The Rude Awakening
Wall Street, New York
Thursday, November 10, 2005

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Eric Fry, reporting from an undisclosed location near the
epicenter of the housing bubble...

Last Tuesday morning, your New York editor persuaded
himself, once again, that there is simply no better value
for your investment-research dollar than our free
publication, The Rude Awakening. Tuesday morning, as you
may have heard, Toll Brothers shocked the investment world
by forecasting LOWER home sales next year. Its stock
tumbled 14% on the news.

Faithful Rude Awakening readers may have been slightly less
shocked than most investors. Back in early August, your
editor took a few pot-shots at Toll Brothers' stock...that
happened to hit the target.

For those who may have missed the original presentation of
our column, "For Whom the Toll Sells," please allow us to
reprise an excerpt:

"Why are the Toll brothers selling their stock? Are they
selling to conduct 'personal financial planning?' Or
because the housing market is topping out? Or because Toll
Bros., itself, is facing more challenging times? Or all of
the above?

"We have no idea, but we are nevertheless intrigued by the
size and frequency of the recent sales.

"Last month, the Toll brothers – the actual brothers,
Robert and Bruce, not the home-building company they
oversee - sold more than 2,000,000 shares of their
company's stock. The sales netted them about $120 million –
also known as 'real money.'

"We do not begrudge the Tolls their good (and very large)
fortune, but we would point out that insiders NEVER sell
because they expect conditions to improve.  That's what
buying is for. If insiders are selling, should we outsiders
be buying? If the Toll brothers are selling, what fate lies
in store for the U.S. housing market?

"To be sure, the housing market needn't fall, merely
because Robert and Bruce Toll are lightening up on their
stock holdings.  But their hefty sales hardly inspire
confidence...We would not consider these sales a favorable
omen for home-building stocks or for the housing market in
general."

Our timely observations prove the adage that "even a blind
squirrel sometimes finds an acorn." We blind squirrels here
at the Rude Awakening are very grateful for every acorn we
find, but we are forever in the hunt for the next one.
Thus, Toll Brothers' grim report prompts the question:
Who's Next?

We would quickly concede that a soft housing market would
provide very few thrills for anyone, except renters and
short-sellers. Even so, some companies (and individuals)
seem likely to suffer more pain than others. Countrywide
Financial, for example, seems ideally positioned to suffer
a greater-than-average share of pain.

Please allow us to re-load, as we take a few pot-shots at
the nation's biggest mortgage lender.

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WHEN BUBBLES BURST
By Eric J. Fry

For the last couple of years, the prospect of a housing
bust seemed purely theoretical. But now it seems all too
real. Suddenly, the worst-case scenarios seem uncomfortably
plausible. And even the best-case scenarios don't look that
great.

Thus, when Toll Brothers offered its disappointing sales
forecast earlier this week, the mortgage lenders of the
nation must have felt a few pangs of anxiety. Afterall,
what's bad for the homebuilding goose is never good for the
mortgage-lending gander. The nearby chart illustrates the
close connection between the two industries. For several
years, companies like Countrywide and Toll Brothers have
been nurturing each other's prosperity. No surprise then
that their respective share prices have been rising in
tandem. Perhaps, then they will also fall in tandem.

 "Since Hurricane Katrina in early September, we have
observed buyers taking longer to make their purchasing
decision," Robert I. Toll, chairman and CEO of the nation's
largest luxury homebuilder, glumly explained. "We attribute
this change to the significant decline in consumer
confidence in the last two months that was precipitated by
the hurricanes and their aftermath, and to record gas
prices. It appears we may be entering a period of more
moderate home price increases, more typical of the past
decade than the past two years."

Left unsaid was the unnerving possibility that Toll's
downbeat forecast remains still too optimistic...and that
we may be entering an atypical period of moderate price
DECREASES, in which case, mortgage lenders like Countrywide
Financial may be entering a period of moderate (to
substantial) earnings decreases.

 "A bubble is to a boom as a martini is to a beer," writes
James Grant, editor of Grant's Interest Rate Observer, "So
much more potent is the former, why does anyone settle for
the latter?  You know the reason: the morning after. Which
will serve to reintroduce Countrywide Financial Corp., the
nation's top mortgage originator and No. 1 mortgage
servicer."

Countrywide is the biggest, and fastest-growing, mortgage-
lender in the nation, which is exactly the wrong kind of
lender to be if, as Grant believes, the housing boom is
about to become less boom-like.

"House prices, say we, are in a bubble, not just a boom,"
Grant declares. "Their rise in real terms in the decade
since 1995 represents a significant and telltale break from
the experience of at least the four prior decades...
Equally, mortgage debt is in a bubble, as it must be. 
Without the debt, who could afford the houses? As these
bubbles have inflated, Countrywide has dazzled. It must
dazzle less after the comeuppance."

Grant has not always cast a skeptical eye toward
Countrywide. To the contrary, in February 2000, he penned a
glowing - and timely - analysis of the mortgage lender's
stock. The share price has soared fivefold since then.
Therefore, now that Grant has turned bearish toward the
stock, we are inclined to lend him our ear.

"A post-bubble mortgage crisis has no place in
Countrywide's five-year plan," Grant jokes. To the
contrary, the company's CEO, Angelo Mozilo, dismisses such
doomsday notions. Therefore, Mozilo seems vexed and annoyed
the Countrywide's share price carried such a miserly PE
ratio of less than 9. (Perhaps he is also annoyed and vexed
that he did not unload more of his shareholdings at price
north of $50 a share).

"Like Mozilo, [we also] expect that Countrywide's multiple
might expand. Unlike Mozilo, we expect that earnings will -
at first - fall faster than the share price. The share
price will catch up as the market realizes that the house
party is finally over."

Whenever asset prices tumble in any financial market,
profit-making opportunities become far less numerous than
loss-avoidance opportunities. Unfortunately, many market
participants continue to position for profit-making rather
than loss-avoiding. They keep trying to make a buck in a
falling market instead of looking for a place to hide.

If, therefore, the housing boom is winding down, the
nation's largest mortgage lender will be unlikely to find a
place to hide, especially because its CEO dismisses the
need to look for one.

"In refusing to crown Countrywide with a double-digit P/E
ratio," Grant continues, "Mr. Market might reason that
there will likely never again be a half-decade in
residential real estate quite so sweet as the one now
drawing to a close.  How could it have been improved upon? 
House prices soared and mortgage rates fell...All the
while, financial engineers ingeniously produced new kinds
of mortgages that virtually absolved the home-buyer of the
customary obligation to come to the closing with a modicum
of cash. The probable passing of this golden age means that
the great question surrounding Countrywide is about the 'E'
more than that 'P'..."

When Grant published his bullish analysis of Countrywide
stock in early 2000, the mortgage lender claimed only 7% of
the nation's origination volume. Today that number tops
14%, en route to 30% by 2010, according to Mr. Mozilo's
ambitious plans.

"Five years ago," Grant recalls, "Countrywide was the No. 3
servicer; now it's No. 1. And in this subprime market, it
has climbed to third place from seventh. It's a nationwide
branch network numbers 800 offices. From 2002 through 2004
the size of its sales force more than doubled, to 13,000
from 6000, and it has quintupled since December 2000."
Because the housing boom contributed greatly to
Countrywide's rapid growth, we may only imagine the
contribution a housing bust would make. To assist the
imagination, it bears mentioning that Countrywide's
profitability per loan has been shrinking...EVEN DURING THE
BOOM!

Its mortgage-lending profit margins have been plummeting
all year. The so-called "gain-on-sale margins for all loans
'products' fell to 102 basis points [in Countrywide's
second quarter] from 164 basis points in the first
quarter," Grant reports. "For the smoking subprime segment,
gain-on-sale margins plummeted to 190 basis points from 282
basis points in the first quarter (and from 466 basis
points one year ago)."

For those readers who may not understand this terminology,
suffice to say that Countrywide's profitability trend is
not encouraging. If profit margins at the giant mortgage
lender were falling during the boom-time first half of
2005, what will become of these profit margins during the
post-Katrina-post-Toll-Brothers-warning second half of
2005? And what will become of them in 2006?

Your editor, a homeowner, does not relish the thought that
the housing boom may be ending...but Countrywide Financial
must be relishing that thought even less.

[Joel's Note: You would have noticed the volume of public
dialogue regarding the housing boom, and now bubble, in a
huge upswing of late. This means the mainstream media is
finally picking up on the tail end of what the fringe media
has been banging on about for a while. Still there are
folks out there that insist on ignoring the warnings and
turning their back on the mounting data and indicators
pointing towards imminent collapse. This is called denial.
Protect yourself against the hidden drop here:

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[Joel's Note: You will recall earlier this week Eric
solicited suggestions of mid-sized oil companies that would be
prime acquisition targets. Needless to say, this little
request has flooded my inbox and kept me under the hammer
all week. If I didn't so love this job I wouldn't be
reminding you that today is your last chance to send in
your picks. Address them to:

aussiejoel@the-rude-awakening.com

You can check out the entire issue, and all the Rude
archives for that matter, at the new website. Just head to
www.the-rude-awakening.com and click the archives tab.

Cheers,

JB

And the Markets...