Subprime Lending's Next Act


What the market will look like for borrowers after the shakeup—which players are likely to suffer and which are positioned to weather the storm

Sour subprime loans have devastated lenders, dashed the hopes of borrowers, disappointed banks, and demanded tighter standards—but has the recent shake-up altered the risky mortgage landscape for good?

Not likely. Though many lenders have already closed up shop and others are headed toward extinction, lending to home buyers with weak credit at high interest rates is much too profitable a business to go away completely, especially for those lenders that know how to underwrite carefully and box their risk.

"The industry has been down this road before," says Bennet Koren, a banking industry attorney with McGlinchey Stafford in New Orleans, who has represented finance companies and mortgage lenders. "At the end of the day, there was still a demand for the product."

Some Lenders Will Rebound

Ever hear of United Companies Financial Corp.? The Baton Rouge (La.) mortgage company, which filed for bankruptcy in March, 1999, was one of many subprime lenders to liquidate in the late 1990s when financial markets hit a bump.

New Century Financial (NEW) managed to pull through a similar liquidity crisis in the late 1990s. But the company, which is facing a criminal accounting probe and has stopped accepting loan applications because some of its creditors are refusing to provide access to financing, could face Chapter 11 this time around. The Irvine (Calif.) company's stock has dropped from $30 to $3 in the last month.

Shares of other lenders with sizable subprime businesses, including NovaStar Financial (NFI) and Fremont General (FMT), have also gotten hammered. Fremont has said it plans to sell its subprime business, which accounts for half of the company's total operations. NovaStar expects to recognize little or no taxable income between 2007 and 2011 and may consequently lose its status as a real estate investment trust.

Many analysts see little possibility of recovery for lenders like New Century and NovaStar. But even if these companies fall of the face of the earth, "two or three years from now there will be new subprime companies," Koren says.

Good Deals

And there may still be hope—bargain hunters are already snatching up battered mortgage stocks. On Mar. 7, shares of Fremont General surged over 25% on news that as many as six suitors were interested in buying its residential mortgage business. The same day, New Century and NovaStar saw significant stock increases (see BusinessWeek.com, 3/7/07, "A Bit of Relief for Housing Stocks"). "I'm not going to bet my retirement on it, but if I had any guts I'd buy [New Century and NovaStar's] stock right now," says Koren.

Though the industry should cycle upward in the long term, there's no doubt that the playing field for subprime lending will look a little rocky in the interim. The market for subprime loans will shrink as the fallout leads to fewer players and more negotiation with prospective borrowers. According to Standard & Poor's (MHP) equity analyst Stuart Plesser, "2007 is going to be a tough year [for lenders]." "But toward the latter part of 2007 and 2008 the subprime mortgage origination business is going to be a lucrative business for the people who stay in."

With fewer independent lenders around, commercial banks may dominate the subprime lending scene over the next couple of years. Since banks are both lending to lenders and buying those lenders' mortgages on their own, "it's in their best interest to drive [the lenders] out of business," Plesser adds.

Banks Better Positioned

Because they are diversified, banks won't suffer as much from rising subprime mortgage defaults. "In the scheme of things it's a small part of their overall business," says S&P equity analyst Matt Albrecht. After issuing a profit warning on Feb. 8, banking giant HSBC Holdings (HBC) suffered $10.6 billion in losses on bad loans from its U.S. subprime mortgage operations in 2006, but said profit still rose 5% over 2005.

Albrecht recently downgraded Merrill Lynch (MER) and Lehman Brothers (LEH) on concerns about the banks' subprime portfolios; he says Lehman, along with Bear Stearns (BSC), is nevertheless best positioned to weather the subprime storm. Merrill and Morgan Stanley (MS) are less experienced in loan securitization and may consequently get hit harder, Albrecht says.

Last year banks were still showing interest in subprime loan companies despite the increasingly clear risk they pose. Bear Stearns completed a takeover of subprime lender Encore Credit in October, 2006, and Citigroup (C) struck a deal to provide funds to ACC Capital Holdings, the parent of subprime lender Ameriquest Mortgage.

Mandated Borrowing Opportunities

One of the reasons for lending to subprime borrowers is that, besides their profit potential, banks are obligated by law to offer lending services to clients of all income and credit levels. "The social and political forces at work suggest that credit availability is a good thing," says Tom Vartanian, a Washington (D.C.) partner at law firm Fried, Frank and former general counsel of the Federal Home Loan Bank Board and the Federal Savings & Loan Insurance Corp. Vartanian points to the Community Reinvestment Act, passed by Congress in 1977. The Act requires that insured financial institutions such as commercial banks offer equal access to lending to all those in an institution's geographic assessment area. Before the CRA, many bankers excluded low-income neighborhoods from their lending products.

Even if banks have to adhere to stricter lending standards, it's likely that they would have implemented them anyway since they don't want to lose any more money. "They do such a good job of managing risk in other businesses I would assume their standards are tighter [than those of other lenders]," says Albrecht.

Nonbank mortgage lenders have also been tightening their standards. The trend picked up after government-sponsored mortgage financier Freddie Mac (FRE) said on Feb. 27 that it will no longer buy high-risk mortgages. Federal Reserve chief Ben Bernanke has also urged Congress to boost regulation of Freddie Mac and its government-sponsored-enterprise sister, Fannie Mae (FNM).

The government can't regulate independent lenders, but lenders will continue to tighten standards anyway over the next year to cauterize their losses, Plesser says. "In general lenders are being much more careful."

Unmanageable Interest Rates

Tighter standards are locking a large part of the American population out of home buying, especially first-time home buyers: "The same person who went for this loan three months ago wouldn't be able to qualify now," Plesser says.

Many others are being forced into foreclosure because their credit is no longer good enough to refinance, like Trisca Jackson of Lithonia, Ga., an Atlanta suburb. Jackson, an employee at a wireless communications company, bought a house for $129,900 in 2002 with zero down by using two loans. She covered 80% of the purchase price with a 3/27 adjustable rate mortgage starting at 8.25% and the remaining 20% with a 30-year fixed-rate loan at a rate of 12.25%.

At the end of the three-year "teaser period" Jackson could not qualify for a better loan, and her payment rose to $1,500 a month from the original $946. She tried unsuccessfully to sell the house (two potential buyers' financing fell through) and eventually had to foreclose.

Rising Values Could Offset Defaults

As credit becomes tighter, it's going to be harder for homeowners like Jackson to make payments, adding insult to the injury of stagnant home prices and slipping sales. But a market of escalating home values will prove favorable to subprime lenders, who lend based more on a home's value than on an individual's credit score. According to the National Association of Realtors, the national median home price will rise 3.4% in 2008 after growing just 1.9% in 2007 and 1.1% in 2006 (see BusinessWeek.com, 2/19/07, "Out of the Basement for Housing").

"Subprime lending won't go away," says Vartanian. "There will always be upturns and downturns and overreactions to downturns—my concern is that overreaction doesn't gobble up the good [aspects of subprime lending] with the bad."


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