Subprime Market Reshaping

CDOs at risk, sources say

February 20, 2007

By NEIL J. MORSE

A weakened housing market, softer underwriting standards and a relatively sudden unwillingness by the secondary market to fund many subprime loan pools have combined to pull the rug out from beneath the sector.

Now there are rumblings on Wall Street that collateralized-debt obligations, which have been a big support for subprime bonds, could be at risk if more secondary market funders recoil from faltering credit performances of subprime loans and companies.

One long-time Wall Street figure who, citing extreme nervousness on “the Street,” declined to be identified for this story, said that, in particular, CDOs backing home equity loans “can’t be placed and this ‘fade’ may be enough to have fairly demonstrable impact on some originators. It would be like [an official] throwing the flag [in a football game] and players continuing to pile on,” he remarked.

Many lenders that are up-for-sale are “limping into these transactions — not so much being bought as picked up for breach of contract,” the source said. In such a “fire sale climate,” the good companies “with something to offer” could get hurt, he said.

One subprime wholesaler who hit the wall earlier this month Lenders Direct Capital Corp., Lake Forest, Calif.

The company laid off 150 employees in its wholesale group, leaving 40 retail personnel still operating. At its peak last summer, the company’s revenue was split 80/20, wholesale-to-retail, with originations running “close to $200 million per month,” according to Mike McQuiggan, its chief executive.

“Right now, liquidity has gone out of the market,” McQuiggan said. “We’ll have to see what happens. When I started 30 years ago, we charged brokers two points [to take a loan]. We might end up going back to that time again if that’s how the market [wants it].”

McQuiggan said “it’s almost self-fulfilling what’s happening out here. Everybody’s afraid. They don’t know what to do — we’re in total flux.”

He added: “I see [subprime] in true recession right now; it’s a total meltdown and it’s touching everybody.” He did offer one glimmer of hope, noting that the subprime sector could rebound, “if the loans are made at the right LTV and the right [borrower] income. We have to get back to basics,” he asserted.

What will Wall Street do?

Wall Street firms are not likely to cease their continued move into the originations end of the mortgage business, according to Peter DeMartino, managing director, Greenwich Capital, Greenwich, Conn.

“Dealers have an incentive to be part of originations [because] they already have the securitization and a huge CDO pipeline. They want to fund originations for their CDO clients so they’re trying to vertically integrate.”

While vertical integration is the vogue term, DeMartino said Wall Street dealers “have been originators for a long time, “playing both sides of the fence.”

Indeed, he said, the creation of mortgage-backed securities more than 20 years ago has had them “intimately involved in the mortgage business” all that time. “It’s not new, it’s just that people are finding out about it [now],” according to DeMartino, who added that these secondary firms have owned servicers too, for a long time.

The current market turmoil is reflective of problems “front-to-back [end] across the credit spectrum,” beginning with lenders, said the Wall Street executive who did not want to be named. “What they originated was plainly awful” in the last two years, he declared.

Additionally, he noted that Wall Street had doubled its footprint in the mortgage market in recent years, now doing 70% of all “shelf transactions,” thus changing the operational mind set dramatically. “Wall Street is not a holder of risk typically; it likes to carve up [investments] and move on. But now we’re seeing push back from investors and with all the vertical integration, [Wall Street firms] are not willing to take more risk.”

So, it is “not unexpected,” he said, that firms like New Century and HSBC are feeling the pressure from “the degree and speed of early payment default issues. They’re coming home to roost and I think it has caught a lot of people by surprise,” the observer said.

The light at the end of the tunnel, he went on, will be a policy shift and scenario in which larger banks operating under strict guidelines will fill the spreading void for mortgage originations.