The Sub-Prime Inferno

Written By Brian Hicks

Posted March 2, 2007

What started as a mere brush fire in the sub-prime mortgage market has now quickly turned into a five-alarm blaze. Fed by tinder-dry bundles of risky loans, the fire has now singed the fingers of investors and lenders alike on one bad deal after another, as the notices of defaults begin to pile up in mailboxes around the country at a record pace.

In fact, since last December some 27 sub-prime lenders have called it quits in the face of what most of them called "deteriorating market conditions."

The industry’s biggest fire broke out during Novastar Financial’s (NFI: NYSE) conference call last week after the close.

The Kansas City, MO, mortgage lender reported a loss of $14.4 million or 39 cents a share, compared with a profit of $26.4 million or 84 cents a share a year earlier.

The losses, like those of other lenders, stemmed mostly from almost $45 million in accounting charges the company recorded in the expectation that many of their borrowers won’t be able to repay their mortgages.

News of the losses sent shares of the company into a freefall. Its investors headed for the exits on the news that the Novastar expects to recognize little, if any, taxable income in 2007 through 2011. Shares of the company have fallen over 50% as a result.

The news came only two weeks after another spill of dirty laundry from two of the industry’s top players shocked the sub-prime world.

New Century Financial, the nation’s number three sub-prime lender, had earlier warned that its earnings would come up short and alerted investors that it would have to restate its results for the quarters ended March 31 through September 30 to correct accounting errors related to loan-repurchase losses.

Meanwhile, HSBC Holdings, one of the world’s biggest banks, warned that bad-debt charges are set to exceed forecasts by about $1.76 billion. The company cited higher interest rates and a lack of refinancing options in the slowing U.S. housing market as reasons why its customers are unable to pay their mortgages.

Taken together, the bad news only heightened the sense that a credit crunch was looming just around the corner.

Given the deteriorating market, investors have become increasingly wary of sub-prime loans, which in turn has brought on higher rates as bond holders demand greater risk premiums. Additionally, the credit derivatives markets that in essence insure sub-prime bondholders against losses have dramatically fallen, substantially raising the cost of covering pools of potentially bad loans against defaults.

The net effect has been a drain on liquidity and a sales environment with substantially higher costs.


To make matters even worse, the grind of tighter underwriting guidelines has also greatly diminished the number of qualified buyers. According to industry analysts, nearly 25% of the potential sub-prime market has effectively been eliminated as lenders have tightened their purse strings.

Earlier this week, government-sponsored mortgage marketer Freddie Mac, a major player in the secondary market along with Fannie Mae, also joined the chorus. The buyer of loans announced that it was tightening the reins on risky loans and sub-prime products.

Freddie Mac said Tuesday that it would stop buying those mortgages that have "a high likelihood of excessive payment shock and possible foreclosure." Additionally, Freddie Mac said that it would limit the use of loans that don’t require income verification or other documentation, and would recommend that lenders collect adequate escrow for taxes and insurance payments.

The firm also said that its new requirements would cover mortgages known as 2/28 and 3/27 hybrid ARMs, which currently make up about three-quarters of the sub-prime market. Specifically, Freddie Mac said it would require that borrowers applying for these products be underwritten at the fully indexed and amortizing rate, as opposed to the initial "teaser" rate.

Doing so, Freddie Mac delivered yet another body blow to the pool of marginal borrowers and, by association, their lenders.

Further down the chain, the news has even greater implications for the housing market, and none of them are good. At the exact point that housing seems to be teetering on the brink of further steep declines, the contagion in the mortgage markets has now begun to pull the rug out from underneath of the bulls that were hoping for a rebound.

And regardless of their spin, the offices of the real-estate bulls are now beginning to belch smoke themselves as the shrinking pool of buyers gets even smaller.

So while David Lereah and his friends at the National Association of Realtors continue to make nice talk about bottoms, the real fire has just begun.

Unfortunately it has come at a time when the all wells have run dry.

By the way . . . a housing index released Tuesday by Standard & Poor’s showed that prices of single-family homes across the nation were flat in December, the worst results since slight price declines seen in early 1996.

David Blitzer, S&P index committee chairman, compared the decline to that of the early 1990s but said this one could be even more pronounced. "By most measures, the current slide is steeper," he said. "It could outdo the 1989, ’90, ’91 event. I don’t see any signs that we’ve hit bottom and are about to turn up,’ Blitzer said.

In a related note, according to the National Association of Realtors the nationwide median price of an existing home sold in January sank to $210,600, a drop of 3.1 percent from last year and the third-largest annual decline on record.

Total housing inventory levels also rose 2.9 percent at the end of January to 3.55 million existing homes available for sale

Not surprisingly, those figures have prompted David Lereah to call yet another bottom.


Wishing you happiness, health, and wealth,

Steve Christ, Editor

Mortage Matters will return next week.

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