I've referred to the $1.3 trillion subprime mortgage market as a bloody economic wound and a tornado. But now I think a rapidly spreading cancer would be a better analogy. BusinessWeek provides fresh evidence that the damage from the collapsing subprime mortgage mess is not isolated to the mortgage originators. Rather this article provides startling revelations about how hedge funds and Wall Street banks are going to post losses as a result of their involvement with subprime.
The biggest concern I have though is that nobody has yet provided a comprehensive map of how far the subprime damage has spread. But one way to think about it is that, like any industry, subprime has a value network. Moving from left to right are:
- Wholesale lenders to the mortgage originators,
- Investors in the mortgage originators,
- Mortgage originators themselves,
- Packagers of mortgage-backed securities,
- Agencies that rate the servicing capabilities and credit strength of the originators and packages of securities,
- Regulators who oversee the mortgage originators and packagers of securities
- Investors in the mortgage-backed securities, and
- Homeowners who borrowed from the subprime mortgage originators.
Damage to the subprime market will affect all of them in different ways and since there's no map, it will only be after all the damage has been done that evidence will emerge from investigations resulting from lawsuits which are sure to proliferate. And this doesn't even refer to the wider damage to the housing industry which affects building materials, construction, and real estate agents as well as anyone who owns a home and might feel a bit poorer as a result of declining home equity.
Big financial institutions are likely to take a subprime hit. For example, Citigroup, Inc. (NYSE: C), HSBC (NYSE:HBC), and Countrywide Financial (NYSE: CFC) have boosted their estimates of losses and warned of credit troubles. Sanford C. Bernstein analyst Brad Hintz predicts that the subprime meltdown will result in earnings reductions for Bear Stearns (NYSE: BSC), Lehman Brothers (NYSE: LEH), Goldman Sachs (NYSE: GS), Merrill Lynch (NYSE: MER), and Morgan Stanley (NYSE: MS). As I pointed out here, some of these firms were lenders to and/or investors in New Century Financial (NYSE: NEW).
The big revelation to me is the hedge funds getting burned by subprime. $700 million Greenwich, CT-based Carrington Capital was launched in 2003 with $25 million in seed money from New Century, which owns about a 35% equity stake. Such an intimate tie between a lender and a hedge fund is highly unusual. Carrington turns subprime mortgages into collateralized debt obligations (CDOs) and sells them to other investors. Not surprisingly, New Century provided 17% of the loans in a recent deal.
Another loser is David Einhorn, manager of $3 billion hedge fund Greenlight Capital, who fought his way onto New Century's board last March. Greenlight, which has in the past posted double-digit annual gains, is down about 2.5% on the year; its stake in New Century, valued at $109 million at the start of the year, has shrunk to $21 million. Einhorn's seat on New Century's board prohibited him from selling even as the lender warned that it would restate most of its 2006 earnings results and said federal prosecutors are investigating its accounting.
When cancer spreads to the lymph nodes it's really hard to stop. And the economic equivalent of this is starting to come to light. But until the entire subprime value network is mapped out, I expect more -- much more.
Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm. He also teaches management at Babson College and edits The Cohan Letter He owns shares of Citigroup and has no financial interest in Bear Stearns, Countrywide Financial, Goldman Sachs, HSBC, Lehman Brothers, Merrill Lynch, Morgan Stanley, or New Century.
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