Another Stumble for Subprime Lenders

Stocks in the sector dropped Monday as New Century Financial announced more financing woes and a probe of its trading practices

The subprime mess has taken another ugly turn: New Century Financial (NEW) faces the threat of bankruptcy, as the mortgage outfit grapples with financing challenges as well as an investigation into its accounting and trading practices. The company now has a poorer credit rating and will have a tougher time obtaining needed funding for its business. The company's disclosure of its current predicament after the market close on Friday, Mar. 2, roiled shares in mortgage lenders on Monday, Mar. 5, as investors worried about how companies that sell loans to people with poor credit will survive the weaker housing market (see, 2/19/07, "Out of the Basement for Housing").

The Irvine (Calif.)-based New Century provides loans to high-risk borrowers and then sells most of them to third parties. But the business has taken hits in recent months as borrowing rates got more expensive and increasing numbers of debtors failed to repay what they owed. New Century couldn't report at least $1 of net income for any two-quarter period, as it had promised to 11 of its 16 financing arrangers, according to a statement filed with the Securities and Exchange Commission on Friday Mar. 2. So far the company has only managed to persuade six of its arrangers to waive the requirement on certain conditions. If New Century can't win enough waivers or raise funding some other way, its auditor KPMG is going to warn that "substantial doubt exists as to the Company's ability to continue as a going concern," according to the filing.

When borrowers don't repay their loans, those who originated them typically have to take a loss, buying back the bad debt that had been sold to outsiders. New Century said it got a letter on Feb. 28 from the United States Attorney's Office for the Central District of California, explaining that investigators are conducting a criminal inquiry into the company's trading and accounting errors on its allowance for repurchase losses. The Securities and Exchange Commission is planning to meet with New Century to discuss its February announcement of intentions to restate its financial results during 2006. As New Century grapples with its accounting problems, the company has had to delay its reporting of financial statements for the year ended December 31, 2006.

Meanwhile New Century faces more legal battles. The company had on Feb. 21 reported a class action lawsuit for violating federal securities law and said it was aware of nine additional cases purportedly filed against it. Now New Century on March 2 reported another four related complaints against its officers that are likely being filed in the Orange County Superior Court. The company warned that it's expecting more in the future.

The barrage of bad news has dented New Century's ability to struggle through its travails with the help of additional debt. Standard & Poor's Ratings Services on Mar. 2 lowered its long-term counterparty credit rating on New Century to 'B' from 'BB-' -- and the agency continues watching to see if more negative action is necessary. Bad credit for New Century, like its customers, means the mortgage lender will have to pay more to borrow -- or may prevent it from obtaining financing at all.

"We have growing concerns regarding the amount of financial stress facing New Century following the company's announcement," credit analyst Adom Rosengarten said in a note. "In a residential mortgage market where investors and other participants are rapidly losing confidence, it may be a challenge for the company to work through current credit trends." (S&P, like, is owned by The McGraw-Hill Cos.)

S&P wasn't the only one to voice concerns. Expressing doubt that New Century's business can survive this intense combination of funding and reputational risk, Stifel Nicolaus analyst Chris Brendler downgraded the stock to sell from hold. (Stifel Nicolaus does business with companies covered in its research reports.) The market dumped New Century shares by nearly 62% to $5.

63 per share in early afternoon trading on the New York Stock Exchange.

Tremors were felt elsewhere in the sector. Fremont General (FMT) also announced late Friday that it's going to exit subprime real estate lending and is in talks to sell the business. The Federal Deposit Insurance Corporation, which insures the deposits in the company's industrial bank, Fremont Investment & Loan, had on Feb. 27 called for the Fremont General to "make a variety of changes designed to restrict the level of lending" in its high risk residential mortgage business, according to a press release March 2.

Fremont General shares plummeted more than 20% to $6.93 per share on the Nasdaq. Other mortgage lenders also took hits. Countrywide Financial (CFC) fell 2.5% to $36.09 per share and the San Diego mortgage lender Accredited Home Lenders Holding Co. (LEND) plunged more than 22% to $16.85 per share on the New York Stock Exchange.

This isn't the first time mortgage lenders have scared the market in recent weeks. On Feb. 8, the same day New Century had announced its plan to restate financial results amid accounting errors, HSBC Holdings (HBC) said it was setting aside more than expected for bad loans in 2006 (see, 2/9/07, "Subprime Time Bomb"). HSBC has moved swiftly since to rectify the situation, with CEO Mike Geoghegan saying the "buck stops" at his door. HSBC has replaced U.S. management, tightened loan requirements, and stepped up collections activity. It's also working with customers to stretch out loan payments.

Still, the London-based bank admitted at a Mar. 5 press conference that it would take two to three years to correct the situation. The sad irony is that HSBC, Europe's largest bank, had first entered the sub-prime market in the U.S. when it splashed out $15.5 billion for Household International (now HSBC Finance) in 2003. But the acquisition has proved even more costly now.

Others are scrambling too. On Feb. 21, NovaStar Financial (NFI) reported bad news including the possibility that the company will have no taxable income through 2011 (see, 2/22/07, "A Painful Hiss from the Subprime Balloon"). NovaStar shares dropped more than 29% to $5.12 in early afternoon trading Mar. 5 on the New York Stock Exchange.

There has been no lack of red flags. "We think (New Century)--along with its entire industry--will be struggling to stay alive over the next year or so," Morningstar analyst Ryan Batchelor had warned in a report Feb. 9.

Kate Norton contributed to this report

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