360 Degrees of Subprime Lending

RealMoney Staff

Editor's Note: In this edition of "360 Degrees," commentators Jim Cramer, Doug Kass and Joe Capone examine the subprime lending market.

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Subprime May Give Fed Crisis Cover

By James J. Cramer

This was originally published on RealMoney on Feb. 15 at 1:36 p.m. ET.

Bring on the bad!

I wish the bears understood how important subprime lending is to my thesis about the market going higher. But then again, if they did, they would be forced to cover everything.

For as long as I have been at this game, it has taken a crisis for the Federal Reserve to move. The Fed is always reluctant to move because it needs the crisis as a cover so it doesn't look like it's soft on inflation. Maybe you think we have good growth in this country; I think we just have easy retail comparisons because of nat gas and gasoline bills being down but that in reality we're in a slump that the international portions of our great businesses are saving.

That's not enough for the Fed to cut on. That's not obvious enough.

Ah, but if all of the subprime lenders pull out of that market and if Merrill(MER Quote) and Bear(BSC Quote) and Lehman(LEH Quote) -- big subprime lenders via acquisition -- start saying "it's a crisis" and New Century(NEW Quote) goes belly-up or Accredited Home(LEND Quote) takes down a big part of its book value or Countrywide(CFC Quote) leaves the business -- then we'll have a crisis that can justify not one but maybe three or four cuts.

When you have the housing industry building a fraction of the homes it was building and credit hard to come by, you are giving Benanke the crisis cover he needs.

Some of my friends who read RealMoney are freaking out about the negative columns that are being written about how dangerous this subprime crisis is. I'm taking those columns very seriously, which is why I am growing more bullish by the day. The fact that the Fed chairman bought into it today in front of the House of Representatives shows me that the Congressional drumbeat -- remember, prime is Republican, subprime is Democrat -- could be building and building fast.

Am I Mr. Brightside? No, I believe that subprime's awful, even worse than the bears think. When I look at the cancellations that a KB(KBH Quote) or a Toll(TOL Quote) has, I know that the same rate applies to those who took these loans down. That's maybe 30%-40%, not the 7%-10% default that their models presume when employment is this low.

If anything, they're saying there might be a fire. I say it's raging, which is why I believe the crisis is about to give us that May cut that I am counting on to take the Dow up 17% this year.

At the time of publication, Cramer had no positions in any of the stocks mentioned in this post.

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Subprime Fungus Will Spread

By Doug Kass

This was originally published on Street Insight on Feb. 15 at 9:27 a.m. ET.

Wednesday saw another large mortgage bank, Silver State Mortgage, cease originating subprime loans. Silver State Mortgage was, according to National Mortgage News, one of the fastest-growing wholesale lenders in the country.

The relatively healthy subprime originators, like Washington Mutual's (WM Quote) Long Beach Mortgage, are downsizing around the country faster than you can say BBB-minus.

And the subprime mortgage shakeout is the subject of the lead article in today's Wall Street Journal.

In a related note, Standard & Poor's might have been reading my story from last week as they downgraded ratings on 18 securities from 11 mortgage-backed bond issues and put on review a number of other bonds sold by units of Goldman Sachs(GS Quote), Lehman Brothers(LEH Quote), Barclays Capital, Countrywide Financial(CFC Quote) and New Century Financial(NEW Quote) on Wednesday.

Many in the media (from Jim "El Capitan" Cramer to Sir Larry Kudlow to Bob Pisani) have opined that the bears "don't understand the conditions under which real estate markets collapse, and these conditions (suggestive of a broadening credit problem) are not present." And, in a series of perfunctory conference calls over the last week, the leading brokerages have supported their case that there will not be a credit contagion emanating from subprime lending and that the brokerage exposure will be contained and limited, even though none of the banks disclosed their involvement in the subprime market (as agents and as principals).

It appears that the principal reason these observers are ignoring the subprime problem and its ramifications is that the equity markets are ignoring them. Ergo, it must not be a problem. This is the definition of a Goldilocks mindset (see no evil, hear no evil), not a Goldilocks scenario.

The subprime carnage (like HSBC's nearly $2 billion addition to subprime loan losses in the fourth quarter 2006) is ignored as is the commentary from merchant builders like KB Home(KBH Quote) (below) and others (perhaps because their stock prices are also rising).

We began 2006 with a strong backlog that produced record deliveries. However, as the year progressed, market conditions worsened, cancellations increased, net orders declined and margins came under pressure. The result was a 2006 year-end backlog substantially below the year-earlier level. At a minimum this will likely result in a year over year decrease in our unit deliveries through the first half of 2007 and potentially longer.
-- KB Home CEO Jeffrey Mezger (Feb. 13, 2007)

Two Toxic Reagents

The credit containment argument ignores the parabolic growth and rising role of subprime lending (relative to total mortgage industry loans) -- never before have lenders relied more on the candor and integrity of borrowers, and never before have underwriting terms been so lax. These are two toxic reagents, especially within the context of the biggest housing boom in history, in which real estate mortgage receivables have mushroomed to all-time records at the major (and minor) banks.

The "dot condo" CondoFlip Web site that encouraged investors/speculators to day-trade condominiums (and proudly declared that "Bubbles are for Bathtubs") has been dismantled and is no longer operational, replaced by a Condo Super Center. The site now admits, in a mea culpa, that "the condo boom was driven by overly-ambitious speculators, many of whom had been successful in flipping condos in the past. As condo inventories grew and prices rose, many speculators realized that further purchasing was increasingly risky. So, buyers just stopped buying."

There is an emerging credit crisis and it will lead to rapidly rising charge-offs. Construction lending on land and condominium loans are the next area to implode (examples of exposed intermediaries are Fulton Financial, National City and Corus Bancshares).

As night follows day, the enormous securitization markets will shortly begin to demonstrate the same sort of delinquencies we have witnessed in subprime mortgage lending. Then a continued acceleration of subprime loan problems will creep into the prime market (where equally creative mortgage loans have been made to prime borrowers).

Restrictive credit practices are just beginning to unfold as a consequence of the poor underwriting standards applied over the last decade. The more things change, the more they stay the same.

At time of publication, Kass and/or his funds had no positions in stocks mentioned, although holdings can change at any time.

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Too Late to Short Subprime

By Joe Capone

This was originally published on RealMoney on Feb. 15 at 2:21 p.m. ET.

Every market participant knows that the subprime mortgage industry is struggling and that many marginal players are being shut down. In the past several months, 22 subprime mortgage companies have been closed or acquired. The cost to insure against losses in subprime loans has soared.

And most people who own a house, live in a house or want to buy a house think they know everything about real estate. However, that doesn't mean they should go all-in shorting these mortgage stocks now. While short interest in the group is tremendous, I believe short sales are now too late.

I want to go through why I bought some shares of New Century (NEW Quote) after its recent decline from above $30 to below $20, sparked by a warning of an unexpected fourth-quarter loss.

I'm not suggesting this trade, as I believe owning these shares involves far too much homework for nonprofessional investors. Instead, I'd like to use it as a talking point for why the short thesis may have run its course for these names.

New Century was the second-largest originator of subprime loans in the third quarter, with $13.8 billion (behind Wells Fargo (WFC Quote)). It's also a large servicer of subprime mortgages, although not in the top 10. In addition, New Century is a real estate investment trust, which means that it must distribute more than 90% of its taxable income to shareholders but that it's not taxed at the corporate level.

Given the recent news at the company, its competitors and the market in general, I asked myself three questions: Will this company survive? What is its "true" book value? What can it earn off that book value in 2008 and beyond, after the subprime crunch abates? Let's try to answer them.

Survivability

With most lenders, survivability is about confidence in whether it will retain its funding during times of distress. New Century stated it had cash and excess liquidity of $350 million (not a tremendous amount) as of Dec. 31. It does have substantial room (multiple billions) in its warehouse facilities, which are lending arrangements with firms like Morgan Stanley (MS Quote) and UBS that agree to finance New Century's originations until New Century can sell or securitize those loans.

Because New Century's current financials will require restatement, it is likely in violation of covenants on those facilities, but there may be room for negotiation, as Wall Street probably wants to keep the major players standing. Surely, the eventual investors will want the ability to put defaulted loans back to their originator.

Generally, if a lender is to be shuttered, it happens quickly. This is intensely speculative, but I believe New Century has already passed the point where if it were to be closed, we'd know. I believe even plain survivability could prompt a rally in the shares.

True Book Value

To calculate this, I start with Sept. 30 numbers and then adjust for writedowns. Stated equity in the third quarter was $2.06 billion. Subtract $95 million of goodwill, which is an intangible asset. Divide by the fully diluted share count of 56.5 million for $34.82 per share. The company stated it is making two major adjustments.

First, it is writing down its residual assets. For New Century, these are retained interests in its securitizations. Its valuation is based on the assumptions it made when the loans were originated and packaged. Default rates, prepayment rates and the like factor into the equation. We all know the market has worsened, so I estimate a 50% writedown. (This is more punitive than most sell-side analysts have estimated, but I think it is prudent.) This results in an after-tax writedown of $1.19 per share.

Second, it needs to record a reserve for early payment defaults. In the second and third quarters of 2006, it misapplied an accounting rule and did not adequately reserve for these defaults. Some have speculated that as many as 10% of loans originated are or will be in early payment default status -- that is, missing one or more of the first three to six payments, triggering a repurchase request from the warehouse lender and/or securitizer to the originator.

On a Feb. 14 conference call, Accredited Home Lenders (LEND Quote), a well-run company that makes similar loans, said it was conservatively predicting 2% of loans originated would be in early payment default. If we take 2% of New Century's 2006 originations and write them down by 20% (remember: New Century itself does not lend 100% of home values), that results in a writedown of $2.18 per share. Adjusted book value is $31.45.

I want to be more conservative, though. Tighter underwriting guidelines, less origination going forward (it said it would originate at least 20% lower in 2007 than in 2006) and possible litigation reserves for shareholder lawsuits could take another $1.45 off book value after tax. Therefore, I use $30 for adjusted book value.

Profitability

I will say it upfront: I don't expect any pure-play subprime originators to make money in 2007. This is a cyclical business, and cyclical companies don't usually make money in the trough. That said, the consolidation of this business, the permanent growth in nontraditional mortgages and New Century's scale suggests to me that 15% return on equity (pretax) is possible as we move into 2008 and 2009. I will provide updates on this in the future as we see the landscape unfold.

Bottom Line

At $20, or two-thirds of my adjusted book value estimate, short plays here seem risky. As this market turns, I expect shares of New Century and its peers to come close to book value. I also expect short-sellers to cover and move elsewhere.

A great security to look at is the ABX-HE (BBB-) 06-2, available on markit.com for individual investors. This is an index of BBB- rated securities of subprime originated loans in late 2006 and a good "fear gauge" for subprime. As many have discussed, these securities were in free fall, well below where the index components traded, but people want to hedge. The index made a small turn upward yesterday.

It's too soon to see if fear is permanently abating, but the easy money has been made shorting. I'm focused on trying to buy the right securities for the turn.

At the time of publication, Capone and/or his fund was long New Century, although positions may change at any time.

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