A Painful Hiss from the Subprime Balloon

Subprime lender NovaStar's warning of little, if any, taxable income through 2011 sends another unwelcome jolt through mortgage company stocks

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Well, at least NovaStar Financial (NFI) has $154 million in its bank accounts.

In a quarterly report that staggered analysts with the breadth of its bad news, the Kansas City (Mo.) subprime mortgage lender revealed a quarterly loss, said it may not have any taxable income through 2011, and strongly hinted its days as a real estate investment trust (REIT) are drawing to a close. Many subprime lenders avoid Uncle Sam's tax take by distributing their taxable income as dividends. If they don't have any taxable income, well, operating as a REIT may not make much sense. And as NovaStar's loan volume drops, that $154 million will serve as a needed cushion throughout a lean 2007. Chris Brendler, an analyst with Stifel Nicolaus in Baltimore, called the report "alarming" and a "shock." And as NovaStar's loan volume drops, that $154 million will serve as a needed cushion throughout a lean 2007.

The company's news was especially unwelcome to the market, coming on Feb. 21 just as the Labor Dept. reported a 0.3% jump in core inflation, above the 0.2% increase analysts had expected. That dimmed the prospects of any interest rate cut by the Federal Reserve that could buoy the housing market, and it sent stocks lower (see BusinessWeek.com, 2/21/07, "Consumer Prices Heat Up"). Minutes of the last Federal Reserve board meeting also showed that central bankers remain more worried about the threat of inflation than about an overall slowing of the housing market. "All members agreed that the predominant concern remained the risk that inflation would fail to moderate as desired," according to minutes of the Fed's Jan. 30-31 meeting released on Feb. 21.

"One of the Scariest Signs"

A subprime mortgage is one granted to borrowers with less-than-perfect credit histories because they've missed payments on credit cards, they are too young to have established a credit record, or a similar issue. As housing boomed in recent years, lenders rushed into making these loans, in some cases letting people borrow hundreds of thousands of dollars without ever having to prove their income or assets. Subprime lenders now represent about one-fifth of the overall $5.5 trillion U.S. mortgage market.

The quick growth of subprime mortgages in the recent housing boom has been eclipsed by an equally rapid decline, with several major subprime lenders, ResMae Mortgage, Mortgage Lenders Network USA, and OwnIt Mortgage Solutions declaring bankruptcy since December. Others very well may follow.

The question now: whether these troubles will spread to the broader housing market. Some argue that they will be contained, because most of these purchases were at the low end of the market. But some experts are concerned. Michael Simonsen, president and CEO of Altos Research, which studies California and 15 other major U.S. real estate markets, says subprime lenders' recent performance is "one of the scariest signs" for the larger housing market.

Ripple Effect

"The majority of the subprime business is with first-time buyers. So it may take several years to shake out," Simonsen says. "But when it comes time to sell and trade up we may find that the low end has been squeezed out." In other words, a meltdown in the subprime market could affect the supply of future buyers for years to come.

Tightening credit standards may also ripple through the broader market. Lenders across the spectrum are rewriting their loan guidelines, checking applicants' incomes and credit histories far more diligently, and generally becoming more rigorous in the face of consumer and regulatory scrutiny. That will lead to fewer loans and less access to credit. New Century Financial (NEW), for example, said its new loan business would be down 20% this year. Also this week, Wells Fargo (WFC) said it would eliminate 250 jobs in Fort Mill, S.C., as tighter lending policies it implemented last week will generate lower loan volume. Wells Fargo ranks among the country's largest subprime lenders.