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     Mar 16, 2007
The subprime dominoes in motion
By Julian Delasantellis

An earlier article [1] argued that the big worldwide stock-market declines of February 27 were not a result of that day's selling on the Shanghai Stock Exchange. A more important factor was the growing realization that real credit problems were developing in the United States' subprime mortgage sector, where prospective homebuyers with less-than-stellar credit histories obtain mortgage financing.

Since then, media outlets from Beijing's People's Daily to Pat Robertson's 700 Club have taken note of the problems with

subprimes. And over the past few weeks, matters have gotten a lot worse.

The subprime mortgage industry in the United States is in the process of being eaten alive. From March 5 to March 13, shares of the four top pure subprime mortgage players, New Century Financial, Fremont General, Accredited Home Lenders and Novastar Financial, were down an average of 43%.

Since February 5, when HSBC reported on its subprime mortgage problems and it began to dawn on investors just how serious the problems in this sector had become, these stocks are down an average of 80%. The once-high-flying New Century Financial is down 97% and has been delisted from the New York Stock Exchange.

As with the flexible morality that accompanied the Internet bubble, questions are now being raised whether these banks' business relationships with stock-brokerage houses clouded the advice produced by the brokerages for average investors.

Massachusetts Secretary of State William Galvin has issued subpoenas to investigate Bear Stearns' March 1 ratings upgrade (in essence, a "buy this stock" recommendation) of New Century. In the eight days after the upgrade, the stock declined 94%.

The pure subprime mortgage lenders are most likely soon destined for the dustbins of history, but the real potential problems lie in the extent to which the large, powerful institutions of Wall Street were exposed to subprimes.

In retrospect, one might argue that they should have known better. But the questions remain: Did they extend credit or short-term loans to subprime lenders? Did they buy collateralized mortgage securities to hold in their own portfolios? Did they, through the clever camouflage afforded by a supposedly arm's-length subsidiary, actually write their own subprime mortgages?

No one really knows, but Wall Street fears that the answer is yes.
H&R Block has reported that its otherwise profitable tax unit was dragged down by losses at its Option One Mortgage Division and its stock is down 18% from February 5. Countrywide Financial is the market leader in the US mortgage business, and its stock is down 24%. Washington Mutual, meanwhile, the biggest US bank-mortgage originator, is down 12%.

The fear is that both will soon report that their excellent revenue numbers of the past few years were pumped up with subprimes. Even the stocks of Goldman Sachs, the US finance capital's golden goddess, which lately has been feasting on the fatted calf of the private-equity buyout boom, [2] declined 10% from February 5 to March 5.

The fear driving down the big names is that through the good times they had became way too involved with the subprime market and its now-doomed institutions. As the New Centurys of the world sink, their wake will pull down the big names as well.

Every debt that the subprime mortgage companies owe them, be it a standard loan, an outstanding letter of credit or a securitized mortgage bond, the big institutions carry as an asset. If those loans or bonds don't get paid back, the big institutions are required to "write down", to subtract, the value of these obligations from their balance sheets. This will result in billions of dollars of corporate value disappearing, and in that instant, the US and the world economy will be a lot poorer.

But the most scary part of the ride is what this all means beyond Wall Street. On Tuesday, Countrywide Financial chief executive officer Angelo Mozila warned that the US lending industry has entered what he calls a "liquidity crisis". This is a gentle way of stating that the engine that is supposed to provide new housing finance to US homebuyers, and to the US economy, is seizing up.

Lenders are now demanding that prospective borrowers actually prove both their ability and, even more remarkable, their desire to pay back their mortgages. Until recently, that was considered, well, just so quaint.

Consider, too, if you combine this factor, which will significantly hold down housing demand, with the fact that all the mortgages being defaulted on today will result in fire-sale bank-foreclosure auctions tomorrow. You suddenly have a lot less demand and a lot more supply - the exact reverse of the conditions that stoked the great real-estate boom of the early part of this decade.

So far the US real-estate sector has avoided the fate that many economic observers say is its rightful due - a crash following a boom. Nevertheless, forced liquidation of excessively leveraged buyers' assets has traditionally been the starter's pistol of the worst parts of financial panic. And that is what the US real-estate market faces now - let alone the separate and equally grave problems of demand.

In 1843, Charles Mackay published the first, and still arguably the best, tome on financial-market manias and panics, Extraordinary Popular Delusions and the Madness of Crowds. He stated:
We find that whole communities suddenly fix their minds upon one object, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first ... Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper ... Melancholy as all these delusions were in their ultimate results, their history is most amusing.
Perhaps it will take time. But those who are now being forced to sell homes on which they can't make payments to buyers who won't qualify for mortgages, or who have seen their retirement savings vanish along with the subprime lenders' equity values, are not feeling very amused.

1. Rocking the subprime house of cards, Asia Times Online, March 6, 2007.
2. The highs and lows of buyouts , Asia Times Online, February 22, 2007.

Julian Delasantellis is a management consultant, private investor and instructor in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.

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Rocking the subprime house of cards (Mar 5, '07)

The highs and lows of buyouts (Feb 22, '07)



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