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I’m no sub-prime conspiracy theorist but…

Ah, spring in America. The cherry blossom is starting to show its buds and the last piles of snow are beginning to melt – along with a considerable chunk of the residential sub-prime industry.

In case you haven’t been reading the wires – and recent reports in Mortgage Strategy – the US sub-prime industry has been hammered. Though perhaps the word hammered doesn’t quite do justice to the situation.

Here’s a short run-down on the carnage from the past couple of weeks.

According to Lehman Brothers, General Motors may take a $1bn hit due to delinquencies at GMAC and GMAC-RFC.

Countrywide Financial, the poster child of US mortgage banking, revealed its sub-prime servicing portfolio is suffering from a 19% delinquency ratio.

New Century Financial, a publicly-traded non-depository, is the focus of a criminal probe regarding trading in the company’s securities and errors tied to its accounting for loan repurchases. Its stock has dived to $4 from $52.

And the nation’s second largest sub-prime funder, New Century, could file for bankruptcy protection.

Meanwhile, as I put the finishing touches to this column, rumours abound that Wall Street firms – Merrill Lynch and Bear Stearns to name but two – have stopped bidding on most sub-prime loans from non-depositories which means liquidity for these institutions is in doubt.

Translation – if liquidity does not return and Wall Street does not start bidding again, about 100 sub-prime shops could close in the next 30 days.

In short, this is the worst operating environment the sub-prime sector has faced since 1998 when the Russian debt crisis sparked a sell-off in the bond market and Wall Street firms pulled funding for several publicly traded sub-prime non-depositories, questioning their accounting which allowed securitisers to book tomorrow’s profits today.

How bad will it get? And is there any relief in sight? It’s already been ugly. About 30 non-depositories have gone bust since late December and hundreds of brokers have shut down or seen their sources of funding disappear.

It’s hard to put a dollar number on losses because many of these firms were privately held. But keep in mind that the real losses will not be known for years.

Scores of sub-prime loans are going delinquent but that doesn’t mean they will enter foreclosure. Delinquent loans often get worked out with minor damage to lenders and consumers. Usually, fewer than 4% of sub-prime loans reach foreclosure.

About 19% of Countrywide’s sub-prime servicing portfolio is in delinquency. It services $119bn in sub-prime loans but does not own these loans.

Many were securitised or sold into the secondary market which means the ultimate owner is a bond or hedge fund or some institutional investor. And Countrywide has insurance to cover losses on some of these loans.

In a recent interview, Countrywide chief executive Angelo Mozilo told me that although 19% are not performing, 81% are. He’s concerned about the situation but he’s seen cycles before.

And as companies go bust, he expects to benefit from less competition and better quality loans being offered by brokers.

The difference between the present sub-prime crisis and the 1998 strain is the wreckage.

Last time around publicly traded firms and a few banks folded their tents, causing billions of dollars in losses for shareholders.

This time, very few publicly traded companies – and none of a substantial size – have gone bust. Of course, as I write the publicly traded New Century could be on the verge of bankruptcy. An analyst at Lehmans alleges that the lender is “running on fumes”. There are also rumours that New Century might be sold to a hedge fund, so go figure.

What is clear in this is that the outlook is cloudy for sub-prime. As I have noted in previous columns, the present crisis was sparked by factors including razor-thin profit margins since 2005 and poor underwriting by originators.

Firms were providing loans to consumers who shouldn’t have been granted credit and declining home values made refinancing out of resetting adjustable rate mortgages difficult or impossible. The final straw was Wall Street warehouse lenders forcing sub-prime originators to buy back bad loans and making margin calls on thinly capitalised non-depositories.

Wall Street has been roundly criticised for being inflexible with regard to buyback requests on delinquent loans.

Mozilo says: “Wall Street has no mercy and no compassion. That’s not how it operates. It did this in 1998 and it did it the day after 9/11.”

There is one point to keep in mind regarding Wall Street and the liquidity crisis it has caused for many sub-prime non-depositories that they once banked – these same Street firms now are in the business of originating sub-prime loans themselves.

Bear Stearns, Merrill Lynch, and Credit Suisse have all gobbled up wholesale lenders in the past year.

A growing chorus of conspiracy theorists believe Wall Street is being tough because causing so many firms to fail will result in less competition for its own mortgage entities. I’m not a conspiracy theorist but it is an interesting take on the situation.

Paul Muolo is executive editor of National Mortgage News



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