Mortgage Lenders: Close to the Edge?

Execs at Countrywide and Thornburg say the companies are safe despite hazards stemming from the subprime crisis. Can investors believe them?

An anxious stock market, always looking for the next subprime-related blowup, has been giving the mortgage industry whiplash. Thornburg Mortgage (TMA), for instance, fell 47% on Tuesday and then was back up 39% the next day.

There's no doubt things are looking terrible in the mortgage industry. But there's a lively debate about how terrible. Analysts, investors and executives disagree on which mortgage company is the next to trip and fall into bankruptcy.

As Keefe, Bruyette & Woods analyst Frederick Cannon wrote this week, major lenders "are in a crisis mode." The declining housing industry means fewer mortgages to begin with. A growing number of Americans can't make the payments on their mortgages, both subprime loans and other types, causing a rise in delinquencies and defaults. They can't refinance, both because their home's value has fallen and because the Federal Reserve hasn't cut interest rates.

Those are all reasons to worry, but the most immediate concern for mortgage companies is the horrendous conditions on the secondary market.

Parts of the market for mortgage-backed securities are essentially frozen, meaning that investors are unwilling to buy up mortgage debt at all.

That's bad news for stand-alone mortgage firms like American Home Mortgage (AHMIQ) (which recently declared bankruptcy) because re-selling debt on the secondary market is how these firms raise the cash to keep making loans.

But what about firms like Thornburg Mortgage, a real estate investment trust or REIT, that tends to buy and hold high-quality loans? Or Countrywide Financial (CFC), the industry giant that is rapidly expanding to take over market share while smaller and weaker rivals disappear?

Thornburg shares fell by almost half when the firm said it was delaying its dividend payment by a month. The move was designed to save cash to meet its creditors' demands. A similar move by American Home Mortgage preceded its bankruptcy by a few days. Jefferies analyst Richard B. Shane reacted to the news by writing: "Given the severe liquidity crisis, we do not recommend investors hold shares of TMA at any price."

On Wednesday, Thornburg shares bounced back after executives said bankruptcy wasn't in the cards. "I'm hopeful by the end of this week we will be completely out of this situation," president Larry Goldstone told CNBC.

It's true that Thornburg is different from other mortgage players. Its "loan portfolio is extremely high quality," Shane wrote.

However, it does rely on debt, leveraged 12 to 1 on certain lines of credit. The tough secondary market would make it hard for Thornburg if, for any reason, the company needed to liquidate its portfolio to raise cash. And it may need cash to pay its dividend or because creditors call in debts. "We believe the company's sustainability is currently subject to the whims of Wall Street lenders," Shane wrote.

"Given this uncertainty," A.G. Edwards (AGE) analyst Greg Mason wrote Wednesday, "we would choose not to play guessing games." (Thornburg is a AG Edwards investment banking client.)

Countrywide is a very different company from Thornburg, but it's also a subject to the whims of its creditors and the secondary market. Its stock plunged Wednesday afternoon, down 13% for the day on unconfirmed reports that the company was having trouble borrowing money. Trading volume in Countrywide shares was six times the normal daily level, Standard & Poor's equity analyst Stuart Plesser noted, "leading us to believe that some major institutional holders are selling shares."

Apparently financially strong and making efforts to actually boost its loan originations, Countrywide is the "supermarket" of mortgage lenders, offering mortgages of a wide variety of qualities. The company also owns a bank, whose deposits give it more stability than other mortgage firms.

Still, it relies on the secondary market to unload most of the loans it originates, which caused a recent SEC filing to scare investors. The firm cited "unprecedented disruptions" on mortgage markets and noted "our capacity to retain mortgage loans and mortgage-backed securities is not unlimited."

Nonetheless, executives and many analysts believe it has enough to cash to keep more loans on its balance sheet until the secondary market returns to normal.

"Countrywide is the best-positioned mortgage originator to handle the disruption," Morningstar (MORN) analyst Ryan Lentell wrote recently. If the market disruption lasts just a few weeks, it would be merely "a hiccup" for Countrywide earnings. "The disruption would have to last for a year or more to place Countrywide in serious financial distress," he wrote.

Or as a Friedman Billings Ramsey (FBR) analyst Paul Miller wrote in late July, even as the firm downgraded the stock: "We still view Countrywide as 'best of breed' in the space, with more than 18% market share and growing as many competitors fall by the wayside." (FBR is also in the morgage business through a subsidiary.)

Despite the optimism, there are no shortage of reasons to worry about Countrywide.

Plesser says 37.5% of the loans it holds are option ARMs (adjustable rate mortgages), "a very dangerous type of loan in this environment." He worries defaults on the loans are about to spike, following the high defaults on subprime and other types of mortgages.

What could help the mortgage industry find its equilibrium?

First on everyone's list is an interest rate cut by the Federal Reserve. Among other effects, indebted homeowners could refinance their mortgages at better rates.

Second, the panic could die down on the secondary markets. But that could take a while.

Markets "are beginning to sober up," said James Trozze, chief executive of research firm Copell Financial. "They're in a hangover phase. That can last a while," he says, perhaps into early 2008.

S&P's Plesser notes that problems on the mortgage credit market aren't just irrational anxiety. It's based on fundamentals: American homeowners are having trouble making mortgage payments. Don't expect the mortgage industry to recover until the news on defaults improves. "These loans have to perform," Plesser says. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies.)

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