New Century Outlook Stuns Subprime Investors

In a financial activity analysis of major subprime lenders, FindProfit reported shares of subprime lenders fell Thursday after New Century Financial Corp. lowered its earnings outlook for 2005.

New Century, which reduced its 2005 earnings estimates due to intensifying competition and margin pressures, saw its shares fall 12% to $54.25 for the day. The real estate investment trust has been among the nation’s fastest-growing mortgage-related entities and was recently ranked by the Mortgage Bankers Association as the largest subprime originator — with 8.7% of the market share.

On the same day, Accredited Home Lenders shares sank 14% to $41.56, according to FindProfit’s analysis.

New Century, a MortgageDaily.com advertiser, reportedly said competition has “intensified pretty meaningfully” in the past 90 days and that it believed some national and regional players are “originating loans below their costs.” The Irvine, Calf.-based lender noted that, in order to gain market share, competitors have not raised their rates to reflect their rising cost of capital, which is “translating to lower gain on sale” margins, FindProfit said.

Countrywide’s shares got hit Wednesday after it widely missed fourth quarter earnings estimates due to a flattening yield curve and rising competition, FindProfit reported.

The Calabasas, Calif.-based lender reportedly said it intends to pick up share in “both the subprime and home equity areas,” despite that it anticipates there “is a contraction or compression” underway in the subprime business. Countrywide welcomed greater market “efficiency” since it “can produce substantial volumes of that product.” Countrywide is uniquely positioned to leverage its massive platform to “make it up in volume,” FindProfit said.

New Century said the “gain on sale” margin on its originations and securitizations fell by more than expected from the prior quarter and lowered its outlook. Margin compression was “primarily competitive related,” and partly due to rising interest rates, as the yield curve flattened.

New Century, which started the year with weak mortgage production in January, also expects total origination volume to grow by only 6.6% in 2005 to $45 billion — versus a 54% gain in 2004, FindProfit reported.

The lender anticipates it will make $9 per share — $0.78 below what Wall Street was estimating.

Additionally, New Century said it will accelerate the growth of its own investment portfolio to $17 billion by the end of June instead of the $14 billion that was originally planned. It may look to increase its leverage from its current 12.5x to the “15x to 18x” range, according to the publication.

“In other words, [New Century] is going to have to dramatically expand its balance sheet and leverage just to hit its lower targets,” FindProfit said. “This highlights just how much [New Century’s] expectations for its origination business have decreased.”

Wall Street does not value investment portfolio returns as much as origination/securitization profits due to the higher capital intensity involved, high degree of leverage, and exposure to defaults, which will rise as now generally young portfolios age.

Most mortgage REITs trade at around book value or at a slight premium to book, FindProfit noted, while New Century trades for more than 2.2x book value.

Accredited Home is very similar to New Century in that it plays heavily in subprime, and makes money both by originating and securitizing as well as by investing its own capital. The differences are that it does not operate as a REIT and that its portfolio is already leveraged up by around 18x, which means that there’s little room to grow via additional leverage. Most of Accredited Home’s growth is currently coming from the company’s fall preferred stock financing deal which expanded the amount of capital it could invest.

Even after Thursday’s dive, Accredited still trades at 2.8x book value, or more than 25% greater than New Century’s multiple.

But FindProfit believes Accredited Home is a “ticking time bomb” and has pegged the fair valuation of the stock at 1.5x to 2.0x book value, or $21 to $28 per share. As rates rise and investors become more concerned with credit quality, Accredited Home’s returns from selling mortgage-backed securities will be curtailed and its expanded balance sheet from buying many of its own loans will start hurting when defaults on its now young loans begin to rise. While the company’s primary avenue for growth will increasingly be balance sheet expansion in the short term, this will be harder to maintain as Wall Street starts to wake up to the credit quality risk.

Subprime unwinding has just begun, the publication said, adding that IndyMac’s case will be similar to Accredited even though “management has nimbly managed itself through this minefield.”