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Kass: Subpar Subprime a Growing Problem

The economic risks are numerous for these lenders.

These items by Doug Kass were originally published on Feb. 8 on Street Insight. The original version contained an error that has been corrected. They are being republished as a bonus for and readers. For more information about subscribing to Street Insight, please click here .

Takeover Rumors Abound

2/8/2007 10:03 AM EST

Rumors of takeovers of




Circuit City

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abound on trading desks today, which could explain the higher moves in the stock - OMX up about 5%, and CC up about 4%.

Fungus Among Us

2/8/2007 8:35 AM EST

Over the last several months I have been

writing on Street Insight

and talking on


"Kudlow & Co." about the ramifications of the developing implosion in the subprime mortgage market.

Last night there was more evidence:

HSBC Holdings



New Century Financial

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-- two of the three largest subprime mortgage lenders in the U.S. -- reported disastrous credit losses stemming from their real estate origination businesses.

HSBC announced that its allowance for bad debts will rise to $10.6 billion (more than $1.75 billion above estimates) and New Century (whose stock fell nearly 20% on the news on Wednesday evening) projected a fourth-quarter loss and the need to restate its prior quarters because it materially understated subprime delinquencies and foreclosures.

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Nationwide, the subprime default rate soared to 10.09% in November 2006 -- it stood at only 6.62% a year earlier). Despite a growing economy in early 2007, November's industry default rate exceeded the level of November 2001, which was recorded at the bottom of the last recession. However, the problem runs deeper than 5 1/2 years ago because nearly 15% of the mortgages made in 2006 were subprime. That is almost triple the penetration of subprime compared to 2000-01.

Making matters worse:

  • Subprime has never been more levered -- just as the housing cycle has peaked. Loan-to-value ratios have risen from about 78% in 2000 to 86% today.
  • Subprime has never been more dependent on the candor of borrowers. Low-documented loans have doubled to 42% of subprime loans over the last six years.
  • Creative loans -- non-interest paying, option ARMs, etc. -- represented nearly half of all loans made over the last 12 months. At the turn of the decade these loans represented less than 2% of total mortgage loans!

Before the extraordinary start in home-price appreciation six years ago, bank charge-offs for home mortgages peaked at 45 basis points. If we simply move to that level again (and considering the above three factors, this seems reasonable), that would imply more than $40 billion in charge-offs.

However, given the alarming swiftness in recent foreclosures and delinquencies, debt downgrades of subprime pools and looser standards that accompany mortgage loan "innovation," it is hard to believe charge-offs won't exceed the 2001 levels.

Many have dismissed the subprime risk, even though originators like Sebring Capital and Ownit Mortgage Solutions were filing bankruptcy in late 2006 faster than you could say "five-year balloon mortgage."

For that matter, many other economic risks also have been dismissed, including the bubble in credit availability, a spent-up consumer, tightening labor markets and lower productivity, the rising CRB RIND Index and the attendant cost-push inflation.

Also dismissed are the bubble in emerging markets, a levered and vulnerable (long-biased hedge fund and fund of funds (especially of a Swiss-kind) industries, the broad and negative tax implications of the Democratic tsunami and a more hawkish

Federal Reserve

than many


as being compartmentalized with little chance of a broader contagion.

After all, an investor base immersed and captivated by "Cramerica" sees no evil and hears no evil, as the market just chugs along ever higher (13 out of the last 14 months have boasted positive returns).

That fungus of subprime credits is now clearly not only among us but it is now upon us, and the implications for a tightening in mortgage credit will likely serve to contribute to the second leg down in housing over the balance of 2007.

The tidal wave of liquidity and cheap borrowing over the last seven years -- which has permeated the mortgage, private-equity and stock markets -- has created an attitude toward risk-taking unlike almost anything ever seen before.

Except for a brief period in late 1999-early 2000, the spread of risk taking to risk aversion has never been wider. Like eight years ago, this condition has produced a market that is currently priced for perfection, poorly positioned for any unpleasant surprises.

We entered 2006 with most investors holding the highest degree of confidence in rising prices for their homes. As it turns out, homeowners were materially disappointed last year.

We enter 2007 with investors having the highest degree of confidence in rising prices for their stock holdings. They too might be disappointed as the year progresses when the hidden fragility of an overpriced, overleveraged world will soon be revealed.

I have written that "in time we will undoubtedly see a mean reversion in home prices, interest rates, credit spreads (and losses), corporate profit margins ... and in the world's equity prices."

Last night's subprime mortgage news that credit losses are skyrocketing is the first shot across the bow of the boat called market optimism.

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

Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd. Until 1996, he was senior portfolio manager at Omega Advisors, a $4 billion investment partnership. Before that he was executive senior vice president and director of institutional equities of First Albany Corporation and JW Charles/CSG. He also was a General Partner of Glickenhaus & Co., and held various positions with Putnam Management and Kidder, Peabody. Kass received his bachelor's from Alfred University, and received a master's of business administration in finance from the University of Pennsylvania's Wharton School in 1972. He co-authored "Citibank: The Ralph Nader Report" with Nader and the Center for the Study of Responsive Law and currently serves as a guest host on CNBC's "Squawk Box."

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