Is the Crisis Overblown?

 
Most of you have probably heard about the recent difficulties in the subprime mortgage market.  It actually is beginning to have an effect on my business .  Subprime mortgages are designed for those people who have credit scores below 620.  These loans are typically amortized over 30 years, but the initial rate or start rate is only fixed for 2 or sometimes 3 years after which time the rate adjusts to a (usually) much higher variable rate.  These loans are designed to force the borrower to refinance the loan at the end of the 2 or 3 year fixed rate period.  They do this by adjusting the rate so high at the end of this period that the payment becomes virtually unmanageable for the borrower to make so they must refinance to get their payment lower.

 Why do the lenders do this?  Well, it is in the best interest of the investors who provide the money for these loans to turn their loan portfolios over every 2 or 3 years.  This way they can ensure that they will always have their money being lent out at close to market rates.  They are not exposed to the type of long term interest rate risk to which investors who provide 30 year loans at fixed rates are exposed.  In the last few years investors have loved these loans.  The portfolios turn quickly and if the loan pays off early, these loans usually have a pre-payment penalty that compensates the investor for the early payoff.

 The current problems stem from the fact that the mortgage lending business is hyper-competitive.  In order for suprime lenders to increase market share they began to offer more and more higher risk products.  In retrospect it seems almost silly that some of these loan programs were ever offered.  I remember lenders offering loan products that were just begging to be defaulted on.  For example, a couple of years ago I could find a lender who would offer  a loan to a w-2'd person but using stated income (the borrower 'states' what their income is instead of verifying it from w2's and tax documents) to 100% of the value of the home with cash out and only a 580 credit score (average credit scores nationally are about 675 to 680).

Fast forward to today and subprime lenders are beginning to feel the effects of these riskier loans.  More and more subprime borrowers are defaulting.  The biggest implosion has happened with New Century, formerly one of the nations largest subprime lenders.   The way it works is that a subprime lender like New Century buys loans from retail mortgage originators (mortgage brokers) and re-sells them to investors on Wall Street.  As an inducement to buy the loans, Wall Street investors make New Century sign agreements that require New Century to re-purchase loans (buy them back from the Wall Street investors) if there is an early payment default on the loan (borrowers miss payments within the first 6 months of the loan), or if an audit of the loan file by the Wall Street investors finds any fraud in the file.

 A big lender like New Century would typically have a large credit line, on the order of several hundred million dollars, offered by the Wall Street banks that ultimately buy New Century's loans.  Other large banks would also offer large credit lines to New Century.  New Century uses this credit line to buy the loans from the retail originators.  New Century would only hold the loans long enough to aggregate them into large pools and re-sell them to the Wall Street investors.  This process typically takes about two months.  New Century makes money by taking a little (a lot?) off the top before re-selling the loans to Wall Street.  When New Century does sell the loans to Wall Street, that frees up money on the credit lines to allow them to do it all over again. 

When there is an early payment default, or if an audit of the loan file causes the Wall Street investors to force New Century to re-purchase a bad loan, New Century uses its credit line to re-purchase this loan.  This uses up their credit line and diminishes their buying power for new loan originations.  If the loan is in complete default then it stays on the credit line until New Century can foreclose, a process that can take as long as a year.  If the proceeds from the foreclosure sale do not cover the original amount that the homeowner borrowed, then New Century takes this as a loss.

I don't have access to the agreements between a lender like New Century and the Wall Street investors.  However, I know that in most cases there are blanket buy-back clauses.  This occurs when a certain percentage of loans is shown to be bad.  If that percentage is reached, then Wall Street can demand that New Century must re-purchase all of the loans that New Century sold to Wall Street even if all the loans are not bad and most of the loans are still performing.   In the  case of New Century, this is about 8.4  BILLION dollars in loan buybacks.  Keep in mind that New Century only has credit lines in the several hundred million dollar range.   There is no way that New Century can buy all these loans back becasue their credit lines are not big enough.  Furthermore, when the banks offering the credit lines realize that New Century is going to be asked to buy back all of the loans, they immediatley freeze the credit lines for fear they may lose the money.  This not only keeps New Century from buying back any loans, but it keeps them from buying new loan originations which cuts off their revenue stream.  As a retail originator, it was almost surreal for me to receive an e-mail from New Century telling me that their credit lines were frozen and that they not only could not take any new submissions from my company, but they could not even fund the loans they had currently underwritten and approved.  The only option for New Century was bankruptcy. 

Why did the Wall Street investors ask New Century to buy back all the loans?  What they are saying is that basically, because a higher percentage than normal of New Century originated loans are defaulting, Wall Street is assuming that the entire amount of loans originated by New Century must be bad.  This clearly cannot be the case.  The vast majority of loans sold to Wall Street by New Century are performing loans.   They are not all in default.   Typical default  rates for  subprime mortgages run around 8% to 10% over time (some option-arm loans are estimated to have higher default rates, but these loan types are not considered subprime and were not offered by New Century).  The recent spike has pushed these default rates to something closer to 15%.  Furthermore, just because a loan defaults it does not mean that all of the money is lost.  Remember, these loans are backed by real-estate.  This real-estate can be sold and a significant portion of the original amount borrowed can be recovered.  Lets say a lender can recover 75% of the amount borrowed by the homeowner.  If normal default rate on subprime loans is 8%, and the new default rate is 15%, then the difference between these is 7%.  If you take $8.4bn X 7% you get $588 million.  However, if you recover 75% of this money through real-estate sales you have a loss of $147 million.  Now, $147 million is a lot of money to you and me, but as a percentage of the total loan originations of New Century it is only 1.75%. 

Even allowing for some adjustment in the numbers, the overall difference is not enough to cause Wall Street to basically destroy an entire company.   I'm not sure why Wall Street did this to New Century.  They had to know that New Century could not buy back all the loans.  Furthermore, they had to know that if they forced New Century to buy back all the loans, New Century would declare bankruptcy and would not be able to buy back any of the loans.  The loans are not going away.   Wall Street still owns these loans.  Only the loans that are not performing have to be foreclosed on but instead of making New Century do this dirty job and take the losses, now the Wall Street investors have to do it themselves.  The main point is that the vast majority of these loans are still performing and will not have to be foreclosed upon.

That is why I think the crisis is overblown.  In typical Wall Street fashion, investors are having a knee-jerk response.  They are way undervaluing the portfolio that New Century sold to them.  Like what happens every time the markets behave irrationally, I think some large, smart investor will come in and buy these obligations for a song from investors who will be all to willing to sell at a discount.  This investor will then proceed to make a killing on the performing portions of these portfolios.

Wall Street is also valuing the entire substantial origination organization set up by New Century as basically worthless.  Countless offices, underwriters, sales reps, processors, and valuable relationships with retail brokers are given no value.  New Century is shut down and all of these people laid off and forced to find work elsewhere.

 So, how does this affect originators like me?  Well, the subprime lending requirements are becoming so restrictive now that I think it will cut out a full 25% of the loans that we were previously able to write.   I know that times will be tight now, but ultimately I think that lenders will slowly begin to loosen up.  Over time, Wall Street will realize that they made too much of the crisis and the cycle will come around.  Lenders will begin to feel the need to gain market share again and increase revenues.  The question is...how long will this take?

In the meantime, how can you and I profit from this meltdown caused by over-reaction?  Good question.  At this point I think it is too late.  I am kicking myself because I was aware of problems in the subprime markets way back in November.  I can distinctly remember sales reps in my office telling me about problems that were beginning.  If there is one lesson I should have learned over the past few years it is that markets over-react.  I am in this business, nobody is closer to it than me.  I should have been shorting the heck out of these stocks, or buying put options like crazy.  But, I was so busy running a business that I was just not paying attention to subprime stocks.  Even after the first big blow-up on New Century where they lost like half of their market value in one day, my partner came to me and said "Matt, New Century just got hammered, we gotta get in on the action."  We spent the rest of the day finding other publicly traded subprime companies to short.  After looking at them, we decided that we were too late, the bloodletting was already over.  However, we were wrong, New Century went from where it was that day down to worthless.  That is why I'm kicking myself, I never learn my lesson.  I know that markets over-react but I was to cautious to pull the trigger.  I'm cautions becasue I have been burned before.....but, I guess that is something for another post!