Carnage In The Subprime Mortgage Market, Part One

The subprime mortgage market is in fullscale meltdown. This involves one of our companies, HSBC. Earlier in the week HSBC dropped a bombshell when it announced that it is upping loss reserves by 20%. Elsewhere, New Century annouced that it was going to restate most of its results for 2006, and guided revenue for 2007 to a whopping 20% below 2006 levels. Here's a picture of what happened next:



Here's what the Wall Street Journal had to say about the situation:

Default worries are growing at the risky end of the mortgage market.

Those worries sent some home lenders' shares plunging yesterday and highlighted uncertainties about how many investors in mortgage-backed securities might be vulnerable.

New Century Financial Corp. shares dropped $10.92, or 36%, to $19.24 in 4 p.m. composite trading on the New York Stock Exchange after the big Irvine, Calif., lender disclosed late Wednesday that it expects to report a fourth-quarter loss and will restate results for the previous three quarters to correct accounting errors.

New Century is one of the nation's biggest specialists in "subprime" mortgage loans, or home loans for borrowers with weak credit histories. The company blamed its woes on "the increasing industry trend of early-payment defaults," those that occur within the first few months after a loan is made.

Shares of other subprime lenders, including Fremont General Corp. and NovaStar Financial Inc., also plummeted. The combined market value of seven U.S.-based lenders active in the subprime market dropped more than $3.7 billion yesterday.

Contributing to the selloff was an announcement, late Wednesday, by British banking giant HSBC Holdings PLC that problems in its subprime- mortgage business were worse than previously indicated. Yesterday, shares of HSBC, whose operations extend well beyond the subprime sector, fell $2.44, or 2.7%, to $89.78 in 4 p.m. Big Board composite trading.

Many in the industry are wondering how well investors in mortgage- backed securities will cope as delinquencies rise. Lenders quickly sell most subprime mortgage loans to packagers of securities, such as investments banks, or directly to investors. The riskiest of those securities, those that absorb some of the first losses from defaults, are typically sold to money managers and hedge funds in the U.S. and abroad.

"The thing none of us know, including the [Federal Reserve], is who is holding this stuff," Richard Kovacevich, chief executive of Wells Fargo & Co., one of the nation's biggest mortgage lenders, said in a recent interview. "The assumption is that it is well-diversified. If it's concentrated, it's going to be a disaster."

For now, most people in the $10 trillion U.S. mortgage market argue that the current slump in housing and surge in loan defaults won't lead to a disaster. "The mortgage market is vast, and the vast majority of the mortgage market is fine," says Lewis Ranieri, a pioneer in mortgage-backed securities in the 1980s, when he was a star trader at investment bank Salomon Brothers.

But some investors are getting singed, and jitters are growing about how widespread the damage will be and where it will show up next.

The number and variety of investors in U.S. mortgage securities has mushroomed in recent years even as lenders made riskier loans to help stretched consumers afford pricier homes. "There's been a sea change in the market," says Mr. Ranieri.

By packaging loans into securities, lenders can spread their risk and issue more loans than they might otherwise. But they aren't fully insulated. Investors have been forcing lenders to buy back many dud loans, creating a sudden financial burden that has led to the closure of several smaller subprime lenders in the past two months.

A report issued by Credit Suisse on Wednesday found that nearly one in four subprime mortgage deals issued in 2006 had a delinquency rate of at least 8% as of December. The analysis looked at loans that were at least 60 days past due.

Until about three years ago, two U.S. government-sponsored companies -- Fannie Mae and Freddie Mac -- dominated the market for mortgage loans purchased from the original lenders. Fannie and Freddie package loans into securities and guarantee that holders of those securities will receive principal and interest payments. But, as Fannie and Freddie found themselves hobbled by accounting scandals, other investors flooded into the market, snapping up loans that the two companies otherwise might have bought.

As a result, the two companies' share of the market has plunged to about 40% at the end of last year from 70% in 2003, according to Inside Mortgage Finance, a trade publication.

When Fannie and Freddie dominated the market, Mr. Ranieri says, they generally set the standards for what types of loans would be made. Now, those standards are largely set by the risk appetites of thousands of hedge funds, pension funds and other money managers around the world. Emboldened by good returns on mortgage investments, they have encouraged lenders to experiment with a profusion of loans.

Many subprime borrowers aren't required to prove their financial health with tax forms or other documents. Lenders also sometimes rely on computer programs, rather than human appraisers, to estimate the value of homes.

"We don't know how much the guy makes or what the house is worth," says Mr. Ranieri.

The housing boom of recent years held defaults to very low levels because borrowers who fell behind on payments could easily sell their homes or refinance into a loan with easier terms. But as house prices have flattened or dipped in many parts of the country, far more borrowers are falling behind.

In November, payments were at least 60 days overdue on 12.9% of subprime loans packaged into mortgage securities, up from 8.1% a year earlier, according to First American LoanPerformance, a research firm in San Francisco.

Another innovation of recent years -- the collateralized debt obligation, or CDO -- has made it possible for far more investors to make bets on U.S. mortgages. They are akin to mutual funds. By investing in a single CDO, investors can gain exposure to hundreds of different mortgage securities of varying quality.

CDOs buy the bulk of the lower-rated rungs of subprime-mortgage securities, those that take some of the first hits if defaults are higher than expected, says Kedran Garrison, a CDO analyst at J.P. Morgan Chase & Co. CDOs are especially attractive to investors in Europe and Asia, as well as many in the U.S. But there is no way to identify the biggest holders of CDO notes and shares or to know how well they understand the risks and have hedged themselves.

That could be a problem for regulators. In 1998, the Fed convened investment banks and worked out a rescue plan for hedge fund Long Term Capital Management LP, which was on the verge of collapse. But in today's splintered mortgage-securities market, the Fed wouldn't be able to "get the involved players into a room" to work out a plan to help a distressed institution sell off assets in an orderly manner, says Josh Rosner, managing director of Graham Fisher & Co., a New York investment research firm.

A spokeswoman for the Fed declined to comment.

CDOs aren't the only ones on the hook. Hedge funds, mortgage real- estate investment trusts and the trading desks of Wall Street firms are among those that could be hurt if their bets on the mortgage market don't turn out as planned.