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Who Will Get Shredded?


The canaries in the coal mine are keeling over fast. After years of easy profits, the $1.3 trillion subprime mortgage industry has taken a violent turn: At least 25 subprime lenders, which issue mortgages to borrowers with poor credit histories, have exited the business, declared bankruptcy, announced significant losses, or put themselves up for sale. And that's just in the past few months.

Now there's evidence that the pain is spreading to a broad swath of hedge funds, commercial banks, and investment banks that buy, sell, repackage, and invest in risky subprime loans. According to Jim Grant of Grant's Interest Rate Observer, the market is starting to wake up to the magnitude of the problem, entering what he calls the "recognition stage." Says Terry Wakefield, head of the Wakefield Co., a mortgage industry consulting firm: "This is going to be a meltdown of unparalleled proportions. Billions will be lost."

Hedge funds, those freewheeling, lightly regulated investment pools, seem particularly vulnerable. BusinessWeek has learned that $700 million Carrington Capital and $3 billion Greenlight Capital may have gotten badly burned because of their intricate dealings with New Century Financial (NEW), a major subprime lender whose stock has plunged 84% in four weeks amid a Justice Dept. investigations into its accounting. Magnetar Capital, a $4 billion fund formed two years ago, may be on shaky ground, too. The question is, how many others may be suffering? "This is a very opaque industry, so no one really knows," says Mark M. Zandi, chief economist and co-founder of Moody's Economy.com Inc. (MCO). "My guess is that if you look at the top hedge funds, they're bearing most of the risk."

Not that big commercial and investment banks will go unscathed. Citigroup (C ), and Countrywide Financial (CFC) have boosted their estimates of losses and warned of credit troubles. Sanford C. Bernstein analyst Brad Hintz predicts that the subprime meltdown will result in earnings reductions for Bear Stearns, Lehman Brothers, Goldman Sachs (GS), Merrill Lynch (MERR), and Morgan Stanley (MS).

Among hedge funds, Greenwich's (Conn.) Carrington seems particularly vulnerable. Managed by ex-Citigroup (C) banker Bruce M. Rose, the fund was launched in 2003 with $25 million in seed money from New Century, which owns about a 35% equity stake. Such an intimate tie between a lender and a hedge fund is highly unusual, say analysts. Carrington specializes in turning subprime mortgages into sophisticated bonds called collateralized debt obligations (CDOs) and selling them to other investors. Not surprisingly, New Century is one of Carrington's biggest suppliers, providing 17% of the loans in a recent deal. Another major supplier is Fremont General, which says it plans to exit the subprime business.

With Carrington on the verge of losing loans from two major providers, the fund, which counts Citigroup as an investor, seems to be in a bind. Rose says he expects the market for subprime loans to pick up again and is in talks with several lenders to buy mortgages. "We have no exposure to New Century as a corporate entity," he says. "Our deals have outperformed just about everything out there."

One clear loser is David Einhorn, manager of hedge fund Greenlight Capital, who made a big, ill-timed gamble on the subprime sector when he fought his way onto New Century's board last March. Greenlight, which regularly posts double-digit annual gains, is down about 2.5% on the year; its stake in New Century, valued at $109 million at the start of the year, has shrunk to $21 million. Einhorn's seat on New Century's board prohibited him from selling even as the lender warned that it would restate most of its 2006 earnings results and said federal prosecutors are investigating its accounting. Einhorn, through a spokeswoman, declined to comment.

Some on Wall Street point out that Magnetar showed bad timing, too, by entering the subprime arena last year just as the underwriting quality of subprime loans began to deteriorate rapidly. For now, Magnetar isn't showing any outward signs of trouble. A person familiar with the fund says it took steps to minimize its exposure to the subprime market, and a Magnetar spokesman says the fund is doing well.

Other hedge funds that have feasted on mortgage-backed securities will be hit hard if rating agencies start downgrading them, as is widely expected. That would be likely to send their values plummeting. "This is indeed a stress scenario," says Glenn T. Costello, co-head of the residential MBS Group at Fitch Ratings Inc. Kevin J. Kanouff, who heads bond surveillance for Clayton Holdings Inc., a consulting firm for institutional investors, adds that "hedge funds are getting very nervous about their investments."

But those downgrades likely won't come right away. Observers say ratings agencies may rely on some models that don't fully account for the recent explosion in exotic mortgages, such as interest-only loans. Says Susan Barnes, managing director in the U.S. residential mortgage-backed securities group of Standard & Poor's, which, like BusinessWeek, is a unit of The McGraw-Hill Companies: "Our models are continually adjusted and enhanced." Adds Fitch's Costello: "There's a clear trend that we've expected higher and higher losses."

Commercial and investment banks have many tendrils in the mortgage business, too. They earned fat fees during the housing boom by packaging loans into pools and selling them to investors. That market is shrinking as subprime lenders and investors pull in their horns, leaving banks holding risky loans.

UP THE FOOD CHAIN

There's also growing talk that many firms, in particular Goldman Sachs Group Inc., incurred steep losses in trades based on the ABX subprime index. As market makers, the big banks were forced to take the other side of clients' short trades, or bets that the index would fall. When the index plunged 34% in the first 10 weeks of the year, the banks lost. Goldman, which reports first-quarter earnings on Mar. 13 and is a big player in the ABX market, declined to comment.

In another case of dreadful timing, Citigroup disclosed on Feb. 28 that it recently upped its stake in New Century to over 5%, adding some 1 million shares just weeks before New Century revealed the investigation by federal prosecutors. Citigroup declined to comment.

The biggest fear is that the trouble will move up the food chain. The same questionable lending practices that were used for subprime mortgages during the boom were also used for regular, or "prime," mortgages--among them low or zero downpayments, loose loan-to-value ratios, and exotic mortgages with low up-front payments that balloon later. While subprime loans accounted for 20% of mortgages originated last year, David Liu of UBS estimates that fully 40% of last year's loans are "showing a lot of signs of stress." Says Nouriel Roubini, economics professor at New York University's Stern School of Business: "The risk that prime borrowers will start to feel financial stress in 2007 cannot be underestimated."

Click here to join a debate about the housing market.

By Mara Der Hovanesian and Matthew Goldstein, with Spencer E. Ante in New York


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