American Home Mortgage: nearly bankrupt?

In a news release issued yesterday, July 31, American Home Mortgage (AHM) announced that it is “experiencing a hindering of access to its traditional lending facilities” and will be unable to fund its lending obligations. The lender has paid “very significant” margin calls in recent weeks and “has substantial unpaid margin calls pending”. AHM has retained Lazard, the same company that served now-bankrupt New Century, to assist in evaluating “strategic options”, including liquidation of its assets.

Shares dropped more than 90% immediately after trading was resumed, to close at $1.04. According to analysts, a bankruptcy or major restructuring is very likely because AHM can not function without its financing. Shareholders will probably be left with nothing. The whole story looks a lot like the subprime lender meltdown, only that now it’s Alt-A.

Lawsuits seeking class action status are already being filed against AHM. Charges include failing to disclose substantial information that affected its earnings and resulted in overstating its financial results.

Shares of other lenders were affected, too, with Countrywide down 3.8% to $28.17, Fremont General declining 11% to $5.77 and NovaStar losing 25% at $9.64.

More layoffs in the lending industry

Late last week both WaMu and Indymac announced they’ll be laying off hundreds of employees in an effort to cut costs and down-size to match current market conditions. Indymac will fire some 400 staff members, or “roughly 4%” of its workforce in the coming weeks, according to an e-mail from the lender’s CEO, Mike Perry, which was distributed to all Indimac employees. Of course it contained many good words about how the company tries to avoid layoffs whenever possible, and how hard it was to fire these people; it also doesn’t fail to mention how Indimac is better than its competitors. For example here:

“Most companies in the mortgage industry employ layoffs as standard operating practice, staffing up in good times and letting people go as soon as loan volume falls off. I have never been a fan of this practice”

And here:

“while most other companies in our industry pay very little, if any, severance, Indymac has a generous severance package for laid off employees”

Or here: “many of our competitors are cutting much more deeply”.

I’m afraid I don’t understand why a CEO would employ such marketing means in a letter to employees, but he probably has some reason for it. Certainly the mail was distributed to all staff members, including those who get to stay with the company. Maybe he was feeling just a little bit guilty and trying to convince himself that others are no better? Or perhaps Indimac fears that their employees may decide to leave and join the competition? It doesn’t sound realistic, given that nearly all lenders are cutting workforce in today’s market. Take Washington Mutual: 210 employees will be gone by August because their jobs at subprime loan fulfillment centers are being eliminated. Subprime lending is shrinking, and dragging home sales with it. Even more disturbing, some states are already admitting that they’re either on the verge of, or experiencing a recession.

2/28 Subprime ARMs no longer profitable

In a recent announcement issued by Option One, the lender informs its clients that it will eliminate all 2/28 ARMs effective Monday, July 16^th. Anyone holding a 2/28 ARM that hasn’t adjusted yet gets a 3/27 product at no cost, thus receiving another year of fixed mortgage payments.

2/28 ARMs are 30-year hybrid mortgages that have fixed monthly payments for the first 2 years of the loan and begin to adjust afterwards. 3/27 loans have a fixed-rate period of 3 years.

In its statement, Option One says that news received on Friday suggested that rating agencies “have made significant changes to their loss coverage assumptions on subprime 2/28 ARM loans”. As a result, 2/28 ARMs “lost a great deal of their economic value”, and Option One decided to eliminate the product altogether. Option One will honor the approved rate on 2/28 mortgages that will be replaced with 3/27 loans.

It is possible that many other lenders will follow suit, because issuing loans that can’t be resold makes no sense to anyone. A sensible move amid the subprime mess at last. Apparently the ARM market in general is going to contract significantly in the coming months. So perhaps the market is, after all, regulating itself.

NovaStar pays $5.1 million to settle class-action law suit

NovaStar, one of the subprime borrowers hardest hit by the current Real Estate market slowdown, has agreed to pay $5.1 million to settle a lawsuit accusing it of charging excessive interest rates to cover broker fees. The sum includes $3.3 million in payments to 1,600 class members and $1.8 million for legal fees.

As problems in the subprime sector started emerging, borrowers and investors began filing class-action lawsuits against subprime lenders, accusing them of various wrongdoings. Some law suits are already getting settled, and I guess this comes as a relief to many. NovaStar said it does not admit any liability, and decided to settle the case because it was an obstacle to a possible sale. Officials claim that the company has followed “standard practices in the mortgage industry that comply with the law and applicable regulations” – which doesn’t say much, since regulation has been quite loose on lending practices and many procedures that became standard within the industry were not in borrowers’ best interest.

Meanwhile, mortgage rates eased somewhat this week, but are still higher than earlier in the year. Interest on 30-year fixed rate mortgages averaged 6.69 this week, down from 6.74% a week ago. 15-year fixed-rate loans dropped to 6.37% from 6.43% last week, 5-year hybrid adjustable-rate mortgages were at 6.31%, down from 6.37%, while 1-year adjustable loans averaged 5.66%, compared to 5.75% a week earlier.

Lenders are adopting federal guidelines

General Electric’s WMC Mortgage and Merrill Lynch’s First Franklin Financial are adopting the federal underwriting guidelines proposed in March. Lenders will have to determine the borrowers’ ability to make fully-indexed monthly payments instead of the initial, smaller payments at “teaser” interest rates. For many subprime borrowers, this will mean cutting off or limiting credit, but it’s probably better than putting them into a mortgage they cannot afford to repay. A large part of those who took adjustable-rate loans in recent years wouldn’t have qualified had the lenders taken into account the full monthly payments, scheduled to kick in two or three years down the road. No wonder we see a spike in delinquencies and foreclosures. The bad news is, economists say even more foreclosures are to be expected as ARMs begin adjusting later this year and in 2008.

The Fed is still considering steps to prevent “predator” lending and encourage “responsible” loan providers, but a number of economists are skeptical. “Bailing out” troubled borrowers would mean paying with taxpayers’ money for other people’s foolish and irresponsible financial decisions, instead of letting them bear the consequences of assuming too much risk. Plus, the market is already casting out lenders who were all too willing to provide junk loans, and the rest are tightening underwriting standards. In the months and years to come, fewer loans will be originated, so there will probably be fewer buyers house-hunting out there. Sounds like a nasty housing slump to me.

Shares of subprime lenders tumble

On Wednesday, February 21^st, a number of subprime lenders saw their shares tumble in response to news of financial instability at NovaStar, the 19^th largest subprime lender. NovaStar stocks dropped 39% since the news came out, to reach $10.68, as shares of New Century Financial declined 7% to $17.45 and those of Countrywide Financial went down 2.4% to $40.66.

Stocks of nearly all subprime mortgage lenders have been falling sharply during the past few months, as a response to deteriorating market conditions, but they are not the only sign of trouble in subprime lending. Approximately 1 out of 10 sub-prime mortgages has defaulted by the end of 2006, and banks are forcing mortgage companies to repurchase the bad loans. Since a large percentage of mortgages originated in 2006 are either “stated income” (which means that borrowers don’t have to provide proof of their income) or “interest-only” (where borrowers can pay the interest alone for a certain initial period), the risk of delinquencies is incredibly high and investors are pulling their funds out of the subprime mortgage market.

Now that lenders are tightening their underwriting standards, origination numbers are slowing down, but so are loan purchases by banks. HSBC announced it would have to spend more than expected on loan repurchase, New Century reported 4^th quarter loss and said it would have to restate its income for the previous 3 quarters due to accounting mistakes, Accredited and NovaStar posted loss in the 4^th quarter as well. Countrywide is stronger financially but high numbers of delinquencies will affect its stability too.

This is yet another installment in the wave of bad news that flooded the subprime market since the end of 2006. As lenders adhere to higher standards, loan origination volumes drop but loan quality increases. Loan providers predicted a tough 2007, but for some it proved tougher than expected. Several dozen smaller lenders have closed down or been sold recently in the challenging market environment. LoanCity closed seven branches, leaving 5 still operating, due to a “softer market”. Wells Fargo is cutting 250 jobs at its Fort Mill, S.C., offices, because lower origination volumes are expected due to tightening of policies.

The current situation is a challenge for subprime lenders, but it will eventually lead to improvements in the industry sector altogether. As the housing market shrinks, so does the demand for mortgage loans and some companies find themselves with little or no work to do. By the end of the year, we’ll probably see stricter mortgage standards and fewer lenders still operating in the new market realities.

NovaStar reports fourth-quarter loss

On Tuesday, February 20, NovaStar, a residential lender and mortgage real estate investment trust, announced loss of $14.4 million or 39 cents per share in the last quarter of 2006. A year earlier, the company reported earnings of $26.4 million, or 84 cents a share. In after-hour electronic trading NovaStar’s shares dropped 33% to $11.81.

Earnings for 2006 were $66.3 million, a remarkable 50% drop from $132.5 in 2005. Loan origination was up 20% in the fourth quarter of 2006, and 21% higher than 2005 levels for the entire year. NovaStar specializes in subprime mortgages and, as default rates increase, it is forced to repurchase the bad loans it sold to banks earlier. This type of problem is increasingly affecting subprime lenders, who loosened their underwriting guidelines in 2006, allowing the issuing of high-risk loans. Now that borrowers are defaulting, mortgage companies are forced to buy those loans back, suffering further loss and reducing earnings estimates.

So is NovaStar the next New Century? According to Scott Hartman, Chief Executive Officer at NovaStar, probably not. Even though the repurchase requests were at record levels in the fourth quarter of 2006, the company believes its cash and available liquidity of $154 million will cover the risk for all loans sold to date. To ensure better results in 2007, the company is tightening its underwriting guidelines, enhancing the appraisal review process and avoiding loans that carry “unacceptable levels of risk”

Nevertheless, next year’s dividend could fall to $4 from $5.60 in 2006. According to company officials, there may be little to no taxable income from 2007 through 2011. The management is currently evaluating whether it is in shareholders’ best interest to abandon the company’s REIT (real estate investment trust) status, given the restrictions it imposes on the company’s operations. For 2007, NovaStar believes it will meet the REIT distribution requirements of distributing at least 90% of undistributed 2006 taxable income.

This news may be a bitter pill to swallow for NovaStar investors, but it is not as bitter as the one New Century shareholders got. It seems the end of subprime lending, or at least a significant contraction, is near.

A Better Outlook for "New Century"

Chris Brendler, an analyst with Stifel Nicolaus upgraded New Century from “Sell” to “Hold”, saying the company still has enough cash to handle its current tough situation. He called liquidity concerns, which led to last week’s 43% drop in stock prices, “premature”. Before last week’s disaster, Stiefel Nicolaus’ opinion of New Century was quite negative, which means they foresaw trouble ahead.

According to Brendler, New Century has $360 million in cash and $17 billion in borrowing arrangements, 50% of which aren’t utilized and it seems that the company will be able to manage. It is still unclear how badly the adjustments to mortgage value will affect New Century, but analysts believe it will be able to wriggle out of its financial fix.

New Century shares rose 2.9% to $17.70 in pre-market activity, as other subprime lenders’ stocks climbed an average of 0.5%. These include Countrywide Financial, IndyMac Bancorp and Novastar Financial.

Nevertheless, the outlook for subprime mortgage lenders remains challenging, as delinquency rates on high-risk loans rise.

Subprime lenders worried by high default rates

Last week some serious problems in the subprime mortgage business became evident, as a number of lenders announced higher-than-expected losses. HSBC officials said the company’s US division reported rising defaults, and New Century declared its financial results for 2006 contained accounting errors and overestimated the company’s earnings. Shares of subprime lenders saw serious declines throughout the week, exacerbating the situation for mortgage companies.

The subprime sector has been especially productive recently, with lenders looking to close as many loans as possible and allowing for lower mortgage quality. As delinquency rates begin to rise, they’re likely to start tightening their standards and raising interest rates on high-risk loans. This means that many borrowers will be unable to access credit, which may lower housing sales.

An estimated 17% of home purchases are now made using subprime loans. If these consumers are left out of the housing market, the effect will certainly be felt throughout the industry, but it’s hard to quantify the impact. The overall delinquency rate was 4.7% in 2006, up from the historic low of 4.4% in 2005. Probably not all subprime borrowers will leave the market, and economists say the reduction shouldn’t be a big problem for the industry.

Experts are optimistic in their forecasts and believe that the economy will remain stable throughout 2007, and the housing market will start to improve later in the year. Freddie Mac forecasters say the economy won’t be dragged down by the slumping Real Estate industry.