Cockroach Principle and the Subprime Mortgage Market

from John Mauldin's e-letter...

The Cockroach Principle says there is never just one cockroach. If you see one running across the room, that means there are many more in the walls and behind the counters. I have been highlighting the problems in the subprime space for a long time. As I wrote months ago, this is going to be a major scandal. It is the main (and almost only) reason that I think we are going to have a recession in the US.

Last week www.lenderimplode.com listed 28 subprime mortgage firms that were shut down or taken over. The count is now 34. Yesterday the third largest lender of subprime mortgages, New Century, stopped accepting new loan applications. The shares were once at $50. Now they are under $4 and falling. The Financial Times reports that they cannot meet their margin calls from their lenders.

Essentially, New Century has been shut out of the capital markets. They are being hit with a wave of lenders who are demanding they take back the mortgages they sold, and my guess is that they do not have the capital they need. Maybe they can sell assets and get them. Who would take their paper or their mortgages today, knowing the problems? The money available to subprime lenders is rapidly evaporating, and until the lending standards are tightened considerably, it will remain that way. Many of the buyers of the Mortgage Backed Securities are going to lose some money.

Option One is an Irvine, California-based subprime lender. Yesterday they stopped doing 100% loans on the value of a home. CEO Steve Nadon pointed to an increase in loan submissions as a result of many of the company's competitors running into funding problems. "We are getting a lot of 80/20s and 100% CLTV deals that used to go to our competitors," the letter said. "While there is nothing inherently wrong with those types of loans from a pure credit standpoint, right now they have a fundamental flaw that we simply cannot overcome. That is the almost complete lack of appetite for the product by the bond market... To originate a loan product that no investor, in today's market, wants to buy is irresponsible."

Consider even a lender like Countrywide which only had about 10% of its portfolio in subprime. They can probably weather the storm, as their main business is prime mortgages. But the founder and CEO, Angelo Mozilla, has sold $140 million of his personal holdings, and almost $600 million of insider stock at Countrywide has been sold in the past two years.

I have highlighted this problem before, so will not go into it in detail again. Subprime mortgages are pooled and divided into different risk tranches, with the most risky being the "equity" portion of the pools, typically about 4%, and these equity portions are again put into pools with 80% of these equity portions now getting investment-grade ratings. These latter pools are going to lose money, if not go bust outright. The rating agencies are going to have major heartburn over this failure to adequately see the risks. Cue the lawyers, stage right.

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