OC Blog: OC/DC: Not Ready for Sub-Prime Time

Today's financial media was busy reporting the news about Irvine-based New Century Financial and rumors, analyst predictions and Wall Street buzz that they will likely go BK in the next few days. While we do not know for sure, it is clear that the company's challenges will reverberate through the Orange County economy and job market and also through the halls of Congress.

In Washington, House Financial Services Chairman Barney Frank has long held views critical of one of New Century's business lines: sub prime mortgages. (Fullerton GOP Rep. Ed Royce and Irvine Rep. John Campbell are both members of this committee). These mortgages, made to lenders with less than "good" credit are called both non-prime and sub-prime, depending on the lender involved. Either way, the transaction typically involves a lender easing traditional mortgage qualification standards in exchange for a rate as much as 2-3 points higher than a typical applicant with good income and credit history. The numbers work as long as a certain percentage of lenders continue making payments. It seems from early reports, New Century has a higher than normal percantage approach default.

In recent years, the mortgage industry has grown rapidly (particularly in So-Cal where the real estate market has boomed) fueled by an aggressive and until recently high-flying non-prime market with lenders such as New Century cashing in on the growth in the market, the volume of transactions, and a bustling re-finance market.

The trouble for the industry is that mortgage lending is basically an arbitrage operation more or less. New Century (and others) make loans to non-prime applicants at 2-3 points above market rates -- and bundle these loans as securities, to be sold to Wall Street investors as investment instruments. The payment on these securities is less than the rate of the mortgage -- but nonetheless still a reliable income stream (as mortgages have historically proved to be). As a result, in a good economy, and with "prime" and many non-prime mortgages, the system works and the money flows. Investors are paid a steady return over the life of a mortgage....as long as most mortgage holders keep paying.

Early reports appear to indicate that New Century essentially faced a call on earlier funding from one investor, and paid it with fresh capital from another -- thus generating speculation of BK from analysts as defaults climbed. The NYSE even suspended trading according to one recent report I saw.

While this all seems to be financial services mumbo-jumbo, the reality in Congress is very different. Led by Massachusetts liberal Barney Frank, the House Financial Services Committee has been signaling an interest to aggressively pursue non-prime lenders for some time. The reality is a double-edged sword.

Many non-prime lenders have helped literally open family homes to those with less than perfect credit, less than legit citizenship status, and non-traditional income and savings pictures. On the one hand it's the American Dream; and on the other it's a financial liability. Congress is particularly concerned about the tactics many lenders have used in offering these loans, especially if they are OPTION or neg-amortization loans or ARMS vilified in the media. You can bet hearings will be held, lenders will be criticized about keeping the poor, minorities and non-traditional borrowers out of homes at the expense of those with better credit pictures. Sadly for the industry, hearings will likely paint the industry as predators rather than facilitators willing to invest in those who can meet the standards of committment to make a mortgage work.

The challenge for the industry is that Congress will likely paint New Century and other primarily PRIME lenders with a broad brush, accusing the entire industry of practicing tactics that really only a few have dared to use. As sure as the housing market will rise, so too will Congress take a hard look with less than perfect legislation to address what it perceives to be a crisis but in reality is just the markets working the way markets were designed.

It will be interesting to see if the media coverage and Congress' action is ready for prime time, or is just like the mortages: non-prime.