Subprime lending: a domino falls two ways, Part 2
[Continued from yesterday's Part 1.]
With the spectacular collapse of the nation’s largest subprime lender, New Century Financial, the financial markets are jittery:
New Century is the center of speculation about the fallout from the subprime market in part because it is one of the nation’s largest subprime lenders, with an estimated $52 billion in subprime loans last year.
When a $50 billion balance sheet suddenly flips upside down, everybody gets worried.
Nothing to worry about, folks
The troubles at New Century are the latest sign of the deterioration in subprime lending — until recently the fastest-growing segment of the mortgage business. The market has been struggling to contain the fallout from rising default rates and weakening home prices. Late last year, some smaller lenders started going out of business and last month several bigger companies, including New Century, started reporting problems.
Little dominos falling leads to bigger dominos falling
It’s worth stepping through very carefully who is exposed for what. Start with the unhappy company and its unhappy debt and equity providers:
The future of New Century
From a legal/ technical standpoint, New Century meets the definition of insolvency — it has admitted in writing that it cannot pay its debts. Further, it has no working capital to operate.
Also, the company will have to seek waivers from lenders that have provided it with 11 financing arrangements, because it will not have at least $1 in net income for the six months that ended in December. It has gotten six waivers so far, but they are contingent upon the company getting similar leniency from the other five.
Even if that happens, it’s very hard to see how New Century avoids bankruptcy. Who gets hurt when that happens?
The company’s fate will probably hinge largely on the providers of its capital, which include Wall Street’s biggest banks, which also own a hefty chunk of the company. Morgan Stanley, Goldman Sachs, Barclays Capital and Deutsche Bank own about 16% of the company, according to securities filings. Citigroup recently bought a 5.1% stake in the company and Greenlight Capital, a prominent hedge fund, owns 6.3%. Its president and co-founder,
For companies, bankruptcy comes in two flavors:
Choose the red one, or the blue?
· Chapter 7 means legal liquidation. The company shuts down and all its assets are sold, for cash, and the proceeds distributed to creditors.
· Chapter 11 means legal reorganization. The company continues operations via a recapitalization under which its capital structure is revamped: debt crunched, repayment rescheduled, new cash injected, old equity trimmed.
Chapter 11 is pursued whenever the operating entity has a business with profit-making potential and the creditors become persuaded they will recover more by allowing it to continue as a going concern. Here, with New Century providing loan servicing and asset management on a portfolio of questionably performing loans, it may well be in the creditors’ interest to maintain a slimmed-down loan collection facility under the New Century operating umbrella.
Either way, the creditors and debtor (New Century) have a mutuality of interest in stabilizing the portfolio. Insolvency makes strange bedfellows.
Put your impulses aside and join me
Shrinkage/ consolidation among subprime lenders
When the mighty fall, everyone worries that others will fall too. In fact, others have been falling:
About two dozen lenders have closed or sold themselves this past year because of troubles similar to those New Century faces.
Shakeout drives consolidation. Those who survive are the large, the capable, and the better capitalized — and these attributes tend to find one another. In fact, that’s where New Century came from a decade ago:
New Century, which was formed in 1995, narrowly survived a shakeout in the subprime sector in the late 1990’s when concerns about faulty accounting and
I knew there was something wrong with buying subprime securities
Sometimes the capital markets have an amnesiac quality; they forget about risk until shockingly reminded of it, and once reminded, they panic:
The credit crunch caused several of its rivals to disappear, but New Century pulled through because it received a large cash infusion from U.S. Bancorp in
Having once recapitalized probably increases New Century’s chances of recapitalizing yet again. Survivors prosper:
With fewer competitors, the company was well positioned to grab market share during the housing boom that began earlier this decade with the help of low interest rates.
Such thinking will animate New Century’s large, institutional, well-capitalized shareholders:
Subprime loans, which are largely given to poor and minority borrowers, had rapid growth but as more lenders jumped in lending standards were loosened and default rates for loans made in 2006 have been high.
Particularly as other subprime lenders will be running for big-brother partners:
Recapitalize me!
Another large lender, the Fremont General Corporation, said yesterday that it planned to sell its subprime mortgage business after reaching an agreement with the Federal Deposit Insurance Corporation to restrict its activities in that area. As part of the agreement,
Market flutters yield consolidation, as the flight to credit and capital brings smaller fry into larger entities. By itself this makes little difference to customers — instead it serves to provide a continuity of origination, loan servicing, and loan collection.
Credit standards tighten
If the biggest (ergo presumptively best) subprime lender was making bad loans, does that imply the whole industry was over-optimistic? Should everyone who followed New Century’s automated underwriting be similarly worried? Even more troubling, does that imply current lender standards are too loose, particularly if homes are no longer appreciating at such a rapid pace?
Watch out, prices in reverse
Some lenders have started adopting tougher standards and are turning away the riskiest of would-be homeowners, something federal regulators have been urging them to do.
Even if one already has the disease (loans already made), it’s probably wise to start using a handkerchief and not make it any worse.
“There’s zero doubt the impact of tightening of the mortgage credit is going to have a negative impact on home sales,” said Thomas A. Lawler, founder of Lawler Economic and Housing Consulting in
Retreat in US homeownership rate?
If all that’s correct, the
Subprime loans, which are largely given to poor and minority borrowers, had rapid growth but as more lenders jumped in lending standards were loosened and default rates for loans made in 2006 have been high.
The last decade saw a steady and significant rise in the
And it went higher through 2005
That rise was a desired outcome of government fiscal policy, where a combination of homeownership incentives, loosening credit policy, automated underwriting, and rising values worked to bring our rate up. Was that a structural change, a new plateau, or might the homeownership rate have been artificially inflated?
Ripple-effect drop in home prices?
If the homeownership rate drops, then one would expect home prices — particularly among lower-end supply — to retreat as well. Certainly there is a shift in the demand-supply balance:
In a report scheduled to be released this week, Lehman Brothers estimates that 300,000 extra homes could flood the market in 2008 and 400,000 more in 2009 because of foreclosures of homes that were bought with subprime mortgages.
There are roughly 125,000,000 housing units in the
While that is not a big portion of the total housing market, it’s still enough to have an effect on the
psychology of home buyers, said Michelle Meyer, an economist at Lehman Brothers.
Be afraid. Be very afraid.
It may also be concentrated in a particular stratum — lower-income households and neighborhoods — and as housing is a continuum of tenure and cost, we can also subtle and not-so-subtle adjustments up and down the line.
“You already have a big excess in inventories,” she said. “So if you add to the large supply of homes, the market will take longer to correct.”
Compared with other asset types, homes are resistant to price drops. So we see the housing-price crumple zone absorbing the weakness across multiple sectors — home builders, unsold land, subprime lenders, the securities market. The distributed and interconnected shakeout reduces the pressure on any one segment — a mark of a robust ecosystem.
Tarring the whole industry as shady?
Because it trolls at the bottom fringes of the credit conundrum, the subprime industry has always lurked in housing’s shadows, always seeking respectability and always sniffed at by the larger, more solid lenders.
Something shady?
For the better part of a decade, subprime lenders have burnished their image, arguing that they perform a needed service and have honorable and socially responsible motives alongside their profit-oriented ones. That reputation appears likely to take a severe knock if any of these allegations prove true:
On Feb. 22, the company said the regulatory arm of the New York Stock Exchange contacted it about sales in the company’s securities before that announcement. On Wednesday, it received notice from the
We saw previously that in addition to keeping the B piece of the securities it created and sold, New Century — like other similar originators — offered a right of rescission for a portion of the loans that secured the A piece. Such a post-purchase buyback greatly simplifies the due diligence involved in a large portfolio, and by lowering transaction costs enhances the likely price of the A securities. When you buy them back, though, you face an accounting issue: are the repurchased loans worth what you paid for them, and if not, how much less? You probably should take a loss — and perhaps New Century took a too-rosy view of the collectibility of its repurchased loans?
We’re all good for the money
And might the senior management have been publicly accounting for these repurchased loans optimistically, even as it was privately much more pessimistic?
It is unclear what stock sales investigators are looking at, but data from securities filings compiled by Thompson Financial show that two of the company’s top executives sold sizable blocks of shares in the second half of last year.
No worries here!
When the founders bail, that can’t be cheery news:
Robert K. Cole, a former chairman and a founder of the company, sold stock worth $6.7 million in the third and fourth quarters after not selling significant numbers of shares for the previous three quarters.
Cole is happy he sold.
And Edward F. Gotschall, another founder and vice chairman, sold shares worth $14.7 million after not selling significant numbers of shares for the previous six months.
Gotschall’s cheery too
The executives themselves have a personal-circumstances explanation:
Earlier last spring, the executives, both of whom are still on the board, said they would be moving out of their leadership positions. They later disclosed plans to sell stock.
Certainly, if you had been running a company for a long time, and then decided to leave, you could plausibly wish to cash in some stock so you can enjoy life more fully with your new leisure time. But it appears that Messrs. Cole and Gotschall will have a fair bit of explaining yet to do:
The Securities and Exchange Commission has requested a meeting with its executives.
All suspects are innocent until proven guilty in a court of law.
