Bargains and Blowups in the Subprimes, Part 1
By Graham Summers
February 26, 2007
Subprime lenders got hammered again this week when NovaStar Financial (NFI) announced that it would have no taxable income for the next four years. Even worse, the company stated it might have to drop its real estate investment trust (REIT) status, a move that would end its tax advantages.
NFI shares dropped more than 40% on Wednesday. The rest of the subprime sector followed suit.
We are effectively witnessing what happens when the fine print of the credit bubble finally takes effect. For years, banks have loaned money to prime and subprime lenders, which have in turn made loans to consumers with faulty credit.
Many of these mortgages were "stated income" loans: loans in which the borrower simply stated how much he or she made, without providing any evidence to support the claims. In this setup, a middle-school teacher could walk into a subprime lender, claim an annual income of $250,000, and receive a million-dollar loan.
Sometimes called NINA loans (no income, no asset), these borderline-fraudulent mortgages comprise an estimated 40% ($500 billion to $600 billion) of the subprime-lending market.
In other words, nearly half of the money loaned to consumers with bad credit was based on the borrower's "word," rather than any real income or collateral. Not that anyone really cared about this when the banks were lending money at 1% or less.
However, since 2003, the Federal Reserve has raised interest rates 17 consecutive times to 5.25%. Those mortgages and loan payments rose with each hike, and suddenly borrowers' pretend income isn't covering the monthly payments.
Last year, foreclosures and missed payments started to show up in the income statements of the subprimes. And the fireworks began. All in all, 23 subprime lenders have closed shop or declared bankruptcy in 2006.
More are on the way...
The entire subprime sector is trading at or around its 52-week low. It's easily one of the most hated sectors in the world right now. The issue now is to determine which of these companies are bargains and which are bombs ready to blow.
The deciding factor here is the big banks: UBS, HSBC, Barclay's, Goldman Sachs, Wachovia, etc. If the banks decide to pull the plug on subprimes and demand their loans back, then, lights out.
It's all a question of liquidity.
Most contracts between the big banks and subprimes require that the latter maintain a certain level of liquidity. That is, the banks require a certain amount of cash to be on hand to cover whatever losses the NINA loans generate. If a subprime doesn't keep enough money as collateral, the bank can terminate the contracts, forcing the subprime to go bankrupt as it ponies up cash for the loans.
We'll cover the liquidity requirements of some major subprimes in the next installment. Until then...
Good trading,
Graham
