Subprime Titanic Hits Iceberg: Wall Street Abandons Ship

[Joseph T. Burkeson, CMI]

February 22, 2007
Subprime Titanic Hits Iceberg: Wall Street Abandons Ship
by Richard Benson

On April 14, 1912, the mighty Titanic hit an iceberg and the ship's fate was sealed in just over 2 hours and 40 minutes. The boat's structural design and weight made sinking inevitable and swift. Over 1,500 lives were lost, along with personal fortunes amounting to over $600 Million in 1912 dollars.

Icebergs are interesting because only about 10 percent of the ice is visible above water. Seeing an iceberg in the distance is any Captain's worse nightmare and the iceberg that took down the Titanic was no exception. The famous ocean liner could not maneuver around the massive iceberg quickly enough to avoid hitting it.

This tragic story reminds me of some of the subprime mortgage lending problems that actually began a few years ago. Indeed, we have been watching this iceberg for three years now, and investing accordingly. Anyone aware of the fraud and foolish underwriting that has been ongoing in mortgage origination should be honest enough to admit we've only seen the "tip of the iceberg" so far, and mortgage lending is heading straight towards a massive piece of ice.



The subprime market is overloaded with bad loans that have effectively smashed holes into the hull of this financial ship. It has been surprisingly easy for people buying a new house to borrow hundreds of thousands of dollars by simply telling the bank how much money they make -- without any proof. It's called a "stated income" loan, but many people inside the housing industry call it something else: a "liar loan" or a "NINA" (no asset, no income verification). Forty percent of the subprime market (about $400 - $500 billion of loans), is made up of these loans. At best estimates, half of all subprime mortgages had no income verification. This is no small problem!

How can a clerk at McDonald's (who claims to earn $10,000 a month on his mortgage application) be approved for a 100 percent mortgage loan on a speculative property? Do you really believe that this marginal borrower - who happened to be approved for a loan with a fraudulent appraisal - will be able to refinance now that housing prices are falling? We don't think so.

What happens when the loan goes bad? Mortgage companies make lots of money writing "iffy" loans as long as Wall Street can package and sell the securities (and risk) into the capital market. All looked well for the Titanic sailing ahead in the fog, until it was too late. Looks can be deceiving, too, in the subprime mortgage market because the mortgage companies are very thinly-capitalized and highly-levered. A few million dollars of capital can end up supporting reps and warranties on billions of mortgage loans.

The securitization mortgage business relies on trusting the mortgage brokers and bankers, who make representations on aspects of loans and borrower quality. For a few glorious years, rising property prices allowed a borrower to avoid default by rolling a loan (headed to default) into a new larger loan. Now, as subprime defaults are picking up, the lenders are taking a closer look and sending all kinds of bad loans back to the mortgage companies that originally made the reps and warranties, but failed to weed out the fraudulent applications. So, while a lot of subprime lenders made a bundle writing bad loans, now they are being asked to give the money back! This tsunami of fraud is enough to crush the lenders. Market reports show that at least 21 sizeable subprime lenders have already shut down or filed bankruptcy, and the head of Countrywide Financial estimates that as many as 20 to 30 small mortgage originators are failing every day!


Following is a typical example of how the market is turning really ugly:

A mortgage company just funded $100,000,000 of subprime loans. Suddenly, the value of the loans drop when the credit spreads on the risky mortgage collateral moves wider before the mortgage company has an opportunity to sell the securities. Now, that package of mortgages that they paid $100 million for (and intended to turn into bonds and sell for a $5,000,000 profit) can only be sold for $90,000,000. Whoa! A $10 million loss!

Between reps and warranties and widening mortgage credit spreads, most subprime lenders will end up closing down or heading to Federal Bankruptcy Court. Indeed, even mortgage firms with limited exposure to subprime loans could fail. Even if a mortgage company survives, it will now have to dramatically raise interest rates to borrowers and put in place sound loan underwriting.

So, how does a lending market go from one with a credit standard where "A Rolling Loan Gathers No Loss" - making a bad loan bigger to pay existing interest, postponing the inevitable - back to a sane lending market? (This would be a market that would require a solid down payment, an appraisal based on an honest valuation, and an applicant with verifiable income who can prove they can really afford the monthly payment for a number of years.) The answer is, "it doesn't".

Over the past six years, home ownership nationwide increased from 66 percent of the working population, to almost 70 percent. Indeed, many loans were extended to borrowers who couldn't afford to rent because they could not come up with the security deposit. Yet, with a liar loan on income, and a "piggyback second" to 100 percent of LTV, they became lucky homeowners. Only now, however, they're not so lucky, because they are struggling to make the mortgage payment. I guess their ship really didn't come in.

2007 is a new year and the mortgage world has changed. Credit underwriting is getting more like old-time religion. Don't expect that housing prices will bail out the lenders. In markets where prices are failing like a stone, lenders will be dangerously exposed to serious losses.

With all these liar loans, coupled with adjustable-rate mortgages that are scheduled to adjust upward within the next 12 to 18 months, I estimate there will be well over a trillion dollars in mortgages that can't be refinanced, until the incomes of wage earners rise significantly. Many homeowners will be trapped in a house they can't sell or take equity out of. Mortgage companies, home builders, and real estate agents have already begun seeking new lines of work.

At the moment, the symptoms of bad loans in the mortgage market are a little bit like noticing rats. (We hate to see them!) You may manage to catch a few, but when it comes to rats and mortgage fraud, if you see one, you know there are a 100 or more you didn't see. Perhaps thousands! It should be no surprise to learn that Wall Street and the hedge funds have quietly begun abandoning ship.

The ocean liner Titanic was designed to hold 32 lifeboats, though only 20 were on board. The esthetic of the ocean liner (too many boats were unattractive) was more important than the safety of the passengers. Only 705 passengers survived because they were lucky enough to get in a lifeboat. I can't help but wonder how many investors will survive if they don't grab the first lifeboat.


Richard Benson
Benson's Economic & Market Trends
Specialty Finance Group, LLC

[William Warner]

Good read... thanks Joe.

[Brian E. Kelly]

Moody's might cut ratings of sub-prime mortgage lenders

From Bloomberg News
February 22, 2007

New Century Financial Corp. and Ameriquest Mortgage Co., both based in Orange County, are among five sub-prime mortgage lenders that may have the ratings cut on the part of their businesses that collect home loan payments amid a rise in delinquencies, Moody's Investors Service said Wednesday.

Moody's said it would review the so-called servicer ratings for affiliates or units of New Century, Ameriquest, NovaStar Financial Inc., Accredited Home Lenders Holdings Co. and Winter Group. New York-based Moody's said it anticipated lowering the ratings by no more than one level.

More than 20 sub-prime lenders have shut down, scaled back or been sold in the last five months amid rising late payments and lower prices for new loans. Others, including San Diego-based Accredited Home and NovaStar Financial of Kansas City, Mo., this month reported quarterly losses.

New Century has said it expects to post a loss. Shares of the Irvine-based lender fell $1.22 to $17.55. Orange-based Ameriquest is privately held.

Moody's said its review was "prompted by the heightened level of volatility in the sub-prime mortgage market." The companies face "lower profitability as well as potentially an increased level of liquidity risk given current market conditions," it said in a statement.

Servicer ratings affect how much protection for investors ratings firms require when mortgages are packaged into bonds, and their reviews of the securities' creditworthiness. Weaker servicing operations at the five companies may hurt existing securities, Moody's said.

Sub-prime mortgages are made to borrowers with poor or limited credit histories or high debt burdens and typically carry rates that are at least 2 or 3 percentage points higher than safer prime loans.

Although the servicing operations of the companies have not suffered yet, their "ability and willingness to continue to invest and maintain current resource levels" in the businesses are in doubt, Moody's said.

[Brian E. Kelly]

http://mortgageimplode.com/

Interesting reading

[Joseph T. Burkeson, CMI]

Originally Posted by bkelly2

Moody's said it would review the so-called servicer ratings for affiliates or units of New Century, Ameriquest, NovaStar Financial Inc., Accredited Home Lenders Holdings Co. and Winter Group. New York-based Moody's said it anticipated lowering the ratings by no more than one level. (my bold)

Imploding NovaStar

Subprimes strike again!!

SAN DIEGO (MarketWatch) -- If investors learn nothing else from the debacle now known as NovaStar Financial, it should be that no matter how the financial markets have changed, no matter how smart people may think they are, no matter how much it may feel that this time is really different, one basic rule of investing stands: The higher the reward, the higher the risk.

That hit home in the hardest way Tuesday after NovaStar (NFI : novastar finl inc com Last: 10.09-7.47-42.53%

2:19pm 02/21/2007

NFI10.09, -7.47, -42.5%) , with its 30% dividend yield, reported fourth-quarter results that left investors stunned as the REIT's shares plunged 33% in aftermarket trading to $11.81. That's lower than they were when I first started raising red flags over the subprime mortgage lender in December 2002.

While investors ignored the warnings, lured by a rising dividend, make no mistake about it: Even back then NovaStar was a high-wire act. Critics questioned the company's earnings quality, lending practices, its business model, its REIT-related accounting and the granddaddy of all concerns: Whether NovaStar really ever really earned its dividend, which is paid based on taxable - not net - income. NovaStar routinely dismissed such concerns, saying that it did indeed earn its dividend.

Whether it does or doesn't is now a moot issue, because NovaStar made it clear on its earnings call that next year's dividend could fall to $4 this year from $5.60 in 2006. Beyond that, the company said it may abandon its REIT status altogether, for good reason: It also said there will be little to no taxable income from 2007 through 2011. (The implication, of course, is that there will also be no dividend.)

All of this has no doubt come as something of a surprise to the NovaStar faithful, who were expecting so much more. On Dec. 20, 2004, newsletter writer Alan Newman wrote a bullish piece on NovaStar that quoted Nelson Woodard, co-manager of the Scudder-Dreman Small-Cap Value Fund -- NovaStar's largest holder then and now as saying that dividends in 2006 could hit $9, rising to $11 or $12 in 2007. (Oops!) Newman then wrote that if Woodard is correct, "our earlier guess of 'possibly $18 in dividends in the next three years' could prove way too conservative. Could it be $25 to $30 in dividends?!"

He then added, "Given that the shorts have totally misplayed their hand and botched their analysis, the outcome could be disastrous for them." The stock at the time was about $50.

[whandley]

Dang Joe,

You've become Mr. Bad News lately.

Confucious say, there are two rules for being successful in the real estate marketplace:

Rule #1. You MUST believe in the real estate market.

Rule #2. When in doubt, refer to rule #1.

[wforsyth]

I guess I'd better hurry up and get my loan.

[Joseph T. Burkeson, CMI]

Originally Posted by wforsyth

I guess I'd better hurry up and get my loan.

Shouldn't be a problem for folks with 20% down, verifiable income & employment over the last three years and somewhat stellar credit. Sorta like it used to be before the free money days.

[William E. Siegel]

Unfortunately there will always be loans out there. This is going to get ugly for a little while. I feel sorry for all those people who got caught up in the frenzy and took out loans that are now going to adjust. Many of them will be forced to sell or foreclose. Its kind of sad when our society allows this sort of thing to happen

[wforsyth]

I actually qualify for 0 down and a decent interest rate without having to go to an interest only or some other crud like that.

I too feel extremely sorry for those who didn't realize what was going to happen and who lost their homes to predatory lenders. It is a big reminder of what people with no morals can do to others.

[Brian E. Kelly]

Originally Posted by jburkeson1

Shouldn't be a problem for folks with 20% down, verifiable income & employment over the last three years and somewhat stellar credit. Sorta like it used to be before the free money days.

A couple more bite the dust Joe.
http://mortgageimplode.com/