Subprime Meltdown: Untested Territory

The subprime meltdown has been in full swing ever since February 7th 2007, when HSBC (HBC) raised subprime loan loss reserves by 20% and New Century (NEW) announced a net loss for 4Q06 and an accounting probe to determine how big that loss was.

New Century filed a form 12b-25 with the SEC explaining why it could not file form 10-K on time. The grimmest part of this filing was:

In the event the Company is unable to obtain satisfactory amendments to and/or waivers of the covenants in its financing arrangements from a sufficient number of its lenders, or obtain alternative funding sources, KPMG has informed the Audit Committee that its report on the Company’s financial statements will include an explanatory paragraph indicating that substantial doubt exists as to the Company’s ability to continue as a going concern.

NEW will be in technical default on its warehouse lines if they cannot get a waiver of the requirement have to at least $1 of net income. Thus KPMG has feels that substantial doubt exists as to the Company’s ability to continue as a going concern.

Should New Century go bankrupt we have an untested situation.

No one with upwards of $16 billion in outstanding Asset Backed Securities has ever gone bankrupt before. In theory the ABS are all done as bankruptcy remote vehicles, and should be unaffected by the parent issuer's problems.

This is untested in practice, especially when NEW is also the servicer on those assets. Much of the investment grade (and especially AAA rated tranches) are held by investors who could be in for a nasty surprise.

NEW's bankruptcy, should it occur, will create huge chaos in the ABS markets. This would be very bad for everyone else in this business. NEW is responsible for about $22B debt and NFI of $4B if Yahoo finance is to be trusted. This could lead to an impressive Treasury bond rally, with a parallel sell off in credit and high-yield bonds.

New Century has had extra fun after receiving a letter on February 28, 2007, from the United States Attorney’s Office for the Central District of California, in respect to a criminal inquiry under the federal securities laws in connection with trading in the Company’s securities (i.e. insider sales) well as accounting errors regarding the company’s allowance for repurchase losses.

NEW isn't only mortgage lender facing troubles (here's a list). Fremont General (FMT) has received a Proposed Cease and Desist Order from the FDIC, requiring them to end subprime and condominium construction loan activity while otherwise conducting themselves in a sober and workman like manner. It is unclear if the FDIC will start chasing after other banks with subprime operations.

The Credit Default Swap market has voted, and declares major investment banks like Goldman Sachs Group Inc. (GS) and Merrill Lynch & Co. Inc. (MER) to be nearly junk. The dirty little secret is just how much income at these firms is sourced from subprime loans. Investment banks provide warehouse lines, buy loans to be securitized for their own accounts, and underwrite public offerings of other people’s loan securitizations. Subprime business has been so profitable for the major investment banks that they have been buying up/building up direct origination platforms (i.e. MER buys Saxon Capital and First Franklin, Bear Stearns Companies Inc. (BSC) buys ECC Capital Corp. (ECR), etc.). Of course the value of those platforms comes into question now that the banks are tightening up lending standards and the secondary markets are less interested in subprime paper.

Comments

[Malkiel:]

So based on past practice I would expect the dozen or so creditors of NEW to miraculously come the unanimous conclusion that they will not declare it in default, with hammerin' Hank Paulson and other G-men (G for "greenback" here) perhaps working the bullpen to make sure that happens. In fact, today's rise in NEW shares must mean that somebody's already come to that conclusion or knows what moves are going down...

2007 Mar 06 03:31 PM

[Ken Bareilles:]

Dude,
Morgan Stanley bought Saxon Capital. Is that just a slip or is there other stuff wrong in your article.

2007 Mar 06 08:16 PM

[Matt Kelty:]

Another false statement: no servicer in an ABS/MBS transaction has ever gone bankrupt? Huh? Someone here must be new to the block... what about all the flameouts in the late 90's (Conti, et. al) that flamed out? Why do the rating agencies rate servicers and require "hot backup" special servicers if a servicer is in doubt?

How does this story make the Seeking Alpha headline with such obviously false statements? I thought the dialogue here was a little more informed.

2007 Mar 06 08:56 PM