Stick With a Proven Winner in Countrywide

As well, the company has implemented a $2.5 billion share-repurchase plan, of which it expects to complete $1 billion to $2 billion in the fourth quarter of this year. Buybacks are appropriate when the stock is not highly valued and investment opportunities are relatively limited, as would be the case for Countrywide in an environment with lower mortgage-origination volumes.

The bigger question is whether Countrywide is prepared for a worsening of credit, particularly in the subprime mortgage segment. As with any financial company, there are reams of statistics to examine, but perhaps the most important is its exposure to Pay Option ARMs.

A Pay Option ARM is an adjustable-rate mortgage with an interest rate that changes monthly and payments that change annually. The borrower can choose among various payment options, including one that is below what would be paid in an interest-only mortgage. Such a choice would result in negative amortization, which means that the loan's principal would increase during this period.

Monthly payments cannot increase by more than 7.5% per year unless the principal balance of the loan is 115% of the original loan amount or five or 10 years have elapsed since the loan was made. In both cases, the loan will become fully amortizing (that is, interest and principal payments will be made like a traditional mortgage). This reversion to full amortization is referred to as a "reset" or "recast" and can result in a very substantial increase in the monthly mortgage payment for a borrower.

Countrywide holds $35.4 billion of Pay Option ARMs, of which $29.6 billion are in negative amortization. This high ratio is not surprising, as the lower-payment option is what attracts borrowers to this loan. To date, the total amount of negative amortization -- that is, interest income booked by Countrywide that has not yet been collected in cash -- is $471 million, or 76 cents per share pretax. This is significant, and the per-quarter negative amortization could be 20 cents per share for the next few quarters.