The Sub-Prime Market is Getting Squeezed

Here’s something I haven’t heard too much about. Normally, conventional mortgage rates are about 15%-25% higher than the 30-year Treasury bond yield. (I’m referring to the rate, so when the long-bond is at 10%, you can expect mortgage rates to be about 11.5%-12.5%.)
Recently, however, the spread has started to widen. Average mortgage rates are now about 35% higher than the 30-year T-bond—this is a level we haven’t seen in four years. In fact, in the last five months mortgage rates have climbed nearly 100 basis points.
What appears to be happening is that the marginal borrower is getting squeezed from the market. One of the major growth sectors of the last few years has been the market for “sub-prime” loans. This is how Buttonwood describes the sector in the latest Economist:

“Subprime lending” to people who would not normally be able to make the grade is running at about $500 billion a year. Much of it takes the form of variable-rate, interest-only and negative-amortisation loans. Both debtors and creditors are now more exposed to interest-rate changes.

Several sub-prime lenders have reached boo-yah stock star status. But in the last few months, their stocks have been severely punished. Consider New Century Financial (NEW). The stock was up 87% in 2002, 134% in 2003 and 61% last year. But since August, the stock is down by one-third. American Home Mortgage (AHM) is off by 30%. Annaly Mortgage (NLY) has nearly been cut in half. And one of the biggest stars of all, Impact Mortgage (IMH), is over 60% below its 52-week high.
Easy credit has been one of the scapegoats for the housing bubble. The Wall Street Journal has an article on C1 this morning about the growth of mortgage loans with less than full documentation. Fully documented loans have dropped from 72% of all mortgages five years ago to just 54% today. As always, bubbles are never the fault of the participants. The participants are merely victims. Who vote.
I think this is one of the first signs that the Fed’s rate hikes are being felt outside the world of high finance. Before, the fear was that foreign investors, especially from Asia, would pop the housing bubble by pulling out of our debt market. But them foreigners is still there, begging us to borrow their money. If last week’s Treasury auction is any indication, our government debt is as popular as ever. Plus, the greenback keeps soaring and euro is burning (literally). Also, I haven’t seen much evidence that the corporate junk bond market is feeling the pain.
I think we may be surprised next earnings season to learn about major banks that were overly exposed to the sub-prime market. Or it may even could from areas you wouldn’t expect. Di-Tech, the guys who advertise heavily on CNBC, is owned by General Motors (GM). It’s one of the most profitable areas of the company, which is ironic considering the company is heading towards a negative FICO score.
Speaking of which, I don’t expect Fair Isaac (FIC), from our Buy List, to suffer. If anything, it might benefit from a more credit-conscious market. Two weeks ago, the company beat expectations by four cents a share. The company is looking for 50 cents this quarter, and $2.15 for this fiscal year (ending in September).

Posted by on November 16th, 2005 at 6:02 am


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