Subprime Lending Bust: Worst Crisis Since Enron?

This is a question that most investors are pondering, including myself. Will subprime mortgage issues impact our financial markets in a way not seen since the Enron scandal? While I am not sure of the answer, here is my point of view.

It all started a few weeks ago with HSBC (HBC) warning of higher delinquencies in their mortgage business and was quickly followed by New Century (NEW) announcing that they would not make a profit for the foreseeable future. All that now seems so far away.

Making a profit is the least of New Century's worries as higher delinquencies and controversial lending has prompted an investigation into its business, not to mention that the company's almost $3 billion market cap has been wiped out.

Last week, Countrywide (CFC) stopped offering 100% financing. H&R Block's (HRB) Option One and some others followed suit. If this tightening flows through to other areas of the finance spectrum, like auto makers and credit cards, it could spell the end of the fierce consumer spending seen in the US these last few years. However, what are the chances that credit cards will start tightening their lending guidelines too?

If the above does indeed happen, it will affect equity markets in a big way. We are a nation that operates on credit a little too freely and putting additional boundaries on credit cards for sub-prime audiences would result in a huge slowdown in the economy. Retailers would be impacted the worst in this scenario.

But if the above does not happen, is the mortgage business alone capable of bringing the consumer to his knees? Default and foreclosures would mean people would have to go back to renting more affordable homes. This would result in property values declining somewhat (which they already have with room for some more declines).

Essentially, this would mean the end of home equity for most home owners, which would slow consumer spending. It would also mean consumers would then rely more heavily on credit cards. Its an unenviable situation no matter which way you look at it.

What does this mean for the stock market? On most days, it seems the market operates more on psychology and less on fundamentals. A slowing consumer spending cycle would translate in a slowing economy, which would mean the S&P 500 companies might post smaller than expected gains in the upcoming years.

While the above scenario sounds extreme, it is not unlikely. So where do big investors like the hedge funds put their money? Corporate bonds? Give me a break! These guys expect to grow their money at 20% annually. They would invest in the stock market or invest against it by shorting it.

Other wealthy investors who were previously picking up real estate now need to put their money elsewhere. They will look to mutual funds. And what about private equity? They are constantly looking for companies to buy, taking away some of the supply from the financial markets. These opposing forces make it confusing for the average investor.

A friend of mine asked me recently the very same question that graces the title of this post. And my answer to him was that I am short term bearish but long term bullish. A fat lot of good that did him. That answer was neither here nor there and I know that.

The above circumstances are truly unique. There are just as many positives in the market as there are negatives. I am leaning more on the negative side until we see the fall out from the Subprime Mortgage issue. If this turns into a "scandal" we have a problem. I am open to your thoughts on the subject.

Comments

[Tom B:]

Any idea what the sub-prime exposure is on some of the other big banks-- BAC,JPM,WFC,C?

2007 Mar 15 09:03 AM

[Faisal Laljee:]

Lehman Brothers and Bear Sterns have the largest exposure in terms of % of revenues. Other brokers are next with Merill Lynch, Goldman Sachs etc. Most of the banks you mentioned don't keep too much sub-prime on their books. They sell it to the brokers above. BAC and others mostly have Prime exposure.

2007 Mar 15 03:48 PM

[Sr. Pessimist:]

That's a good point. Some big banks need some serious income. They can't afford to make a whole lot of bad credit decisions anymore. Bush and the GOP rapists of America have destroyed the economy to the point where most people use credit to buffer their larger or more unexpected moves. What if there comes a time when the banks can't afford to make up for where the Federal Government damages its own people?

2007 Mar 15 10:35 AM

[Tom B:]

Indeed, the same criminals that brought you Enron brought on the current crisis.

2007 Mar 15 10:39 AM

[Faisal Laljee:]

Brian - I understand the general anger that individual investors face towards big business. In this case, as is always the case, there are some bad apples rotting the pie. New Century is the primary culprit. They wanted to keep making money even when the housing market started declining and rates increased. In doing so, they started offering ridiculous kinds of loans to people who could not afford it. Others like Novastar have a history of controversy.

But more importantly, it is also the fault of the US consumer. It takes two to tango and living in So Cal, I see people buy homes that they cannot afford, I see them spending left and right and the moment they have any equity, they borrow against that too. In other words, most of the sub-prime people never own their homes. They don't even own 1% of their home because they have borrowed every cent they can. In other words, banks and investors on Wall Street own these homes.

The key difference between this issue and Enrons and Worldcoms of this world is that in this case, the consumer who kept over extending is just as much at fault as the banks that lend them the money.

At the same time, in So Cal, with the median housing price in the mid-500,000's - it is extremely tough for a middle-income family to make ends meet. The housing here is more expensive than most other states, yet average income is not as high. Taxes are the highest in the nation, yet education at the public school level is one of the worst in the country. Most of the mortgage companies are in So Cal. This includes Fremont General, Accredited Home Lenders, Countrywide and New Century. And there is good reason for that - they are close to the action so they know how bad people have it here. I don't know much about other states, but I strongly believe that home values in So Cal are going to keep declining over the next 2 years. Those calling for a bottom need to look at the correlation between prices here and in the rest of the country. While its more volatile here, the overall trend across the country is dictated by California, Florida and a couple of other key states.

Sorry for the long response. As you can see, the consumer can be blamed for much of this on one hand, but I can understand their longing for the American Dream to drive them to borrow so much too.

I will try to write another post outlining what I think law makers can do to prevent this. Perhaps lenders should not be public companies looking to satisfy investors rather than engage in fair lending practices ... I don't know the answer yet but I will be thinking about it.

2007 Mar 15 04:08 PM

[Jamaicatty:]

Not to overlook the fact many homeowners who refinanced in the wake of previoulsy soaring house values can no longer do so -aying off credit card and other unsecured debts. Usually the shopping avec cards resumes. Very possible credit card issuers may tighten up .

2007 Mar 16 11:31 AM