FLECK: Home-loan house of cards ready to fall
by Bill Fleckenstein
1/15/2007
The collapse of the subprime credit market may come this year, with a major subprime lender going broke. The repercussions will haunt us for years.
With all the talking-head babble about our economy being "not too strong, not too weak, but just right," I think it's high time for a new entry into my "Fleckisms." I'm going to call those who take up that cause "Goldilocksters."
An optimistic lot, the Goldilocksters have been deaf to the increasing rumblings emanating from an arena that has powered our economy for the past few years: the housing market -- and specifically the financial dark matter/subprime credit spigot that has fueled its epic rise.
Bird's-eye view of a bitter housing brew
This week brings an update on the deterioration, via comments from two very knowledgeable friends. One of them, a former top executive at a subprime lender (whose chronicling of the unwind has been amazingly accurate and timely), told me that serious issues are developing, and that large companies like New Century Financial (NEW, news, msgs), Accredited Home Lenders (LEND, news, msgs) and NovaStar Financial (NFI, news, msgs) will, in his words, "hit the wall" very soon. He writes:
"We had a loan that was FPD (first-payment default) on a home in So Cal. It is a very nice high-end town that had a section of new homes built . . . in the low end of town. Normal homes sold for $1 million in value. In this new seven-home development, (homes) sold for $1.3 million to $1.5 million each. The homes you had to drive through to get to this place were worth $400,000 to $500,000. The market topped out, and now most of the seven homes are vacant -- worth no more than $900,000. Thus, all the lenders are sitting on losses of $400,000 to $600,000. This is just one of many that are happening daily.
"The commentary I am getting from field and legit brokers is that fraud is an out-of-control locomotive. Stated-income loans are now finished for all the unemployed people around. We will quickly see cash-out loans curtailed. This vicious cycle has yet to play out. We are in the second inning of the unwinding.
"It is really getting serious. We had a borrower in So Cal who cut and pasted bank-statement copies of Washington Mutual to make it look like he had $400,000 average balances in his account to buy a $1.7 million home. Something did not seem right. Lo and behold, we checked very closely with the bank. The borrower had only $500 in his account. This is also just one of many examples happening daily.
"I am truly worried about the aftermath once it is resolved. It truly becomes a vicious cycle. Each time guidelines are pulled back, fewer buyers can buy homes. Thus, lower property values, and more people underwater. The debt piles up on homeowners' balance sheets, and people consume less.
"This will, and should, take years to play out. (Federal Reserve Chairman Ben) Bernanke will yield to the Lobby and the Street, trying once again to lower rates and allow people to bail themselves out, while in turn allowing the buyout firms of the world to overpay for the companies they buy with easy money. The game is so rigged against honesty, it boggles the mind. I worry about our children having a chance to have a future, at this point."
In the beginning, there was financial darkness
I am not as sure as he is that it will take "years" to play out. The damage will last for years, but the crackup that precedes the big damage will happen this year, I think. Meanwhile, the other friend, a broker who deals in the financial dark matter universe, noted that the risky BBB-minus tranche of the June 2002 ABX.HE (a synthetic version of assets backed by U.S. home loans) just traded at a new low -- down more than eight points from early September. (For a review and the key definitions, please see my September column "Voodoo debt and the coming recession.") Its credit-default swap has now blown out to 477 basis points. Although the BBB-minus tranche is just a fraction of the $1 trillion subprime market, it seems impossible to me that a train wreck there will not have ramifications. Here is how this friend described where he thinks we are -- and what comes next:
"The subprime trade continues to evolve. Stage one was the turn in the housing market in July 2005. Ironically, stage two occurred in September 2006, a month after home builder stocks bottomed, when spreads on subprime home-equity loan securitizations started to widen. I think we are now into stage three, where some of the bigger listed subprime lenders start to get hit. That might bring the ongoing problems in subprime to a wider audience. Stage four is when a top-three-listed subprime lender goes broke, leaving various Wall St. firms saddled with bad loans. Stage five is when the market really gets it, and eurodollars (at least for a time) start to rally hard as the market fears some kind of financial turmoil. We're not there yet, as we are just now entering stage three, but do not take your eye off subprime for a second."
I hope this behind-the-scenes peek at the mortgage market will help readers navigate the difficult period that lies ahead.
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