A Sinking Sensation for Subprime Loans

The default rate for borrowers in the sector has jumped faster than anyone was expecting, raising risks for housing and the overall economy

by Joe Niedzielski From Standard & Poor's Equity Research

The gathering storm clouds over the nation's housing and lending markets grow darker each day. Fueling the latest concerns is further fallout in the subprime mortgage loan market, where lenders offer financing to less-creditworthy buyers.

Global banking giant HSBC Holdings (HBC), the third largest subprime lender in the U.S., disclosed on Feb. 7 that full-year 2006 impairment charges at its U.S. mortgage unit would be 20% higher than the $8.8 billion or so that analysts had been projecting. On Feb. 8, New Century Financial (NEW), the nation's second largest lender to subprime borrowers, said it expected to report a loss for the fourth quarter, and that it would have to restate its financial results for the first three quarters of 2006 (see BusinessWeek.com, 2/9/07, "Subprime Time Bomb"). Another subprime lender, ResMAE, filed for bankruptcy on Feb. 13, bringing the total failures to 21 since December, according to www.ml-implode.com, reports Action Economics.

Wrong-footed by the rapid deterioration in subprime loans, primarily those originated in 2006, lenders such as New Century have had to buy back a growing portion of these loans, which they had sold to investors and other financial institutions, because of faster-than-expected defaults. HSBC particularly identified second-lien or "piggyback" loans (loans made above a first mortgage, generally to help buyers come up with downpayments) in its mortgage book as those that could be hurt by higher interest rates as adjustable-rate mortgages (ARMs) reset over the next few years. HSBC acknowledged that some borrowers face fewer refinancing options amid slowing growth in home prices, and limited if any appreciation in their home equity.

Slo-Mo Flashback

With national home prices appreciating at a compound annual growth rate of around 6% from 2000 through 2005, subprime loans, many of which are tied to adjustable rates and include features that allow buyers to pay only the interest or make even lower payments, blossomed in popularity. Subprime mortgages accounted for 19% of all mortgage originations in the first half of 2006, according to the Mortgage Bankers Assn.

But the recent disclosures from HSBC and New Century indicate that the slowdown in the U.S. housing market could have a larger economic impact than previously thought. As a result of rising delinquencies and foreclosures, most banks and mortgage lenders are tightening underwriting standards, a move that may limit consumers' access to credit. New Century said on Feb. 8 that its improved lending standards would result in a projected 20% decline in total mortgage loan origination volume in 2007, compared with a previous forecast of flat growth.

The trickle of bad news in recent months resembles a slow-motion version of 1998's credit crunch following Russia's debt default of that year and the unraveling of hedge fund Long-Term Capital Management. Back then, the flight-to-quality into U.S. Treasury notes and bonds, along with investors' unwillingness to purchase securities backed by subprime mortgage loans, led to the eventual bankruptcy in 2000 of companies such as ContiFinancial, a former unit of grain giant Continental Grain. An ill-timed bet into specialty lending by life insurer Conseco—which bought Green Tree Financial, a leading lender in the manufactured home market, in 1998—played a considerable part in Conseco's bankruptcy in late 2002.