We have a great investment counselor.  He’s smart and we have done well through him.  Last week we had a conversation about New Century and why they had gone down.  I asked him to send me his thoughts and he has given me permission to reprint them.  It’s a slightly different take on the things in print today.  He is not a mortgage broker/lender.  He’s in financial services.  Read on.

The subprime lenders like New (New Century) have been hit with an big up-tick in early payment defaults, which means that this group of borrowers has begun to fall behind in their mortgage payments.  This has allowed buyers of these mortgages, such as investment banks (they in turn syndicate and sell them as securitized notes to institutional investors), to force the firms that have financed these borrowers (i.e. NEW) to repurchase these delinquent loans.  At the same time, the banks that have funded these companies have cut off the subprime lenders’ lines of credit, making it almost impossible for the mortgage companies to buy back the loans, thus forcing many to file for Chapter 11.  And, certainly they have no means to lend money out to other borrowers.

New Century had a reasonably good balance sheet before this and was considered to use a conservative financial accounting system.  A common measure of balance sheet strength, a debt to total market capitalization ratio of 35% or less indicates that a REIT has a conservative balance sheet and can grow by taking on additional debt.  A ration between 35% and 50% is adequate by most standards.  A REIT with above 50% tends to have limited financial flexibility.  In NEW’s case, their ration in 2006 was 28.39% and over the previous 3 years was 15.41%.  But, of course when all funding sources have dried up as we have seen, they have very little recourse other than going out of business when their cash has been exhausted or assets cannot be sold.  Or, when assets are sold, i.e., loans that would otherwise be sold to investment banks, are sold, they are forced to sell them at fire sale prices which exacerbates their problems.
That’s my take on the subprime mess.  Despite NEW having a decent balance sheet, I never recommended them to my clients even though the yields were very high, because I felt that this problem was looming since last year as the housing market showed initial weakness.  However in the past, they were a fine investment and paid dividends out that were sustainable.
He followed up the next day with this….

Morgan Stanley is selling off $2.48 billion of mortgages from the subprime lender New Century Financial. These loans represent collateral New Century gave Morgan Stanley for a $2.5 billion credit line. Morgan Stanley hasnt commented on the sale.

In our follow up conversation, I asked him what he thought might have happened if Morgan Stanley hadn’t pulled the plug.  He thought that many of the loans would have been repurchased and the people on the hook might have been able to renegotiate their loans and keep their homes.  In a different kind of world, we might have companies that weren’t so greedy for huge returns and more interested in the better good of society.  I’d sure like to find that world.