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.
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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