and there is a logic to this, and follow me through on this.

As you then, you know, look at certain servicing portfolios that have either been for sale or have been sold at much higher capitalization rates, would you have to change your capitalization rate for the entire portfolio to reflect some kind of market value for which servicing is being exchanged at higher rates than what you're carrying or would be carrying even under the more aggressive accounting treatment that would be required later?

Let me-- since most of the questioning involves Keith's area of responsibility, let me turn it over to Keith.

Can you try to answer that?

Sure.

I think your comment relates to a recent FASB announcement where they indicated that they were considering moving from low com to an elective approach where companies can either stick with low com or go to fair value accounting for mortgage servicing rights.

Yeah.

That's-- that's just a thought at this point.

It-- it-- they haven't come down with the final announcement on that.

What I was referring to is the fact that under current accounting, servicers can elect to apply hedge accounting.

Those that hedge their MSRs can elect, if they qualify, hedge accounting which we did not do in the second quarter.

And that was my point.

Others, others did apply hedge accounting and therefore they were able to offset a major portion of their hedge losses by writing up the cost basis of their MSR.

And that's why, you know, sitting here at June 30, our MSRs carried at 126 basis points and Wells, WaMu and Chase on average are about 10 basis points higher, we estimate, because we believe to some extent they all applied hedge accounting.

Did you want to interject something?

Yeah I just want to partially answer your question.

In the event that we acquire either new servicing through our origination activities or where we buy a bulk package, it wouldn't affect how we value our portfolio.

We-- you know, our valuation, if you look at market value computations, are very much in line with where, you know, for example, Wells or, you know, even WaMu has their asset.

It's just that ours are capped by low com and to the extent that we have servicing that we acquire at a higher cost, we would be able to book that, you know, strata or that acquisition at a higher basis.

Keith you want to continue?

Okay.

I want Keith to continue on--

Well, my thought is just the point I've already made.

Is that had we applied hedge accounting, we would have been able to recognize a portion of that otherwise unrecognized appreciation in the asset of about 800 million.

How does that 800 million arise?

That's the difference between what you are booking new servicing for and what you are-- and what you're securing cost is?

The 800 million--the 850 million represents the difference between our estimated-- the estimated fair value of our MSRs and the carrying value or the book value.

In basis points, that's about 138 basis points--is the estimate of fair value and we're carrying asset at 126 basis points.

My question is where do you get the 138, you know, when there are numbers out there that are much higher with respect to the true, you know, value of servicing in a private market kind of transaction?

Well, the 138, as I pointed out, compares very closely to where our competitors are carrying their asset.

Again--

I'm not saying what they're carrying it, what--

Let me try to answer that.

I, I don't think you can use the market.

You know, these transactions that go on from time to time, P&C acquisition by Citicorp, for example, may be what you're referring to.

You know, what the basis of that acquisition price is very hard to determine.

I don't know what drove that.

You're always going to have and always have been throughout the history of this business a substantial disparity between what companies carry the value of that asset on their books at versus what market transactions take place, and it may be-- because the market transactions may not be pure servicing acquisitions.

They may conclude platforms, they may include origination capability, it may include personnel that they're buying in order to manage that asset.

It's a variety of things and there has always been a disorganization.

If you look at the market for that, for whatever reason it is, the market value of these sales that have taken place is always substantially higher than what companies, including Countrywide are carrying that asset on the books for.

I got it.

Last question, Angelo, do you think the disparity, the growing disparity between, you know, the cost structure of various companies, the carrying value of the MSR rights, the mix shifts in the markets, do you expect that to lead to much more greater, you know, greater volatility and more consolidation trends in the industry?

Are those the factors that are contributing to what we are seeing in terms of competitive dislocations and so forth, or are there others?

No, I think-- this is really just trying to respond from my gut to your question without giving a lot of thought to it.

But I think that the consolidation's being driven by a lot of things, the principal thing being scale.

You must have scale today in order to make the servicing asset work and provide reasonable returns and I think that many companies are coming to the conclusion that they just, A, they don't have scale, and two, to obtain is going to be too expensive and they're capitulating.

So I think it's primarily, the scale issue and the expectation of consumers in terms of prices they're willing to pay for mortgage and mortgage services that that's driving the consolidation.

I think that'll continue.

You haven't seen anything yet relative to consolidation in the servicing side.

It's going to be massive.

I'll leave it to others to follow up.

Okay.

Thank you very much, sir.

Our next participant in queue represents Sanford C. Bernstein, Mr. Jon Gray.

Please go ahead.

Yes, you indicate that the MSR recovery, at least the press release does, was 1.4 billion, offset by the hedge loss of 1.2 which would have contributed 200 million rounding to the nearest 100 million to pretax income; but then the release goes on to indicate that impairment of other retained interests reduced the net contribution to just 30 million.

First of all, can you tell us, you know, can you give us the, the recovery and the hedge loss to more digits than the nearest hundred million?

This is an income statement item.

Okay.

Let's see if we can walk you through that, John.

Then I'll have Keith walk you through each of those items and see if we can get you what you want.

Do we have the numbers?

Yeah.

On the impairment MSR impairment recovery, John, the number is 1 ,358 billion.

The other retained interests, which are primarily sub prime residuals and retained interests were written down 1.78.

1.78 billion?

I'm sorry. 178 million.

Sorry.

And the hedge loss, which is, I want to remind you, net of normal decay of the option position was $1 billion, 149 million.

Can you, let's-- all right.

Well, that quantifies things.

What exactly was going on with the sub prime residual write down, exactly what occasioned that?

Jonathan, this is Keith.

Those, those retain interest in IOs--and I mentioned this in the past, can be characterized as squeeze IO's.

In other words, the underlying collateral is generally either fixed rate or hybrid arm loans that are fixed for a period of time and the-- the rate passed through to the investor is a floating rate and what we earn is the difference, the spread.

So as rates rise, which occurred in the second quarter and the projection is for rising rates built into the valuation, that puts a squeeze on our excess spread and that resulted in a decline in the value of those retained interests.

How much?

Of--

I see, so one could look at these residual interests as actually a part of your servicing hedge; they act the same way.

The next question, if I could ask, what was the-- your--the disclosures made publicly indicated that the sales volume of sub prime was 9 billion, 480 million of HELOC.

Not 6, but 4 billion, 340.

Assuming those volumes were correct, we got them from Bloomburg over the course of the quarter.

Can you tell us what the gain in dollars was on sub prime and HELOCs in the quarter?

First of all, I would like to address the notional number that you mentioned, make sure we got that clear, Jonathan, and then we'll go through the--

Our numbers indicate that we sold 6.1 billion of home equity, which would include our fixed rate second.

And that we sold approximately 9 billion of sub prime during the period.

In terms of the gain on sale recognized, it was roughly 260 million on sub prime and 150 million on home equity.

Okay.

Thank you, and I just want to congratulate you on restraining your earnings below $3.

It looks as though it wasn't easy.

As far as adopting accounting regs that will add to volatility, it seems as though the street wants volatility, but only in one direction.

I-- I, you know, hope the company is able to show a core operating earnings definition even if the accounting profession continues to smoke whatever it is that it's smoking.

Yeah, no question the FASB rulings do distort these things and we will, you know, in order to maintain clarity, Jonathan, we will, as it becomes more clouded by these rulings, you know, go back to core earnings so you're looking really at, as a clear a picture as we can create for the-- for the investors.

Thank you.

Thank you very much, Mr. Gray.

And our next question comes from the line of Ken Posner with Morgan Stanley.

Please go ahead.

Hi.

I just had one simple question on the hedge.

I think the--by the way the production results speak for themselves, and I think your major point about the-- the $900 million in hedge value.

The hedge costs of about 1 billion in the quarter relative to the size of the MSR were unusually high relative to the, you know, the 10-year track record.

Is that because the hedge costs are actually going to hedge some of the unrecognized value of the MSR, or the economic value of the MSR, or are there other reasons why the hedge costs were still high?

Let's just get-- I think for definition purposes, it's not hedge costs.

We define hedge costs as option-- you know, option costs.

It's hedge losses, is what it is, and do you want to pull that apart for him?

And by the way, maybe we should just stop for a second because, again, the value of the company is created on the operating side, but in terms of investors understanding how the hedge works, is looking at the hedge losses relative to the MSR a reasonable metric to study over time?

Well, look Ken-- I'm not totally clear on what-- on your question, but, you know, we run a, you know, a hedge position to protect the accounting value and the economic value of the asset, so, you know, just in, you know, in very broad terms, the asset went up, you know, over $2 billion and there were offsetting hedge losses of a billion one.

Those are if you look back in the history of the company in the first quarter, we had hedge gains of almost $700 million.

So these things are, you know, they flip around.

We had hedge gains in-- in 2003 of $235 million and in 2002 of a billion 8.

So now you have a spike back up in interest rates and those hedge positions are going to move conversely.

The fact is, I think, that where we have distinguished ourselves in terms of hedge performance is the fact that the actual economic value of the asset or the fair value of that asset went up substantially more than the hedge losses.

So we should generally look at the hedge losses relative to the economic value of the asset, not just the accounting value?

I think that that is, you know, frankly the most important evaluation to make.

But, you know, it is, you know, from an accounting perspective and reported earnings perspective, we look to stabilize our quarter-to-quarter earnings and the fact is that if we go back to the macro hedge benefit when we see, you know, a declining interest rate environment where you have impairment on the hedge asset, there is a time delay between the increment, or increase in new loan origination production and the value that that, that the company realizes from that.

And Stan, if I could ask one more question, how would you-- is there any way you can characterize the current environment?

Everybody, you know, talks about interest rates going back up, but of course they might not and in fact in the last few weeks they did head back down, if only briefly.

Is this an environment where you hedge a higher percentage of the MSR as in a traditional purchase market or is this an environment where you hedge a lower percentage of the MSR recognizing the possibility of-- of big gains if rates were to drop?

Well--

Or isn't this, in fact, a bad question to ask?

It's not a bad question.

It's, you know, it's basically what, you know, one of the values that we have because there is a difference between the market value and the book value.

In other words, we're-- there's less asset to be hedged from a book perspective, results in our ability to hedge less, to have smaller hedge positions relative to the servicing asset as it's, you know, the way we look at it is basically it's further out of the money after a rise in interest rates and allows for the hedging costs to decline and the quantity of that position to decline.

And that's a position that we hope to, that, you know, we planned and strategize to be in and so it reduces the-- the result is reduced hedge cost in the--or forecasted hedge costs in a rising rate environment, which produces higher, should produce higher income from our servicing portfolio.

Thank you.

And thank you, Mr. Posner.

And our next question comes from Eric Wasserstrom with UBS.

Please go ahead.

Thanks very much.

Angelo, I was wondering if you could elaborate a little bit on what conditions it was precisely that caused the capital markets activity to be so much less profitable than it was in the first quarter.

And secondly, to comment on what your margin outlook is for that business as you add these new products.

In other words, are these products accretive to the margin in that business or dilutive?

Well, let me make an overall comment and then I'll answer your question directly.

I think it's very, very important.

I know that your role, I know the collective role of analysts to be very granular and to, you know, look at each quarter and each week and each hour of a company's activities, but I think it's also very important that you maintain a perspective on this company in terms of its, you know, the long-term implications of what we have built here.

I think your question talks to that.

The-- even though you saw a reduction in capital markets earnings, you saw an increase in the overall earnings of the company.

Because of the balance that we, again, have built in with the other companies that do well in a higher interest rate environment.

The basic issue of the affected of capital markets was twofold; one is that the, that because of the less--of less activity, transactional activity, there's a margin squeeze.

And so there were two issues, one-- transactions held up better than I thought they would.

The, the-- there was a margin squeeze in the various traunches of their activities, and we have yet to enjoy-- we expect in the fourth quarter to enjoy the results of the-- of the new product, the primary dealer activity as we continue to build that operation, it shows tremendous promise and the-- as we, you know, we advanced on Trade Web and we get better and more skilled people on the voice part of that business, you know, the hand to hand combat part of it, that business is going to prove to be very profitable in the, you know, future quarters and years.

But I think basically it's been a margin squeeze.

Stan, would you comment on that?

Yeah, I think, you know, precisely we-- we had-- we have a significant conduit activity that takes place inside of Countrywide Capital Markets, you know, referring back to the-- they do a lot of their activity in that conduit as sub prime and so as there was generally more competitive environment in the sub prime market, that also translated to the conduits' ability to acquire and the profitability of the spreads on their conduit business.

And the other area is just in the securities trading, just had, you know, a more competitive environment as well, and those are the two areas that resulted in revenue decreases quarter to quarter, and, you know, frankly, it should be one that's expected relative to the changing volumes in the mortgage industry.

Thank you.

And our next question comes from the line of Charlotte Chamberlain with Jefferies & Co. Please go ahead.

Good morning.

Two questions.

I'm obviously doing the arithmetic wrong, but when I divide the, the value of your servicing on your balance sheet at 8.3 billion by the 726 billion, I only get 114 basis points.

What-- I'm obviously missing something.

Yeah, Charlotte, what you need to do is subtract the mortgage inventory, which is included in our servicing portfolio stat, which we have not capitalized MSRs against, as well as the sub servicing component of our servicing portfolio.

Oh, okay.

Okay.

And the other thing, when Cen Net was trying to sell their-- their servicing platform, you were pretty adamant you weren't interested in that and apparently now they are going for the whole enchilada and I was wondering if you had any thoughts on the entire company.

Thanks .

I don't know if I characterize their adamancy.

But, they're certainly a competitor and they rank in the top ten of the competitors that we face and they have a unique model, but that's about as-- my comments on there.

They're a good competitor.

It's not-- but now that they are entirely for sale, is that something-- I mean you haven't bought anything in, you know, anything in your entire history.

Is there any reason to think that this would be particularly attractive to you now?

Yeah, we're not going to-- we're not going to comment on that, Charlotte.

Okay.

Thanks.

Thank you very much, Ms. Chamberlain.

Our next participant is Mr. Michael Cohen and Mr. Cohen represents Susquehanna Investment Group.

Please go ahead.

Hi.

I just wanted to maybe try to get sort of to clarify what, Fannie's comments were to try to get your reaction to it.

Specifically they mentioned two things.

One, they mentioned consumers switching to arm IO products as a means of offsetting rising home prices, you know, to maintain affordability.

The second thing they mentioned was the risk that perhaps the private label MBS market has underestimated the risk of sub prime and alt A that's included in those securities.

And was just wondering if I could get your reaction to those two things.

Okay.

The first, I would say that to some extent, again it's my own personal opinion, to some extent, I think there's some validity to the fact that in some parts of the country the borrower has opted to go to arm loan for affordability issues, but have you to understand that the average price of a home in this country is still under $200,000, and so that maybe an issue on the two coasts, but certainly not for the rest of the country.

I think really we've seen a major switch, as you can see, the majority of our loans now are-- are ARM loans.

As rates have risen, people have opted to go to an ARM for affordability because of rate rise, not because of home prices because just prior to the rate rise, the vast majority of loans were 30-year fixed.

So I would argue that point of view.

In terms of-- I don't know exactly what the point Fannie Mae was making, or maybe I just don't understand your question, relative to the quality of loans in security that people are underestimating the impact of the sub prime loans in these securities, is that--.

Just the risk associated with those loans, meaning perhaps maybe the market has mispriced-- has not properly priced in the risk, the credit risk associated with such loans.

Only, only the future will tell that.

I think that one of the factors have you to always consider in that is appreciating values because as values of properties continue to appreciate, irrespective of what kind of problem the borrower may find themselves in, for overextending themselves, they're able to get out in an orderly way and the lender made whole.

I think the driving force there will be what happens to values, but, you know, I think that comment, you know, is pure speculation on Fannie Mae's part, may be right, may be wrong, but we'll not know for another couple years.

Great.

Thank you very much.

And thank you, Mr. Cohen.

Our next participant is Seth Glickenhaus representing Glickenhaus & Company.

Please go ahead.

Angelo, I want to congratulate you and your team for an outstanding, unique performance.

Not only for the quarter and half, but for many, many years.

The only question I have, I think has been answered, but with the losses-- the-- the hedging loss, wasn't that more or less attributable to the fact that the government market in-- virtually overnight lost a huge amount in the quarter?

No.

Seth, first of all, I want to thank you for your many years of support.

You're one of my personal heroes for what you have accomplished.

And, again, you know, you have been involved with Countrywide for many, many years.

Yep.

And I'm most appreciative of your continued support.

The hedge losses are unrelated to the issue that you raise.

I see.

The hedge loss is a result of market movements as rates rise.

That's why you have hedges, as rates rise, you're going to pick up on the servicing-- on the MSR, the value of your MSR, the offset to your hedge goes up and your hedge-- and your hedge loses.

You notice, that's the offset.

You hope that the value of the asset goes up more than the hedge loss, but--and that's basically what happened.

But that's what it's related to.

It's related to interest rates effecting prepayment speeds.

Thank you.

You're welcome.

I understand.

And thank you, Mr. Glickenhaus.

And our next question comes from the line of Ari Shocket with Citadel.

Please go ahead.

Hi.

I have two interrelated questions that are basically the same.

But, you know, you've talked in a couple different ways about the different competitive factors out there and your risk factor, you talked about the risk factor for imprudent pricing and you've also been asked a couple questions about servicing purchases and what have you.

I guess my two questions are given the distress that we're seeing in some of the other players the market, are you yet seeing irrational pricing and, sort of, can you give an update on what your thoughts are there?

I mean, your production margin was higher than a lot of people thought it would be. so perhaps the opposite's happening.

And then just, you know, the corollary to that, you know, I mean Angelo, you just talked about how you expect a lot of consolidation in the servicing.

Charlotte seemed surprised that you would be interested in that, but I think you've talked many times that you are looking at, you know, possible ways to, you know, get the servicing market share outside of just strictly originations.

I wonder if you could just talk about generally what you see in terms of both servicing possibilities as well as origination possibilities out there in terms of purchasings you could make.

Well, my comment to consolidation is really just an observation, you know, as an observer of the market forces.

And you've seen, you know what's happened with banks and B of A and Fleet and Bank one and J.P. Morgan.

It goes on and on and on.

My comments is related to-- each of these have a commensurate mortgage operation and that consolidation must continue and will continue.

The-- the comments that I made were not to be construed as Countrywide's interest in-- potential interest in acquiring servicing portfolios.

Ad you know, our history is we have not done that.

We grow organically.

That's our basic plan.

And all the projections we put out to 2008 are all based upon organic growth, you know, we are opportunistic people here and obviously if the opportunities come by, we'll take a look and seize them, but historically we have not done that.

But I think that it's very important that you don't construe my remarks on consolidation to mean that we are an agent of that consolidation necessarily.

It's just an observation.

Can you address the pricing of mortgages?

Yeah, I think-- questions-- when you talk about rational, rational to me is a very relative term, or irrational, both are relative terms.

If I relate it to the era that I spoke about earlier when we were facing the competitors who had no interest in profitability, Charlotte Chamberlain is a good-- she's been an observer of that for years.

That clearly was irrational and we see nothing like that.

There is-- you can't expect as rates rise and volumes decrease that you're going to have decrease in margins because capacity grows.

But even with the swing we had in the second quarter, I consider that very rational and one you should expect when, you know, when you have a bump in rates.

But I'd say overall, the atmosphere that we're operating within today, the competitive atmosphere, is very rational, very sound and one that Countrywide has proven to operate very successfully within.

Okay.

Thank you.

And thank you very much, sir.

Our next question comes from the line Gareesh Paku with RCG.

Please go ahead.

Hi, guys.

Great quarter.

In fact, I'm a little surprised given the low margins on sub prime and the low cap rate, as Keith mentioned, that the margins are as high as they are, especially given the competitors' results.

But I had a couple of questions.

One was on the previous question on the squeeze IO's, do you hedge those or not?

Yes, yes.

They're included in the servicing.

So, so some part of the hedge, there would be a hedge gain offsetting those within your hedge losses overall?

Exactly right.

And the couple of questions I have are, one, it came up on the last call, basically what's the impact of all of this ARM origination?

I'm a little new to the idea of ARM origination and sale.

Can you talk about how that's different from fixed rate mortgage, origination--

Well, it's different, there's not as higher margins on many of the-- not all of them, but many of the different ARM products.

There's many, many different variations off the theme on ARMs, but there is a lower margin historically than there are in fixed rates.

Other than that, we don't see any difference in the, in the servicing of those loans.

We don't see any difference in the, currently in the delinquency or foreclosure on those loans, again, partially due to the fact that you've increased values that sort of mitigates and sort of does mitigate the servicing problems.

But you got to remember that these ARMs-- most of these ARMs are not pure ARMs.

They are 3-year fixed, 5-year fixed, 7-year fixed, they're hybrid arms.

So, for-- at least for the time being, these really have to be viewed as fixed rate loans until, you know, until the time elapses where they becomes fixed and go to ARMs.

Then we would be dealing with pure ARMs.

The pure arm portion of the arm business being done is still relatively small.

I see, so the pure arms are much lower margins but the hybrid--

Arms in general are lower margins.

Why aren't we seeing the effect of that in your production margins, Angelo?

We have.

They're amazing production margins.

They're amazing, but they are not as high as they were when we had a, you know, record volumes.

There was no capacity in the industry.

We were able to charge up and we had said at that time many times over in our presentations that that was an unusual period of time where there was no capacity and there was tremendous pricing power during that period.

You know, that period has ended and you're going to see us outperform our competition in this area, one is because we're very technocentric and use technology for a lot of our processes and that drives down our costs.

Secondly, we are very focused and the technology and the focus that we have lends to greater efficiency and therefore greater margins than our competition.

Okay.

If you could-- if you could quantify how much lower ARM margins might be relative to fixed rates just for--

Hang on for a minute.

I just want to comment on the, you know, the general nature of the ARM market in the past has been that portfolio lenders provided very stiff competition for acquiring ARMs in their portfolio and the securities, the ability to securitize and sell ARMs was less liquid than the fixed rate market.

So it presented to us, you know, the general case that the ARM market has slightly lower margins than fixed rate mortgages.

The-- relative to the, you know, a greater percentage of outstanding mortgages being ARMs, it is very-- from a macro perspective, it would indicate that you would have higher refinance activity in a normal market than you would otherwise.

So I think it's, you know, speak highly for the potential of the, in a normal market, for the refi percentage to be greater as these intermediate arms, you know, come due and the consumer looks to lock in for another period.

You know, the ARMs, I don't know the-- the exact difference.

I can't really give that to you off the top of my head, but, you know, it's just generally been, you know, a slightly lower margin for us.

The market itself has advanced in terms of the ability to sell and securitize ARMs and it is, in our view, an improving condition.

Okay, and the second question was on Full Spectrum.

You've been growing the number of sales people just as fast as the consumer markets division and I was wondering if that's a choice you're making or if that's just the way it's shaking out.

And, two, if the sub prime market did dry up sometime in the future, could you switch the to the consumer market production?

Well, yeah.

First of all, we're not a shake-out company.

Everything we do is carefully planned and so the growth in the, both the prime consumer market as well as the Full Spectrum which deals straight with the consumer without intermediaries is a planned expansion of our sales force to create greater market share.

It's not only the sales force, but it's actually physical facilities that are being opened up in strategic areas to increase our market share in both the prime and the sub prime area.

The second question, you know, can they be switched over if sub prime dried up?

Sub prime will not dry up unless that whole strata of our society is somehow anialateed in some catastrophic event.

But sub prime has really been around for as long as there's been an America, in different forms.

HFC was an example of, you know, dealing with the sub prime borrower many years ago, and other finance companies.

And that market has just matured and become a much larger market as the--as the-- more and more of the American people want to enter the home buying arena.

It's really basically a concept that we are priced for every home buyer who wants to buy a home.

Some fall in the prime category.

Some fall in the sub prime category.

Both categories are growing as the homeownership rate grows in the country.

Thank you very much.

We have a question now from the line of Bennett Lindenbaum with Basswood Partners.

Please go ahead.

Hi.

I just wanted to go back to the bank for a second.

Is it-- are you trying to tell us, or are you trying to communicate that as you said, you said rising rates are going to help the margin.

I just want to understand since the yield curve is kind of predicting a flattening of the yield curve, what happens to the bank's margins in a flattening rate environment, the flattening yield curve environment?

It remains stable.

Basically, if you look at the bank's portfolio is primarily adjustable rate-type product that increase as interest rates increase.

The-- on the other side of that--is our pot of deposits, and it's our experience that as interest rates increase or the potential to pay, you know, a greater interest rate on deposits that there's actually a contraction.

The spread to LIBOR decreases.

Therefore what you have is a net widening of the spread between the assets that are repricing and the liabilities that are actually in, decreasing on a relative basis.

What about to the extent that you have hybrids that are repricing, maybe, in three years as opposed to something that's repricing in a month or a year or something?

That's matched.

Okay.

Let me just-- going back to just so we can make sure we beat this horse completely to death.

The MSR recovery issue, I think a loft folks, and I'm one of them, maybe had a misunderstanding or a naive view of all of this, kind of basically thinking, well, gee, on the way down when the servicing was getting crushed as rates fell, you, you had a hedge in place, but net-net you had a hit to earnings.

So I assumed that on the way up it would be symmetrical.

Am I correct in understanding that the reason that's not the case is because of the accounting, on the way down, you wrote down your basis in terms of permanent impairments and so you're locked in by that accounting.

If you didn't have that accounting, it would be symmetrical.

Yes, that's, that's a very good way to describe it, although I want to reemphasize the point that Keith was making earlier, that we could have elected to employ hedge accounting.

Right, but assuming you don't do that, assuming you stick with the accounting you've had all along.

Then you'll see the, you know, the type of, you know, lower of cost or market.

And it's not a symmetrical thing because of the accounting.

That's correct.

Yes.

Okay.

And we try to run an asymmetrical hedge to the extent possible.

Right.

And then just the last question, on the capital markets, obviously profitability and volumes have been extraordinary because of the environment we're in and obviously it's going normalize down to something lower, but beyond that, were there any issues in this quarter about extraordinary losses or lack of hedging or should we assume that there are some pretty significant controls in place there?

Well, all of those.

There's very significant controls in place and I think that, you know, to what extent, you know, it gives you comfort we are regulated by the Fed; this is a very deep area of their concern as it is ours, so we have extraordinary compliance and controls in place there.

But you gotta expect, when you go from a $4 trillion year in terms of numbers of transactions to a one of 2.3 to $2.5 trillion a year and you have transactional issues and that's what's impacting.

I just think that I, and I'm sure others, would like to make sure and I'm sure this is the case that you're not running some proprietary trading operation like some of our friends on Wall Street, that this is a much more controlled flow business.

You know, again, I want to reemphasize the point that the decline in their profitability is totally volume and spread related.

There are no, you know, hedge mishaps or speculation.

Yeah, we don't run proprietary because it's not our business.

We're in the mortgage banking business and I think our 36-year history would demonstrate that it's not our style, who we are and what we're about.

Thank you very much.

And next we go to Wachovia's Jim Shanahan.

Please go ahead.

Hi.

Thank you.

My question is related to the sub prime business.

I hate to borrow from the previous caller, but I guess beating a dead horse here, but guidance for sub prime margins returned to 350 to 400 in the second half.

Can you say where sub prime margins were at the end of June?

Well, as I mentioned earlier, based on, you know, our guidance for the balance of the year or for the near term is based on where we see app trends currently; at the end of June and heading here to July.

Okay.

Safe to say that if you had 290 on average for the quarter and you're saying 350-400 now, that we're probably closer to the 350-400 already?

That's what we're seeing in the app trends.

We're returning closer to that level than we are the lower level.

Okay, and the reason for electing to-- to-- not to sell the $4 billion in sub prime, what was the-- what were you thinking there?

I'm not sure what you're referring to.

Did you look at the market and say I have 4 billion in sub prime mortgage loans, I would rather wait to see if spreads improve or margins improve before I sell those?

I mean what-- you-- you could have sold another 4 billion in the quarter.

You didn't.

I'm just wondering why did you that.

That was not sub prime.

The originations were 4 billion in the aggregate over our sales.

Okay.

My mistake.

Yeah, so that was not-- it was not relegated to the one category.

My mistake.

One more question, please.

What are the current overcollateralization requirements for sub prime securitizations now versus, say, three to six months ago.

Yes.

They went up about 215 basis points from, you know, from about 75 basis points previously.

Thank you very much.

Okay.

Thank you, sir.

And our next question comes from the line of Jim Fowler with JMP Securities.

Please go ahead.

My question's been answered, thank you.

You're very welcome, sir.

Thank you.

We do have a question now from Bill Roy with GM Partners.

Please go ahead, sir.

Hi.

Can you disclose the balance of held for sale sub prime and home equity loans on the balance sheet?

We can disclose it.

Do you have that number?

We do.

Yeah, we have it.

Yeah, look at that.

CHL's balance sheet .

CHL's balance sheet we have been $9 billion in home equity loans between loans and senior securities--

What about sub prime?

I'm sorry.

That was home equity?

Home equity was 9 billion.

How much was held versus investment?

It's invested, held for investment.

Okay.

On sub prime held for sale?

Yes.

How much is that?

I don't have the exact number, but we sold fairly close to what we produced in the current period on the sub prime.

Right.

Yeah, I got that.

It's not a big number.

Okay.

Just again, to go back to the hedge issue, clarification on the, on-- Stan said the $1.149 billion of hedge losses excluded the cost of the hedge or the theta or amortization, whatever you call it, the options.

Included.

Included.

Oh, it did include that?

Yes.

Okay.

I thought he said it didn't.

Do you know what the cost of that is, the cost of the hedge, not the actual loss?

When we talk about hedge, we obviously have the decay in the asset where you have options over the time period that you're holding them.

In our estimate of decay going into the second quarter on the servicing hedges would have been about $106 million.

That was our estimate of decay.

That is not, you know, the hedge costs change as interest rates rise, while the actual decay is reduced on a quarterly basis.

But it is very dependent on the level of interest rates, but, you know, as it related to the second quarter here that was the number.

That was going into the quarter?

Yes.

And now that rates have risen and theoretically you have less hedge applied, it would-- would you expect that number to go down, all other things equal?

All other things equal we expect it to go down because the, if you will, the servicing asset is out of the money and so it's cheaper to hedge.

Right.

Got it.

And just finally, two questions.

Do you plan to adopt hedge accounting and secondly, if you adopt hedge accounting, does hedge accounting serve to offset the hedge costs or the hedge costs and the losses incurred?

On the hedge.

It's just the losses.

You know, there's an effectiveness test in terms of corollating the actual change of the hedge instruments with the change in the value of the MSR or the MSR strata that you're electing to use hedge accounting on.

We always have the option to employ hedge accounting on a going forward basis and it's, you know, really dependent upon where the hedge asset is and what's happened with interest rates.

So really, it's an option that we have used in the past and one that we're likely to use under some condition in the future.

Okay.

And just real quickly finally, so if you can't-- if hedge accounting doesn't allow you to offset the hedge cost, does the impairment reserve in a theoretical high rate environment; could you reverse what remains of the impairment reserve, the $385 million to offset hedge costs or should we--

I think the way that you should look at hedge costs is that you have a servicing asset and it has a yield and we employ a part of that yield in the cost of hedging and that we always are, you know, including in our numbers and in our guidance some level of, you know, normal decay or hedge costs on the servicing asset.

The question about whether it's a recoverable impairment is a very, you know, technical and a lot of these numbers become fungible, so it's really hard to answer, you know, that question.

It was my understanding that if the-- the fair value of the MSR ever exceeded the cost, the impairment reserve would thus be zero.

That is correct unless you increase the basis through hedge accounting.

So if you're not employing hedge accounting your limit to writing up the--the asset is to the extent of the impairment reserve.

Okay.

So should we expect or not expect the $385 million of existing impairment reserve to be recaptured a high rate environment?

Yes, you should.

I mean, if rates go dramatically higher, you should expect that remaining impairment reserve to be recaptured.

Okay.

Thank you very much.

And thank you, Mr. Roy.

Our next participant comes from the line of Nick Adams with Wellington Management.

Please go ahead.

The amount of had HELOC that was produced for the quarter, could you tell me?

Just about 7.5 billion including fixed rate seconds.

And so you produced 7.5 billion, sold 6.1.

7.3 billion.

7.3.

And then you mentioned the sub prime.

You sold about what you produced?

That's accurate.

Okay.

Thanks.

We do have a follow-up question from the line of Jon Gray, once again, with Sanford Bernstein.

Please go ahead, sir.

Yes, the 19.7 million loss provision that was taken in the quarter, could you tell me where, in what business segment that is located?

Is it in the banking segment's expense?

Where, where does that appear in the segments?

It's in both the bank and the mortgage banking segment.

Can you give us the breakout?

I don't have that handy.

I think that banking was $7 million of that.

Okay, and I just want to, you know, I hate to seem like such a pussy cat, but I'd like to compliment you on the absolutely unbelievable financial disclosure.

It's I think without precedent, the detail, the quality, the timeliness.

Thank you very much.

Jonathan, lot of it is due to your requests over the years to be more granular in our disclosures and hopefully we're meeting your expectations in that regard.

Thanks very much.

Thank you, Mr. Gray.

The next participant in queue is Lee Rosenbaum with Loomis Sayles.

Go ahead.

Hi.

I was wondering the amount of cash taxes paid in the quarter.

Thank you.

Are you with the IRS?

I don't have that number.

It will be included in the 10-Q.

Thank you very much, Mr. Rosenbaum.

And next we go to the line of Jordan Heimowitz with Philadelphia Financial.

Please go ahead.

Hey, guys.

Congratulations on a great call, and I commend you as well for using more conservative accounting as opposed to just beating numbers.

Thank you very much.

My question concern as topic that hasn't been asked yet and that is on the bank you seem to be at the end of a, you know, for lack of better term, a new, regulatory de novo institution.

Where is the status from being able to lever up the MSRs in the bank at that point and is that, you know, I guess what status are we at at this point?

Well, we don't have MSRs in the bank.

I know.

But what's the status.

Well, the-- you know, it's something that we continuously debate within the bowels of Countrywide as to, you know, what portion, if any, of the mortgage banking component should, you know, should be in the bank.

We are-- let me just address it this way.

We-- if you look at it purely on a mathematical and leverage basis, clearly the MSR should be in the bank if you look at it just in that form, because of the substantial increase in leverage that we enjoy less capital requirements, if it's in the bank.

The reality is you're talking about a $10 billion asset or close to that.

So the bank clearly could not support it.

You could raise the question, well, maybe they can support part of it.

You know, these things we continue to examine.

We just-- we have come out of our de novo status.

We are, you know, I can say officially out of the de novo status; but just out of the de novo status at the bank.

We want to make sure that we don't do anything in the bank that would cause any concern on the part of the regulators.

So it's a strategy that we continue to debate.

You could look at, put the servicing assets there, leave the originations out of it.

You could put the originations in, leave the servicing out of it, but I can only tell you that this is sort of a continuum and I think my-- my direct answer would be I want to see the bank at a much greater size and stability and higher-- not only a higher capital rate, but higher footings before we entertain taking an asset as large as we have and put that into the bank.

So you don't think any of it will be moved over there this year per se.

No, I do not anticipate anything being moved over this year.

Okay.

Just a second quick question.

The capital markets revenues were in one line item in the income statement.

Is that a question?

Yeah.

They'd be incorporated in gain on sale as well as net interest income.

Okay.

Thank you very much.

You're welcome.

Thank you, Mr. Heimowitz.

And our next participant is Mr. Lawrence Kam with Sonic Capital.

Please go ahead.

Hi, guys.

Great quarter .

I don't know what's more impressive, your performance or how you make it look so easy.

I'm reading these press reports that say you missed.

I think you had a massive beat here.

There seems to be some confusion in the marketplace.

So I just wanted to go over the financials one last time.

Yeah, we-- just-- we feel the same way.

We're very surprised at how this extraordinary performance has been interpreted.

It's like we're speaking English and they're speaking French.

But, please, proceed with your question.

Yeah, as far as I can tell, your MSRs went up 810 million more than what you booked and that's an incremental $1.60 per share after tax.

Now, if you booked that 1.60, if you had-- you would have booked that if you had elected hedge accounting or if the new FASB rule that's under consideration had been in effect.

So if you include the full MSR value, earnings were more like almost $4, right?

And in any case, you'll get that 1.60 through lower amortization going forward, but-- did I get that correctly?

Yes, you're correct.

You're correct.

So that, that-- there is a massive misinterpretation in the marketplace as to--

Yeah, or a misunderstanding.

You know, I-- I don't know exactly, you know, what is taking place here.

Clearly the communication, public communication this morning, you know, on TV as I viewed it was incredibly distorted, I'm sure not on purpose; but there is a, you know, certainly a disconnect between our performance and the perception of our performance .

One other questions, with respect to your margin guidance, it looks fantastic to me, and you've always said it's a function of less competition.

I was just wondering if there is any effect also in your vastly superior cost structure, because I think you mentioned before that this is a scaled business and you really need scale; but you have competitors like WaMu who apparently have scale, but still can't seem to get it right.

Well, scale is one of the issues, but your ability to efficiently process that scale is also equally important from both the origination servicing side, we operate off a proprietary platform.

It's a singular monolithic platform which lends great efficiency to both originations and servicing.

So it's true that it's not, it's not strictly scale because there are examples of massive scale out there that are losing their derrieres.

It is the ability to process that, that--the number of originations or number of phones in servicing as efficiently as possible.

What is should lead to as you get scale is lower cost per unit because that's clearly what Countrywide has experienced over our history as we add loans, particularly to servicing; and as we add loans to the origination side of it, the productivity of each employee rises, substantially, and that's we expect to continue to happen in the future.

Our servicing efficiency should continue to rise.

That's based upon our-- primary simplistic measure is number of loans service per employee and on the production side is number of loans closed per employee.

Those numbers should continue to rise as we continue to employ new innovative technology in both sectors.

Appreciate it.

Thank you very much.

And thank you, Mr. Kam.

And ladies and gentlemen, we appreciate the strong interest shown in today's conference call.

However, with time now for one more question, our final question comes from the line of William Matthews with Canyon Capital.

Please go ahead, sir.

Fantastic.

I think a lot of thought goes into understanding the earnings model and, again, the transparency is excellent.

Can you give us a little color on, kind of, the cash effect.

So, for example, if we've just been through a period where, you know, earnings have skyrocketed because of origination, but that's really a cash negative investment and we're gonna go into a period of more reaping that investment in the earnings stream and the MSR; what will the cash flows look like in terms of you seeing your notes payable jump from a 20 billion number at the end of '02, to now a $42 billion number.

Will we see cash in excess of earnings, go to take down some of those liabilities or where will the cash go?

Well, we expect to continue to grow the portfolio and as long as we're growing the servicing portfolio, we're going to continue to make investments in new servicing.

You know, as we pointed out, we do expect the cash investment that we're making in that new servicing to be less.

It has been less in recent periods than it was historically for a couple of reasons.

Our MSR investment is lower than it was, principally because net servicing fee is less than it was and the competitive--the level of competition in the market is resulting in less cash having to be invested in the servicing that we're producing.

And the servicing portfolio is growing and as it grows it generates more cash.

So I can't give you specific numbers at this point in time, but I think we will be generating more positive cash flow than we have historically, but at the same time, we're going to continue to make those investments as we grow the port.

Is it fair to say the magnitude of investment necessary for a year like 2003 where the originations are so large, you know, is a multiple of what it would be going forward with the origination market being much lower?

That's fair to say, yeah.

Okay.

And so without that huge investment though, we should see an increase in the cash coming off the servicing?

You should.

And that number is going to be used to continue to invest as opposed to--

That's been our MO to plow that cash back into the Company.

Okay.

Many of our new businesses are cash, you know, the banks--the bank, the insurance company, the reinsurance operation, you know, which is very large now; our cash generating businesses.

Great.

Thank you.

Thank you, Mr. Matthews.

With that, Mr. Mozilo and our host panel, I'll turn the call back to you for your closing remarks.

Okay.

Well, thank you very much, you know, for all of your participation and your thoughtful questions and we look forward to getting back with you at the end of the third quarter and if there is any material changes in what we have talked to you about today, you certainly can expect us to inform you of those changes in the interim.

But we certainly will be looking forward to our teleconference in-- at the end of the third quarter and our investor symposium in September.

Thank you very much.

And, ladies and gentlemen, your host is making today's conference available for digitized replay for two weeks.

It starts at 1:05 pacific daylight time, July the 22nd.

All the way through 11:59 p.m.

August the 5th.

To access AT&T's executive replay service please dial 800-475-6701 and at the voice prompt, enter today's conference ID of 736583.

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That does conclude our earnings conference for this second quarter.

Thank you very much for your participation as well as for using AT&T's executive teleconference service.

You may now disconnect.