360 Degrees of Subprime Lending

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.