Winners Could Emerge from Subprime Woe

Once the shakeout ends, large players Citigroup and Wells Fargo stand to pick up business lost by bankrupt subprime lenders

Liquidity issues for subprime lenders may result in a further industry shakeout. Concerned about New Century's (NEW) ability to remain solvent, creditors recently forced the company to stop making loans. Subprime lenders such as New Century are largely dependent on outside creditors to finance new loans. Given the large number of loans that have recently been put back to subprime lenders due to high default rates, subprime lenders' liquidity, and ability to remain solvent, have become even more precarious of late.

The immediate aftermath of a shortage of funding for subprime lenders will likely put additional pressure on the housing market, particularly on the low-priced end of the market. We note that subprime originations comprised roughly 20% of total mortgage origination in 2006. That said, we believe that sometime toward the latter half of 2007, when the subprime shakeout nears an end, the players that do remain in the subprime business may post better results, due to a potentially less competitive business environment.

Some of the companies with subprime exposure that we cover include Wells Fargo (WFC; ranked 3 STARS, hold), Countrywide Financial (CFC; ranked 2 STARS, sell), and Washington Mutual (WM; ranked 3 STARS, hold). Investment banks like Morgan Stanley (MS; ranked 3 STARS, hold) and Merrill Lynch (MER; ranked 3 STARS, hold) have recently entered the subprime business as well. We caution, though, that over the next few months some of these players may suffer further setbacks with their subprime business, as default rates will likely continue to rise.

Over the long term, we believe the rise in bankruptcies of smaller subprime lenders will benefit the larger players. We think industry players with deep pockets and extensive experience in the subprime market will gain significant market share after the subprime fallout runs its course.

Benefits of Consolidation

Wells Fargo, the largest subprime originator in the U.S., as ranked by National Mortgage News, stands to benefit from less competition in the mortgage arena. However, in the near term, Wells Fargo is still exposed to further deterioration in the subprime market. Wells Fargo, where about 20% of mortgage originations are in the subprime area, does not offer option adjustable-rate mortgages, negative amortizing, interest-only, or low documentation mortgage products—another longer-term benefit for the company.

Citigroup (C; ranked 5 STARS, strong buy), another large player in the subprime market, although primarily through fixed-rate products, could also stand to benefit from consolidation.

However, one short-term negative for large players like Wells Fargo and Citigroup could be their equity stakes in smaller companies, especially if these smaller companies enter bankruptcy (see, 3/7/07, "The Mortgage Mess Spreads"). Citigroup, through ClearBridge Asset Management, held a 3.5% stake in New Century, as of Dec. 31. Wells Fargo, through Wells Capital Management, owned a 3.8% stake in Fremont General (FMT), another troubled subprime lender, as of Dec. 31.

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