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Markets: Subprime Surprise
New York: March 19, 2007
By John R. Stephenson

First Shanghai, now the housing market, has spooked the North American stock exchanges. While mama said there would be days like this, it was pretty tough to watch as the Dow tumbled over 240 points this past Tuesday. The reason? Concern over subprime lenders, or the companies that make loans to people with poor credit. With borrowers beginning to default on their loans, the market went into panic mode as concern spread that this could lead to a wave of credit tightening that would eventually choke off consumer spending — the lifeblood of the U.S. economy.

As interest rates dropped in 2000 to 2001, real estate began to look like the surest way there was to make money. The real estate party wasn't restricted to only those folks who could afford a traditional mortgage, anyone who could fog a mirror had a shot at making out like a bandit in the rising U.S. real estate market as subprime lenders sprang up like dandelions to lend money to people who otherwise wouldn't have qualified for a traditional mortgage.

Not only were many of these subprime loans uneconomic, but in some cases they were even fraudulent. None of that mattered when interest rates were at historic lows and property values were rising fast. But today, things are different as rates have backed up and in certain markets house prices have started heading lower. According to the Mortgage Banking Association, some 4.7% of all mortgages are now delinquent or in default, but for subprime mortgages (about 20% of the overall mortgage market in 2005-6), the number is 11.7%.

To pump their products, subprime lenders engaged in some pretty enthusiastic business practices. Many offered "teaser" loans that had a ridiculously low interest rate on their mortgages that helped make the initial payments affordable. After a year or so, monthly payments would increase dramatically so lenders could recover their losses in the early years. One such lender, HCL Financial Inc. of San Jose California, even coined the term NINJA to describe its signature loan — No Income, No Job, No Assets.

As the bull market in real estate continued, subprime lenders became more and more aggressive in their marketing. Today, some 80% of subprime mortgages are adjustable-rate mortgages, or ARMs that carry low teaser rates which, in most cases, re-set to dramatically higher interest rates — often 25% or more. As well, documentation and credit checks for subprime loans were notoriously bad. According to a study conducted by the Mortgage Asset Research Institute, in some 60% of the mortgage applications reviewed, borrowers had overstated their incomes by more than half.

Because the times seemed so good for so long and the loan review process was so light, more and more Americans were able to take on massive amounts of debt to finance a new house. The mortgage market boomed. By most estimates, the size of the U.S. mortgage market (both prime mortgages and subprime) is approximately $10 trillion. As a result, home ownership in America hit record highs and the amount of debt as a percentage of a property's value increased from 78% in 2000 to 86.5% in 2006%.

For a while, nothing could be better. Everyone was making money. Individuals who lied about their incomes got mortgages. Subprime lenders blossomed as the combination of rising property values and low interest rates made home ownership a one-way bet. As long as the homeowner could afford the monthly payments, the likelihood of default was pretty modest. Not only that, but rising property values meant homeowners could double down on their investment by getting their property re-appraised for more which supported more borrowing in the form of a home equity loan. All this cheap money helped fuel a commercial boom in everything from contracting services to cars to big screen televisions. It seemed you just couldn't lose.

For the burgeoning legion of subprime lenders, the story was a simple one. Get market share at any cost and then package up these loans and sell them to a growing secondary market. The real money for the subprime lenders was in the lucrative fees they charged for originating the loans. The fact that many of these loans were uneconomic didn't matter a whit since investment banks stood at the ready to take these loans off the subprime lenders books and repackage them into mortgage backed bonds which they flogged to hedge funds, pension funds and other institutional clients hungry for yield.

By taking these loans off the books of subprime lenders, investment banks, such as Goldman Sachs and Merrill Lynch, were able to shift the business risk away from the subprime lenders leaving them with just the lucrative loan origination fees. For a while, everything worked great. The risk of default had, as if by magic, been shifted to the institutional community.

Figure 1: The packaging of Subprime Loans


The dirty little secret that the investment banks had was to pool these loans and then re-package them in little slices or tranches and sell them as bonds. Each of these slices was backed by a pool of mortgages which had different likelihoods of default. The tranches with the least risk of default carried the lowest returns (yield) but then again the highest chance of recouping your investment. Higher risk and higher return (yield) tranches were sold to mutual fund and hedge fund investors who were looking for that edge in a rising property market.

But then things changed. Interest rates continued their upward path just as cracks appeared in the housing market. All of a sudden, the adjustable rate mortgages kicked in as property values declined or at least flattened out. With that, the borrowers at the low end of the scale (subprime borrowers), started to struggle under the twin burdens of too much debt at too high rates (monthly payments). Default rates started to increase. According to the Center for Responsible Lending, loose lending practices could result in as many as 2.2 million people losing their homes.

That got the market spooked. Already the shares of subprime lenders are down big on the news of rising default rates. Lenders such as New Century Financial, the number two subprime lender in the country, is circling the drain with a bankruptcy likely. But it isn't just the declining share prices of a handful of subprime lenders that has the stock market running for cover, it is much bigger than this.

Figure 2: The Declining Performance of New Century Financial


What this debacle spells is trouble for the economy more broadly. For starters, the investment banks who made out like bandits repackaging these loans and creating these pools of capital, have lost their appetite as more of the subprime lending (credit) practices have tightened and default rates have increased. Not only are revenues and margins down (witness the recent disappointing earnings out of Bear Stearns) at investment banks, but with winning trades suddenly becoming losing trades, the institutional market is unwilling to take any more of this paper. That means the market has dried up and in the future, the subprime lenders will be holding a lot more of these uneconomic loans on their books. As a result, look for bankruptcies to increase amongst the community of subprime lenders.

But as more and more lenders retrench and reign in their lending practices, spending in the broad economy starts to dwindle. That's because prime lenders start to adopt more conservative practices as they witness the meltdown of their subprime brethren. Not only that, but the way that subprime mortgages are packaged and sold to the institutional marketplace is identical to other forms of debt such as car, student and credit card loans as well as home equity lines of credit. As a result, these markets could get caught up in the downdraft of the subprime mortgage market.

With the consumer reigning supreme (72% of U.S. GDP) in the American economy, the fear is that this downdraft in the subprime mortgage market could lead to a dramatic slowing in the overall economy. In the last few years, fifty percent of the growth in the U.S. GDP has come, not from wage gains, but rather from home equity withdrawals. As lenders start to retrench, consumer spending, the lifeblood of the U.S. economy, could be in big trouble. If the Fed (U.S. central bank) doesn't come through with some interest rate relief, things could get ugly before they get better. David Rosenberg, an economist with Merrill Lynch, has put the probability of a recession later this year "very close to 100 percent" should interest rates stay where they are.

According to Henry Paulson, the U.S. Treasury Secretary, the fallout in subprime mortgages is "going to be painful to some lenders, but is largely contained." But is that true? Perhaps. But keep in mind that bubbles have a way of unwinding that goes far beyond their initial scope. By the end of 1999, there were just 350 internet stocks that represented just 6 percent by market capitalization of U.S. stocks. Yet the NASDAQ stock exchange dropped by over 70 percent. The damage was not limited to internet stocks. Likely, the same will be true in this sad episode.

Investors, worried about the repercussions of a real estate meltdown led by subprime lenders, should be thinking of playing great defense. Utilities, gold and consumer staples are great places to hide when things start to turn down. Eventually, it will be a little safer to swim further from shore — just not yet.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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