Subprime lending's next act

By Maya Roney

updated 2:52 p.m. ET March 13, 2007

Sour subprime loans have devastated lenders, dashed the hopes of borrowers, disappointed banks, and demanded tighter standards—but has the recent shake-up altered the risky mortgage landscape for good?

Not likely. Though many lenders have already closed up shop and others are headed toward extinction, lending to home buyers with weak credit at high interest rates is much too profitable a business to go away completely, especially for those lenders that know how to underwrite carefully and box their risk.

"The industry has been down this road before," says Bennet Koren, a banking industry attorney with McGlinchey Stafford in New Orleans, who has represented finance companies and mortgage lenders. "At the end of the day, there was still a demand for the product."

Ever hear of United Companies Financial Corp.? The Baton Rouge, La. mortgage company, which filed for bankruptcy in March, 1999, was one of many subprime lenders to liquidate in the late 1990s when financial markets hit a bump.

New Century Financial managed to pull through a similar liquidity crisis in the late 1990s. But the company, which is facing a criminal accounting probe and has stopped accepting loan applications because some of its creditors are refusing to provide access to financing, could face Chapter 11 this time around. The Irvine, Calif. company's stock has dropped from $30 to $3 in the last month.

Shares of other lenders with sizable subprime businesses, including NovaStar Financial  and Fremont General, have also gotten hammered. Fremont has said it plans to sell its subprime business, which accounts for half of the company's total operations. NovaStar expects to recognize little or no taxable income between 2007 and 2011 and may consequently lose its status as a real estate investment trust.

Many analysts see little possibility of recovery for lenders like New Century and NovaStar. But even if these companies fall of the face of the earth, "two or three years from now there will be new subprime companies," Koren says.

Good deals
And there may still be hope — bargain hunters are already snatching up battered mortgage stocks. On Mar. 7, shares of Fremont General surged over 25% on news that as many as six suitors were interested in buying its residential mortgage business. The same day, New Century and NovaStar saw significant stock increases. "I'm not going to bet my retirement on it, but if I had any guts I'd buy [New Century and NovaStar's] stock right now," says Koren.

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Though the industry should cycle upward in the long term, there's no doubt that the playing field for subprime lending will look a little rocky in the interim. The market for subprime loans will shrink as the fallout leads to fewer players and more negotiation with prospective borrowers. According to Standard & Poor's equity analyst Stuart Plesser, "2007 is going to be a tough year [for lenders]." "But toward the latter part of 2007 and 2008 the subprime mortgage origination business is going to be a lucrative business for the people who stay in."

With fewer independent lenders around, commercial banks may dominate the subprime lending scene over the next couple of years. Since banks are both lending to lenders and buying those lenders' mortgages on their own, "it's in their best interest to drive [the lenders] out of business," Plesser adds.

Banks better positioned
Because they are diversified, banks won't suffer as much from rising subprime mortgage defaults. "In the scheme of things it's a small part of their overall business," says S&P equity analyst Matt Albrecht. After issuing a profit warning on Feb. 8, banking giant HSBC Holdings suffered $10.6 billion in losses on bad loans from its U.S. subprime mortgage operations in 2006, but said profit still rose 5% over 2005.

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Albrecht recently downgraded Merrill Lynch and Lehman Brothers on concerns about the banks' subprime portfolios; he says Lehman, along with Bear Stearns, is nevertheless best positioned to weather the subprime storm. Merrill and Morgan Stanley are less experienced in loan securitization and may consequently get hit harder, Albrecht says.

Last year banks were still showing interest in subprime loan companies despite the increasingly clear risk they pose. Bear Stearns completed a takeover of subprime lender Encore Credit in October, 2006, and Citigroup struck a deal to provide funds to ACC Capital Holdings, the parent of subprime lender Ameriquest Mortgage.

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