Opportunities in the Subprime Implosion

Freddie Mac says that it will no longer buy high risk mortgages vulnerable to foreclosure. While there are many kinds of loans that can be deemed “high risk”, what Freddie is really referring to is “subprime loans”. Freddie Mac is developing new standards for subprime loans; in fact, half of the loans they currently own will no longer comply.

The mortgage leviathan is reacting to surging home-mortgage delinquencies and foreclosures in the subprime market. Write-offs of mortgage loans by banks have reached a three-year high in the fourth quarter last year, according to Federal Deposit Insurance Corporation (FDIC), while at the same time several large subprime lenders have been bleeding – stock shares have plummeted in price, some are teetering on bankruptcy, and others have shut their doors.

Joining noteworthy industry lions such as HSBC, Countrywide and Saxon, New Century reported earlier this week that it too has troubles which are particularly egregious. New Century admits that it’s technically in default with several lenders and is under investigation by federal regulators. Analysts caution that this company – the second largest in the subprime industry – may implode if most of its warehouse lenders do not issue waivers to New Century for being out of compliance with debt covenants.

Companies like New Century rely on warehouse lenders to help finance their operations. These lenders require that the loans they invest in perform to clearly defined standards. If they don’t, the warehouse investor can put it back to the loan’s originator (New Century). Consequently, originators are getting saddled with the non-performing loans they aggressively originated.

How did this happen?

Peter Coy in his BusinessWeek.com article “Why Subprime Lenders Are In Trouble” gives an accurate and succinct description of what went wrong.

He reports that the quality of mortgages underwritten by the industry has dramatically changed in recent years, particularly as recently as 2006. At that time there was a shift in lenders’ loan strategy. Rather than competing with one another based on price (lowering rates), the game became to compete based on easy terms (lowering lending standards). Reducing the standards enabled the most aggressive to keep volume up, and now loans that should never have been made are becoming delinquent and going into foreclosure.

When Countrywide recently announced that 19% of their subprime portfolio is in default (last year it was about 2.5%!), I asked Bill Aubrey, the Chief Investment Officer of Capital Alliance to give me his take on what’s happening to the industry. (Disclosure: I work for Capital Alliance.) Bill Aubrey:

“Despite all the recent blood letting in this industry, there’s nothing wrong with writing subprime/nonprime/non-conforming or whatever the street folks want to call it as long as it’s done correctly. That is to say, don’t let a “restaurant engineer” who also happens to be a 1st time homebuyer with $7,000 per month income stated on his unexamined loan application borrow 100% of the appraised value.

Or for that matter, lend to the quintessential sales guy who states he makes $25,000 per month, but examination of his bank statements shows he made this income 12 months ago! Since then he ran into a small glitch in paying his bills on time because he had to pay all the medical bills for his sick Mother who is 76 years old. Like the lady did not have Medicare.

Or better yet, the guy who wants to borrow $200,000 (at a 100% loan-to-value) for “investment purposes”. Great investment when the borrower is paying 12.5% for the dough!

All three of these scenarios have come across my desk in the last 6 to 8 months and everyone of those so called “deals” were purchased by the big boys on the street! Now the whole industry is getting a black eye because of this stupidity.”

My take is that despite the “black eye”, those left standing will have opportunities to underwrite more quality loans because the “big boys” will be hurting so badly that they’ll make a substantial retreat from funding non-conforming loans. Companies like Capital Alliance — which follow a strict underwriting guidelines that require substantial borrower equity in the collateral, a minimum credit rating, and affirms stated income and appraisals — may find that they have more quality business knocking at their doors than they can answer.

Those with discipline often win in the end, and in this situation, those that followed conservative underwriting policies will look better than ever relative to the subprime industry as defaults and foreclosures soar for the undisciplined.

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