The Subprime Story's Latest Chapter: 11

As New Century joins other subprime lenders in bankruptcy, some players are hunting for alternative funding

New Century Financial's tumble into bankruptcy court shocked few observers of the swift shakeout in subprime lending. Far more surprising could be the industry's difficulties in soothing nervous investors.

New Century, once the second-largest lender in the category of home mortgages for those with checkered credit histories, stopped writing new loans last month, signaling to many the demise of the company's business prospects. On Apr. 2, it filed for Chapter 11 protection in Delaware and laid off 3,200 workers—more than half its staff—"to better align the company's cost structure with the current operating environment and to properly size these businesses in preparation for possible sale," the Irvine (Calif.) company said in a news release.

"The decision to pursue the sale of the company's assets and operations through the bankruptcy process was a difficult but appropriate decision for our board to make," New Century Chief Executive Officer Brad Morrice said in the Apr. 2 announcement. "This was a very hard step for me personally and clearly not the outcome I would have preferred."

Turning to Hedge Funds

The fall of the industry's biggest player to date underscores the market's tough posture toward the whole field in the current era of rising defaults and shaky housing prices (see, 3/14/07, "The Mounting Uncertainty Over Subprime"). "I would say to you that no matter what a NovaStar or a New Century might say to me, I don't think I'd be reassured," says Theodore Kovaleff, a senior bank and thrift analyst at Sky Capital.

That's a sentiment shared by numerous investors. Officials at mortgage lenders are fighting back in several ways. In a new bid for funding, some lenders are turning to hedge funds. Accredited Home Lenders Holding (LEND) said Apr. 2 it has obtained a $230 million loan from Farallon Capital Management. The fund, operated from San Francisco, will be able to buy 3.23 million Accredited shares for $10 as part of the deal. Company shares closed Apr. 2 at $8.48, down 8.5%. Through a spokeswoman, Farallon officials declined to comment.

Shares of San Diego-based Accredited dipped in aftermarket trading on news that its auditor had resigned, then rebounded 4% on news of the financing from Farallon. Accredited said it also has $350 million cash on hand as it works to bolster its liquidity. The company originated $1.8 billion worth of new loans in the first quarter of 2007.

Credit-Crunch Creep

Other lenders, such as Fremont General (FMT), are trying to reassure investors by disassociating themselves from the high-risk lending market as much as possible. And most are promising not to repeat their earlier mistakes and finally taking steps to tighten their lending practices, in the hope of shoring up investors' sapped confidence.

In a further troubling sign that the subprime crisis could be spreading up the mortgage food chain, M&T Bank (MTB) said in a Mar. 30 regulatory filing that it had found less investor interest for so-called Alt-A loans. That product typically falls between prime and subprime mortgages, requiring less documented information from the borrower. "At a recent auction of such loans, fewer bids than normal were received and the pricing of those bids was lower than expected," the Buffalo-based bank said in a statement. As a result, M&T said it expects first-quarter earnings to fall below Wall Street's current expectation of $1.86 per share. M&T shares fell 8.5%, to $105.95, on Apr. 2, setting a new 52-week low.

Such a credit-crunch creep could also spell trouble for others in the Alt-A business, such as regional banks. Shares of Atlanta-based SunTrust Bank (STI) were down 2.4%, Winston-Salem (N.C.)-based BB&T Corp. (BBT) fell 1.8%, and McLean (Va.)-based Capital One Financial (COF) was down 2.5%. Also on Apr. 2, shares of Birmingham (Ala.)-based Regions Financial (RF) fell 1.8% after it closed on the sale of its EquiFirst subprime mortgage business to Barclays PLC (BCS) for $76 million—a 66% discount from the $225 million that Barclays had agreed to pay just three months ago.

Fighting the Uphill Battle

In the case of New Century, the CIT Group (CIT) and Greenwich Capital Financial Products agreed to provide New Century with up to $150 million of financing. The company will also sell its loan servicing assets to Carrington Capital Management, subject to court approval, for $139 million. Morrice called the agreement with Carrington "a significant and positive development."

New Century isn't the only one trying to make the best of a bad situation. NovaStar Financial (NFI) said in late February that its subsidiary, NovaStar Mortgage, had raised $1.9 billion by selling debt backed with its mortgage assets—but the company also said it would initially keep around $106.7 million in debt, including relatively high-risk "junk" debt that is rated below BBB. To raise $1.25 billion in a similar deal in December, NovaStar only had to keep around $26.9 million of debt. Even so, NovaStar officials were relieved this time around. "We were very happy to get that done" in February, said Jeffrey Gentle, an investor representative at NovaStar. "It was a real positive that there was market acceptance for the collateral."

Fremont General has a different kind of collateral. Unlike many of its rivals, the real estate lender does business through a wholly owned industrial bank. As a result, Fremont's resources include the money customers have deposited in its bank, a reassurance to potential investors. The Santa Monica (Calif.) company announced on Mar. 21 that it managed to sell $4 billion of its subprime real estate loans.

Some mortgage lenders in the industry are trying to emphasize that their loans are higher quality. IndyMac Bancorp (NDE), for example, insisted on Mar. 15 that its exposure to subprime mortgages is small, only about 3% of its $90 billion in mortgage loan production in 2006. The company "has been inappropriately categorized by many media sources as a subprime lender," IndyMac said in the press release.

The sector suffered another day of falling share prices following New Century's filing. IndyMac shares fell 4.4%, to $30.65, while NovaStar was down 2.2%, to $4.89, and Fremont General dropped nearly 6%, to $6.52. Shares of Fremont lost another 9.5% in trading after the 4 p.m. ET market close, following its disclosure that auditor Grant Thornton had quit. The auditing firm also resigned its auditing work from Accredited Home Lenders.

Before it's here, it's on the Bloomberg Terminal.