Affordable Housing Institute : US

 

Who tipped number nine?

In a string of falling dominos, there is always a next domino, but also always a previous domino, and in the interconnected financial ecosystem that supports origination of new loans and their resale in the secondary market, it’s easy to become confused which is which. That distinction is blurred in two articles, one from the Washington Post, the other from the New York Times, about the spectacularly sudden implosion of New Century Financial, the nation’s largest subprime lender, whose troubles come not in spies but in battalions:

 

New Century Financial, once a highflying lender of risky mortgages, said yesterday that it does not have the money to pay its lenders, fueling speculation that it might not survive much longer.

The New York Stock Exchange halted trading of New Century’s shares, which had dropped to $1.66 from $3.21 Friday [March 10 -- Ed.].

 

Profile of a cliff; falling off same

The California company said in a filing with the Securities and Exchange Commission yesterday that all of its lenders have either pulled its funding or have said they will do so. “They need to come up with an alternative source of funding or else they are going to file for bankruptcy,” said Matthew Howlett, an industry analyst at investment bank Fox-Pitt Kelton.

 

Bankruptcy seems only a matter of a short time. Meanwhile, what tipped New Century into the soup was this cheery announcement only a week before:

Federal prosecutors and securities regulators are investigating stock sales and accounting errors at the New Century Financial Corporation, the biggest mortgage company that specializes in lending to people with weak, or subprime, credit, the company disclosed in a corporate filing yesterday.

“Stock sales and accounting errors” are the phrases one might use if the captain and crew were dashing for the lifeboats even as the ship was sinking.

 

We’re still making journal entries

The investigations into New Century, which is based in Irvine, Calif., and wrote $33.9 billion in mortgages last year, started after the company said on Feb. 7 that it would restate earnings for three quarters, which sparked a huge sell-off in its shares.

“Errors” is often the safe non-judgmental euphemism for “suspected fraud.”

 

Yesterday, it said its problems had prevented it from filing its annual report, which was to be released Thursday. The board is conducting an investigation of the accounting problems.

 

What put New Century into this pickle?

The unraveling of New Century is one of the highest-profile setbacks to the subprime mortgage market, which caters to people with blemished credit histories or insufficient cash for a down payment. In recent years, when housing prices were rising, millions of people used such mortgages to buy homes they otherwise could not afford. Once home prices leveled off, borrowers started to default on their mortgages.

That statement confuses causality.

 

The shadow makes me move

Changes in home prices make no difference in my monthly mortgage payment; all they may do is influence my motivation to keep making payments, or my options if I fail. What triggered the borrower defaults would have been any of the following:

 

1. Payment increases from adjustable-rate loans.
2. Payment increases from step-up loans when an introductory concessionary rate or payment expired.
3. Decline in the borrower’s financial circumstances.
4. Borrower over-optimism about the borrower’s ability to pay the higher occupancy costs.
5. Mis-statement or outright fraud in the buyer credit underwriting initially.

I can afford it, I really can!

Consumer advocates, and even some percipient bloggers, have pointed out these and many other risks of subprime loans, including the credit conundrum, and the potential for bad lenders to make bad loans.

 

That wreaked havoc on the subprime sector, which accounted for about a fifth of all new mortgages last year.

Here’s where it’s critical to understand (1) why these companies’ problems may have a ripple effect, and (2) who will be hit, and whether that will have spillover consequences for the broader economy.

 

Start with the capital markets impact. Subprime lenders, like all other lenders, put out much more money than they have. (For that matter, so do banks; their capital on hand is always a very small fraction of their total deposits or loans outstanding.) They get the money they need by selling the loans in packages (called a ‘whole loan sale’) or by issuing their own securities (called a securitization), which are backed up by a mixture of a pledge of the loans plus the issuers’ collateral.

Like most subprime lenders, New Century sells its mortgages to investment banks that package these loans into bonds and trade them on the market. In recent weeks, the value of those mortgages has plummeted as investors abandoned the sector.

 

Over the last twenty or so years, securitization has swamped whole-loan selling because it is a more efficient technology. Securities can be standardized; they can be aggregated into vast bulk. Further, because the security is normally issued in an amount less than the bundle of loans pledged as collateral, the issuer retains the top loss (called the “B piece”) while the securities holders have the senior claim (called the “A piece”) on the collateral.

 

The B piece falls first … and then the A?

All this works great until the B piece holder — in this case, New Century Financial, the originator — becomes insolvent. The falling of that domino implies both a next domino falling and a previous one having fallen:

 

· Next domino. If the B piece holder is kaput, there’s no external collateral for the A piece holders.

· Previous domino. Why does a B piece holder lose money? Because the loans themselves aren’t generating enough revenue to pay the A holders.

Default by the B piece holder is a double whammy: it means the external collateral is gone, and the internal collateral is under water.

 

Will the A piece call the B issuer for assistance?

Under ordinary circumstances, the originator also credit-enhances the A pool with a contingent guarantee:

 

Under some of its banking agreements, New Century has to cover the difference between the original and decreased value of the mortgages.

Unfortunately, if the B piece is worthless and the lender is insolvent, then this guarantee is worthless too. Which means the A piece holders are in trouble too:

 

Not quite so sure of my collateral

Under its loan agreements, New Century could be forced to buy back the mortgages that the banks have not been able to sell on the market.

If all the banks force New Century to buy the mortgages, the amount would total $8.4 billion.

I don’t think the $8.4 bil will be forthcoming. And therefore …

 

Its lenders include such banks as Bank of America, CitiGroup, Credit Suisse and Morgan Stanley.

As recently as last week [Late February -- Ed.], Morgan Stanley made an emergency $265 million loan to New Century.

Probably Morgan Stanley got itself a first secured position in an asset that can be extracted from the larger mess.

 

Okay, says the reader, it’s certainly a fiasco, but what does it mean for home owners? If I pay my mortgage, what difference does it make to me?

Concerns about the future of the risky loans have already rattled stock markets. The fear is that problems with subprime borrowers will spill over into the broader mortgage market, damage the economy and dampen demand for homes.

 

What’s going to happen to me?

[Continued tomorrow in Part 2.]

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