Only the Strongest Sub-Prime Lenders Will Survive

A recent article from Forbes states that 42% of the loans issued by New Century Financial (NEW) in 2006 were either stated income or interest only, meaning the income was not checked or the borrower pays only the interest and not the principal.

New Century is also being forced to repurchase previously packaged and sold loans to investors. The firm essentially sold the loans at a premium for cash, which makes sense, but still had responsibility for any future deterioration of credit quality, which does not make sense. New Century’s stock price is down approximately 45% year-to-date [YTD] after a slight gain last year and a significant drop in 2005.

The same article in the Forbes states that 42% of the mortgage portfolio of Countrywide Financial (CFC) is pay-option adjustable-rate mortgages, which means “borrowers decide each month how much to repay and can face negative amortization of the loan.” Countrywide is the largest originator of sub-prime mortgages and is stronger financially, but deterioration of credit quality from 0.24% delinquencies in 2005 to 0.67% in 2006 will pressure the company.

The stock prices of some other mortgage lenders have also decreased dramatically. For example, Novastar Financial (NFI) is down approximately 62% YTD, following a significant drop in 2005 and a slight gain in 2006. The stock price of Fremont General (FMT) is down 18% YTD after losses in 2005 and 2006.

Some of these companies also have extraordinary dividend yields. The yield of Novastar is ~56% while New Century is ~42%. Both will most likely be reduced in the future.

With credit quality deteriorating (approximately 1 in 10 sub-prime mortgages defaulted by the end of 2006), investors forcing the repurchase of packaged loans and reducing purchases of new ones, a slow down in originations, lawsuits, and interest rates trending up, only the strongest lenders will survive.

A blog titled, The Mortgage Lender Implode-O-Meter, lists 23 sub-prime lenders that have gone bankrupt since December 2006. I expect more will do so.

NEW vs. FMT vs. NFI vs. CFC 1-yr chart