Countrywide Financial Corporation:

an example of Failed Business Risk Assessment

Introduction:
Key data important to the business risk assessment of Countrywide Financial
Corporation 2002 -2006 are shown on page 34 of the January 2009 complaint in the
private securities class action. To understand what this case is about, you must first
know how Countrywide Financial Corporation made its money. In other words, what
was its basic business model? Then, you must know what changes Countrywide
Financial Corporation made to its strategy for achieving its objectives. The changes
made to its strategy were extreme.
The complaints both in the private securities class action and in the SEC enforcement
action allege that the management of Countrywide did not disclose in its financial
reporting (including in its audited annual financial statements) that it had made
extreme changes to its strategy (and of course it did not disclose the nature of those
changes). Whether this is true is not the focus of our case study.
The focus of our case study is to simply understand the basic business model of
Countrywide, its objective, and its strategy in 2002 and 2003. Then the focus is to
understand the extreme change in its strategy in 2004. Then we will consider whether
this was a sound change in strategy or a bad change in strategy, from the point of view
of the rank and file stakeholders of Countrywide: its stockholders, bondholders and
employees. We will try to make this assessment of the change in strategy of
Countrywide, looking at it with the information available at the time, and not looking
back with 20/20 hindsight.
Perhaps the major point of Chapter 4 of our text, as well as the major point of this
case study, for auditors, is that a strategy for achieving a companys objectives must
be periodically scrutinized to determine whether it is a sound strategy, or a bad
strategy, that will likely lead to the deterioration, even the collapse, of the company.
This scrutiny is called risk assessment. History shows over and over again that
companies that deteriorate often attempt to issue materially misstated financial
statements. History also shows that auditors associated with materially misstated
financial statements can expect to be sued, or worse, and that auditors who claim they
did not know the financial statements were materially misstated, and could not
reasonably be expected to have known, will generally not be believed. Thus, it is
important for auditors to understand business risk assessment, and to assess in every
company they audit whether proper business risk assessment is being done, and
responded to properly by the senior executives of the company.

1. What are the two ways Countrywide or any mortgage lender - made money?
a)
b)
2. What is the conservative (low risk to Countrywide) type of mortgage loan that
Countrywide made?
3. Countrywide, beginning in 2004, greatly decreased the percent of conservative
type of mortgage loans. It greatly increased the percent of loans that had a high risk to
Countrywide. Briefly describe some of these high risk loans, but make sure you tell
me why such a loan is high risk to Countrywide (i.e. higher risk of default)
a) Nonprime (also called Subprime) mortgage loans
b) ARM (also called Adjustable Rate Mortgage) loans
c) Pay option ARM loans
d) HELOC (also called Home Equity Line of Credit) loans
4. Name three other practices of Countrywide that were risky (either increasing the
risk of default or increasing the risk of inadequate collateral for Countrywide if a
default were to occur):
a)
b)
c)
5. Describe changes in the external environment from 2002 to 2006 that Countrywide
should have responded to by becoming less risky in its strategy, rather than more
risky. Hint: discuss interest rates and the housing market bubble.
6. Do you think the people working on risk assessment at Countrywide were to blame
for the unsound extreme change in Countrywides strategy? Yes or No?
a) Who do you think was to blame for the unsound extreme change in
Countrywides strategy?

6. Do you think the people working on risk assessment at Countrywide were to

blame for the unsound extreme change in Countrywides strategy? Yes or No?
a) Who do you think was to blame for the unsound extreme change in
Countrywides strategy?
No.
Board of Directors has the responsibility to publish extreme changes in strategy.
Stakeholders of the company have the right to know the massive changes in strategy
because their fortune may get huge impact due to the change in strategy. It is the
responsibility of Auditors also to make sure that all the relevant information to be
published in the audited annual financial statements. The article also raises a valid
point that the auditor should have sound knowledge about the risk assessment because
then only he will be able to estimate the impact of certain changes in strategy on the
stakeholders.