Subprime Lending Bust: Worst Crisis Since Enron?

Includes: CFC, HRB, NEWC.PK
by: Faisal Laljee

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 (NYSE: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.