Subprime Time Bomb

With HSBC and New Century Financial suffering losses from subprime borrowers, which other mortgage lenders face an unpleasant reckoning?

by Maya Roney

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As investors swallowed negative news from two of the biggest players in the subprime mortgage market on Feb. 8, the "housing bottom" question took a backseat to a new debate: Who will get crushed in the subprime shakeout, and who will emerge unscathed?

The market started showing more signs of subprime jitters when HSBC Finance, the Prospect Heights (Ill.)-based consumer lending unit of British banking giant HSBC Holdings (HBC) said it was setting aside 20% more than analysts had estimated for bad loans in 2006 because of weakening in the U.S. mortgage business. Shares of the bank were off 3% early afternoon on Feb. 8.

More bad news came from Irvine (Calif.)-based lender New Century Financial (NEW). New Century, the second-largest subprime mortgage originator in the U.S., announced it would restate results for the first three quarters of 2006 to correct accounting errors related to loan repurchase losses, sending the stock down 30% on Feb. 8. The company expects to see a loss for the fourth quarter of 2006 due to early payment defaults.

Defaults Aren't the Whole Story

Shares of other big mortgage players, Countrywide Financial (CFC) and Washington Mutual (WM), were down more than 2% on Feb. 8. Smaller subprime lenders were hit even harder: Kansas City (Mo.)-based Novastar Financial (NFI) shares fell 13%, and San Diego-based Accredited Home Lenders Holding (LEND) dropped 7%.

As investors become more aware of the problems with subprime loans, lenders that focus on customers with poor credit histories will have to face the music. But it may be for different reasons than people think.

"Just because some subprimers are bad doesn't mean all are," says Stuart Plesser, a mortgage lender and insurer analyst for Standard & Poor's Equity Research. "Countrywide will suffer because they are going to face a pricing issue." Plesser has a "sell" rating on Countrywide, the No. 1 mortgage originator and fourth largest subprime mortgage originator in the U.S., according to National Mortgage News.

Many mortgage lenders, including Countrywide and New Century, sell their loans to banks and investors that are attracted to the high interest rates they carry. HSBC got into subprime during the U.S. housing market boom, but when the market began to cool and foreclosure trends accelerated, the bank found itself in trouble. Washington Mutual, another big player in the subprime market, said in January that its mortgage business lost $122 million in the fourth quarter thanks entirely to losses in its subprime segment.

Price Competition

"This is the leitmotif of this whole thing: These people don't really know what they are doing in mortgage banking," says Plesser. "They are writing whatever loans just to write loans, thinking they will worry about it later. But now it's later."

Regular lenders also suffer when banks get into their territory. Companies like Countrywide have been forced to price loans lower since investment banks started buying up subprime loans and pricing them aggressively. Banks assumed they were covered from potential losses by the revenue streams from their myriad other businesses.