A Sub-Prime Primer – Part 1

In less than two weeks, from February 21, 2007 through March 5, 2007, the Dow Jones Industrial Average lost more than 700 points, or almost six percent of its value. In the week and a half since, the Dow has gained less than one percent, after rising more than two hundred points between from March 6 through March 12 only to give all of that back on the thirteenth. Throughout this period of unrest, one topic kept getting the spotlight as main contributor to the unrest – the sub-prime lending market. In this week’s Trends Report, we take a look at the issues surrounding the sub-prime lending market and what it means for the internet advertising market. Here, in Part 1 we look at the multi-hundred billion dollar sub-prime market. In Part 2, we’ll see what the recent shake-up means for our space.

Sub-prime can refer to anything less than ideal, but its most commonly used in the mortgage banking business, referring to those borrowers with low credit scores, poor past borrowing backgrounds, if any, and/or high debt in relation to their income, it suggest a riskier lending profile. The world of mortgage banking is anything but simple. I have spent more than two years with some interaction with the mortgage banking lead generation space; yet I will struggle if asked to explain mortgage backed securities or collateralized debt obligations. Having never bought a house, I find it tough enough just to know the difference between the various types of home loans – from your fixed to variable interest rate, home equity line of credit, cash out refinance, etc. A story I heard on NPR yesterday helped to convey the basic gist – minus the asset-backed security component.

The story told of a man who has made a small fortune lending to people with really poor credit who live in equally poor areas. In a nutshell, he figures out what the people living in a house pay for rent. He then acquires their house or similar and offers people a chance to pay towards ownership. Even though his loans carry a 12% APR, because the house costs so little, their payments end up less than the previous rent. That he gets to charge an interest rate well above the average works out for a variety of reasons, but it comes down to the fact that the people he lends to have a hard time obtaining a loan elsewhere. And, because their current payments come in less than their prior rent, they do not feel he takes advantage of them. While he might have originated a few million dollars in loans, i.e. he markets and services the loan, major banks and mortgage banking companies like Wells Fargo, CitiFinancial, Countrywide, HSBC, and New Century originate loans in the tens of billions per year. According to trade publication Inside Mortgage Finance, subprime-loan originations came in around $605 billion last year, or about a fifth of the overall market for US home loans.

Of the billions lent last year, HSBC and New Century ranked among the top two. They certainly did in the in the fourth quarter of 2006. HSBC had $12.3 billion in loans originated with New Century coming in close at $12.2 billion. If those who borrowed, though, cannot make their payments, these companies can suffer. Of those active in the sub-prime lending space, New Century, in particular, has not fared well of late. Quoting from a recent Wall Street Journal article on the company, the 11-year-old company "billed itself as ‘a new shade of blue chip,’" and "has become a symbol of excess in lending to subprime borrowers…The company has imploded over the past few months as defaults surged and accounting misdeeds surfaced." Regarding excess, just read this as reported in the same WSJ article, "Racing is a passion for one former top executive, Patrick J. Flanagan. While he was at New Century, a division under his control sponsored a Nascar race car. In late 2005, the company granted Mr. Flanagan a six-month leave of absence with pay of $76,445 a month (he had made nearly $4 million the year before), while he looked for new horizons. He then left the company and says he has spent part of his time competing in car races."

The overall industry figures don’t look stellar. According to a recent mortgage banking report, the percentage of mortgages that started the foreclosure process in the final quarter of last year rose to a record high 0.54 percent (two percent if looking at only sub-prime loans), an almost ten percent increase over the previous high of 0.50 percent. The previous high occurred in the second quarter of 2002, right as the economy began recovering from the 2001 recession. Zero point five four percent might sound low, but if $605 billion equals a fifth of the US market for home loans, that puts the total market at more than three trillion dollars, giving us a total of more than $16 billion worth of loans in foreclosure or about the size of the internet advertising sector last year. Foreclosure represents the last and worst step in not affording one’s house. Late payments also act as another proxy for borrower health. This same report announced that the late-payment rate for all sub-prime loans hit 13.33 percent in Q4 2006, also the highest in four years. For those sub-prime borrowers with adjustable-rate mortgages, their delinquency rate was even higher — 14.44.

Before moving on to Part 2, let’s look a little further into the business, one of its key players, New Century. They specialized in loan origination. They found the consumers and approved their loans (either working with the consumer directly or through brokers), but other people, e.g. large commercial banks, provided the actual money. Presumably, as competition for borrowers rose and appetite from money to fund loans kept pace, New Century began taking on increasingly risky loans. The cash from banks often come with implied or explicit repurchase agreements. The specifics vary, but in the broadest sense, repurchase agreements obligate the mortgage originator (e.g., New Century), to buy back a troubled loan sold to a bank or investor under certain circumstances. Loan originators keep cash reserves, but if they keep less, which in New Century’s case was due to their turning into a REIT several years back and originate even riskier loans it makes for a dangerous cocktail, one that has New Century owing upwards of $8 billion to its creditors and most importantly, from an internet advertising perspective, has them not accepting new loan applications.