The Mounting Uncertainty over Subprime

Torrents of bad news from the sector leave Wall Street wondering how far the financial fallout will spread

The subprime mortgage industry's rapid decline is exerting an amplified effect on the markets as uncertainty grows over who will ultimately foot the bill. On a day when regulators revved up postmortems on the mess and even General Motors was touched by the bad news, the question seemed to coalesce: How deep will the subprime problems extend?

The leeriness spilled into the broader financial markets Mar. 13, with the Dow Jones (DJ) index shedding 242 points and other major Wall Street indices declining about 2%. The selling was spurred by a Mortgage Bankers Assn. report that foreclosures hit a record high at the end of 2006 and government data showing paltry February retail sales (see, 3/14/07, "Consumers Feel a Chill").

Some in the mortgage industry believe investors are provoking a liquidity crisis, overreacting to the correction among subprime lenders, companies that loan to borrowers who are considered risky because of their spotty credit histories or low incomes. "You don't know who is swimming naked until the tide goes out," Countrywide Financial's (CFC) chairman and chief executive, Angelo Mozilo, said in a televised interview with CNBC. Mozilo also said the likely "ugly" shakeout of the pure subprime lenders would help companies like Countrywide—the largest U.S. mortgage lender—and banking giants such as Wells Fargo (WFC).

Less Confident

Subprime lenders have been hit by a sharp increase in early payment defaults on residential loans, and skittish investors who purchased the loans have kicked back an unexpectedly high level of loans to the originators. The sheer level of defaults and lack of adequate loan-loss reserves pummeled the earnings of these institutions, according to a Mar. 9 report from Standard & Poor's Ratings Services, while substantial erosion of investor confidence made it difficult for subprime lenders to unload new and repurchased loans at a reasonable price. And the so-called warehouse lenders—bigger financial outfits that provide financing for subprime lenders—have withdrawn funding amid the troubles.

Also on Tuesday, the state of Massachusetts subpoenaed Bear Stearns (BSC) and UBS Securities (UBS) for information on how they rated the stocks of subprime lenders. Shares of Bear Stearns tumbled 6.7% to $142.97 and UBS dropped 3.6% to $56.02 on the New York Stock Exchange.

One of the largest subprime lenders, San Diego-based Accredited Home Lenders Holding (LEND) plunged more than 65% Mar. 13 after the company said it was hunting new capital to maintain its liquidity. Accredited said it has been forced to pay $190 million to cover margin calls, mostly in the past 30 days, and is likely to cut jobs to save money. At least two brokerages also downgraded the stock, and Accredited finished the session at $3.97, a new 52-week low, on trading volume of 42 million shares—more than 18 times its normal daily volume. Accredited shares traded above $60 in May, 2006.

The NYSE is suspending trading in New Century's shares because of the company's disclosures in Securities & Exchange Commission filings on Mar. 12 and 13 that its lenders were discontinuing their financing arrangements with the company. The shares are expected to be quoted in the Pink Sheets.

Shares Fall

Also on Mar. 13, New Century said it was facing an SEC investigation and a subpoena for documents for a criminal probe by the U.S. Attorney's Office and the Pacific Regional Office of the SEC in Los Angeles. On Mar. 12, Standard & Poor's Ratings Services cut the company's counterparty credit rating to D from CC (see, 3/12/07, "More Trouble in Subprime City"). The NYSE move is just the latest in a string of distressing developments for New Century, which is widely expected to seek Chapter 11 bankruptcy protection. The stock has collapsed in the last month, from just north of $30 to its last quoted trade of $1.66 on Mar. 12.

Investors punished shares of other subprime lenders for a second straight day on Mar. 13. Fremont General (FMT) shares fell 8.2%, to $6.18, while NovaStar Financial (NFI) dropped more than 19%, to $3.43, setting a new 52-week low. Meanwhile, Countrywide Financial shares fell 4.7%, to $33.49, on Mar. 13, a day after it lowered earnings guidance and tightened subprime lending standards.

The selling was sparked by a report from the Mortgage Bankers Assn., which said the delinquency rate for mortgages rose to 4.95% of all loans in the fourth quarter, up 28 basis points from the third quarter. Those in foreclosure increased to a seasonally adjusted 0.54% in the last three months of 2006, a new record high. The MBA's survey covers 43.5 million loans. Nationwide, 49 states saw a rise in delinquency rates, led by Mississippi (10.6%), Louisiana (9.1%), and Michigan (7.9%).

A Changed Sector

"As we have noted before and as recent events have made clear, market discipline in this industry is swift, can be severe, and is more effective at changing lending practices than any potential changes in regulation," Doug Duncan, the MBA's chief economist and a senior vice-president, said in a news release accompanying the figures. As the meltdown continues to dominate news headlines, the MBA is warning that efforts by Congress or the states to regulate or legislate changes in lending practices "would impede the ability of the market to respond to changes in underlying economic conditions."

The weakness also spread to General Motors (GM), which fell 2.6% after its minority-owned GMAC Financial Services said its Residential Capital mortgage unit swung to a $651 million loss in the last quarter of 2006, from income of $118 million in the same period of 2005. ResCap said the loss reflected its need to take higher loss reserves and increasing delinquent payments. For the full year, ResCap earned $182 million, down from $1 billion in 2005. GM will kick in $1 billion in common equity to bolster GMAC's balance sheet.

Companies in the industry may not survive the current tumult in their existing state. In a Mar. 9 report, S&P Ratings said it expects the shakeout within the sector to continue, with investment banks and possibly hedge funds and private equity firms purchasing distressed subprime lenders or their discounted assets (S&P, like, is owned by the McGraw-Hill Cos. (MHP)). "Whatever form it takes, subprime mortgage lending will inevitably continue," adds S&P. It will, but the industry landscape may look a lot different once the dust settles.

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