House of NextCard Collapses

Subprime lending will claim many more victims before it's over.
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Neither a subprime borrower nor a subprime lender be.

One business that benefited massively during the roaring '90s was lending at high interest rates to people with weak credit histories. However, that activity, known as subprime lending, is now collapsing, as the economy slows, job losses mount and bank regulators toughen up.

Consumer lender

NextCard

(NXCD)

blew up Wednesday after scrutiny from federal watchdogs. In recent weeks, mobile home lender

Conseco and credit card company

Providian

(PVN)

have revealed numbers that show dire outlooks. Fearing similar problems at auto lender

AmeriCredit and credit card lender

Metris, investors have rushed to dump both names.

"A perfect storm is hitting the subprime sector," says Bill Ryan, analyst at Ventana Capital, a New York-based brokerage. "Economic growth is slowing, credit problems are getting worse and regulators are clamping down."

Messy

How did we ever get into this mess?

NextCard's story says a lot. The stock plunged 84% Wednesday to under $1 after the lender told investors that regulators had demanded that the company clean up its financials, increase protection against bad loans and exit certain business lines. No doubt realizing that it would have a tough time raising new capital to stay in business, NextCard has put itself up for sale, retaining Goldman Sachs to find buyers. After its IPO in 1999, NextCard traded over $40.

The big selling point behind NextCard was supposed to be its cutting-edge technology that allowed it to lend to the right people at the right interest rate. An added bonus was that it took applications over the Internet. Analysts were wowed. On the Bankstocks.com web site, Salil Mehta, an analyst with the Second Curve Capital hedge fund, called NextCard the "single best-positioned, most attractive Web-oriented stock on planet Earth." (Second Curve held 2.8 million shares in NextCard at the end of June, according to Lionshares.com.) When asked about this stance, Mehta replied in an email: "It is difficult for opinions to hold up when the regulators change the rules in the middle of the game."

Ah, Deadbeats

Nearly all consumer lenders have boasted about their technological expertise.

Capital One, Providian, AmeriCredit and Metris have waxed lyrical about their credit-scoring models.

Their shortcomings are becoming apparent. Subprime lending models appear to work fine when the economy is booming. During the go-go years, interest rates may look high, but because the deadbeats aren't defaulting in large numbers, the "risk-pricing" seems to be correct.

But, as the credit cycle turns, many more loans go bad than lenders expect. The answer might be to push up rates even higher to cover the new risks associated with a stagnant economy. But fewer people would want to borrow at higher levels. Moreover, higher rates would be even harder to pay back, meaning higher losses. That is the subprime paradox.

But this is not just a story of whiz kids screwing up their spreadsheets; there's a seamier side to subprime. These lenders appear to be using misleading marketing practices and other tactics to bilk customers of fees. Notice that NextCard was told by regulators to suspend certain "repricing programs and fee-based product strategies," according to its press release.

Similarly,

Metris has gotten into trouble with a federal regulator and the

New York attorney general over marketing and fee practices.

So, who's to blame? Ultimately, the

Fed

and Alan Greenspan, for fueling the massive credit expansion seen over the past 10 years. Historians of booms have noted that dodgy lending practices actually increase in buoyant but overstimulated economies, not decrease. The subprime collapse proves that once again. The regulators were too slow to jump on the offenders. Investors bought the baloney managements fed them. That includes some of the nation's largest mutual fund families. For instance, Fidelity's highly rated Contrafund has been a massive holder of Conseco stock. (A Fidelity spokesman declined to comment on the Conseco holding.) Can't wait for Peter Lynch to mention that pick on those ubiquitous ads.

Fee Simple

And most brokerage analysts took an unquestioning stance. The massive fees that are generated for brokerages that sell lenders' loans may explain the analysts' consistent bullishness on subprime. But some even continue to believe as the subprime sector crumbles around them.

Take Robbie Stephens' Jordan Hymowitz. In a note published Wednesday, Hymowitz points out the differences between Metris and Nextcard, as he sees them. He writes that Metris "does not seek to finagle every dime away from its customers, which could lead to consumer/regulator complaints." Nowhere, repeat nowhere, does Hymowitz mention the fact that earlier this month Metris had a nasty run-in with the New York attorney general due to consumer complaints. (Hymowitz didn't return a call seeking comment.)

But we shouldn't get too upset. The racket has started to unwind. Metris was down another 10% Wednesday, and Conseco 20%. The market is making sure that justice gets done. And it is sweet to behold.

Know any companies that the market may be misvaluing? Detox would like to hear about them. Please send all feedback to

peavis@thestreet.com.

In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.