No Canary in the Coal Mine

Markets were pounded today in what could be the beginning of the second down leg of the correction. Who knows how long or how far the correction will go, but one thing we do know is that nothing's changed. Positive fundamentals remain in place, the global economy is doing very well, and stocks' recent movements appear to be completely psychological.

Today's headlines are doing what they can to call the subprime market the "canary in the coal mine," portending bigger doom and gloom down the road:

U.S. Subprime Mortgage Delinquencies at 4-Year High
By Sharon L. Crenson and Kathleen M. Howley, Bloomberg
https://www.bloomberg.com/apps/news?pid=20601087&sid=aY_SKqJZEdbQ&refer=home

We've written a great deal about the subprime market and the stock market correction recently. See these past commentaries:
• "Don't Go Blind from the Subprime"
• "New Century, Old Worries"
• "Separating the Muck from the Mire"
• "A Bull Market Sell-Off"

What's more, 10 year Treasury yields sank back to below 4.5% today. Even if a small portion of variable loans are truly unpayable and foreclose, it's not going to kill the broader market. Rates are decreasing, not increasing. Interest rates today are very unlikely to price anyone out of the housing market who could afford it a year ago.

And if all that isn't enough to keep your teeth from chattering in fear, here's a bit of analysis on the subprime market from MarketMinder columnist Aaron Anderson:

It's looking increasingly like New Century, the second largest mortgage lender in the US, will join more than two dozen other, smaller subprime lenders by filing bankruptcy in the near future. New Century's problems stem from an upswing in mortgages New Century is required to buy back from banks and Wall Street firms that purchased the mortgages with the intention of securitizing and selling them as mortgage backed securities. Banks can force mortgage originators to repurchase mortgages if borrowers are delinquent in their payments in the first few months or if there are errors or omissions in the loan paperwork completed by the borrowers. The latter are known at "scratch & dent" loans.

Mortgage originators like New Century don't collect deposits, so they rely on short term financing from banks and Wall Street firms in order to make new loans. In many cases, these are the same firms that end up purchasing the loans from the mortgage originators. As a result, many banks have exposure to mortgage originators on two fronts – in the loans they make to the mortgage originators and in the loans they buy from the mortgage originators if they choose to push those loans back. For example, the Wall Street Journal reported that Morgan Stanley has $2.5 billion in repurchase claims against New Century. Morgan Stanley is also one of New Century's largest lenders, paying as much as $265 million in emergency financing just last week (although the funding was discontinued when other lenders refused to continue funding). In total, New Century could face as much as $8.4 billion in repurchase obligations, an amount that would undoubtedly force the company into bankruptcy.

The market seems to be concerned that the subprime market is a canary in the coal mine, and subprime woes will impact the overall mortgage markets and further slow the US housing market. However, the problems in the subprime market seem to be contained to the most aggressive lenders. New Century was well known as a company that utilized outside brokers to generate new loans, and did little in terms of verifying property values or borrowers' ability to pay.

Standards were so lax at New Century that in December 2006, borrowers failed to make even the first payment on 2.5% of New Century's loans. This morning, New Century announced it is being investigated by the SEC and it received a grand jury subpoena. In addition, the NYSE announced New Century shares will be delisted.

Even before the stock price collapsed, New Century was only valued at about $2 billion. It shouldn't be surprising the media focuses all its attention on the failings of $2 billion New Century and not on the successes of other much larger companies participating in the mortgage game. As of yet, there doesn't seem to be any evidence subprime delinquencies are making their way into the overall mortgage market. Yesterday, Countrywide Financial, the biggest US mortgage lender, indicated the percent of overall loans 30 days past due was unchanged in February at 4.71%. This number is up from 4.29% a year ago, but this increase is almost entirely a result of an increase in subprime delinquencies. Countrywide also indicated that almost a fifth of the subprime loans it services for others were delinquent.

The main impact of the subprime shakeout could be a longer period of lackluster returns in the real estate market. As lenders tighten their lending standards, fewer potential home buyers will have access to mortgage loans. Several lenders have indicated they no longer intend to finance 100% of a home's value (no down payment) and many will also cease accepting stated income to qualify borrowers. That means the housing supply glut could take longer to work through although low interest rates should prevent a significant downturn in housing prices.