S&L 2.0?

The New York Times has two stories this weekend that should be red flags to anyone who thinks that the mortgage industry isn't staring into a large, swirling abyss in the form of shaky loans in the subprime lending market, and that it might take more than market forces to fix the problem.

First up is news of trouble at Yet Another Subprime Lendor. Of course, we've been hearing about problems in the subprime market for months now, ever since the Fed started raising interest rates, putting the pinch on homeowners with exotic ARMs and other creative financing arrangements. Hell, there's even a whole blog just for people curious about imploding subprime lenders. Up to now, most of these firms have been bit players: Silver State Mortgage, Eagle First, Ivanhoe. This time, however, its one of the big fish that may be caught in a net of bad loans. According to the Times, Federal prosecutors and securities regulators are investigating stock sales and accounting errors at New Century Financial Corporation, a Real Estate Investment Trust (REIT) and the largest subprime (or, as they call it "non prime") lender in the U.S. Concerns about New Century emerged in early February, after the company warned that it would need to restate earnings for three quarters. New Century's troubles deepened later in the month, after it said it was the subject of an investigation by NYSE into some fortuitously timed options sales by leading executives.

According to the Times, New Century's fate now seems to rest in the hands of Wall St. lenders, since the delay in filing its quarterly earnings has but around $17billion in credit lines in jeapordy. New Century will have to convince its Wall St. lenders to grant it waivers to avoid a cash crunch that would almost certainly sink the company, a la Enron. That kind of backing is doubtful, if New Century's business plan is really as murky as this post suggests (link courtesy of the Implodometer).

The second red flag comes from Times columnist Gretchen Morgenson, one of the most astute business writers around. As she notes in her column for tomorrow's Sunday Times (subscription required), Wall Street's efforts to discount the troubles at New Century and other lenders as a problem that's limited to the subprime lending market don't add up.

The troubles disclosed last week at Countrywide Financial and American Home Mortgage Investment show that the credit crunch that is bringing down lenders like Silver State and New Century are beginning to seep into the mid tier lending market, too. According to Morgenson, American Home Mortgage said 8.13 percent of its loans held for salewere non-accruing, compared to 0.43 percent in 2005.

Morgenson also wonders whether to believe lenders' numbers for the percentage of defaulting mortgages, noting that lenders often go to great lengths to create "workout" plans that avoid foreclosing on homeowners. In theory that's a good thing --except when it's clear from the start that the homeowner in question won't be able to follow the workout plan or recover their footing enough to get right with the lender. In that case, lenient repayment schemes just constitute a form of welfare for unworthy borrowers who plan to declare bankruptcy, but are gaming the system in the meantime -- in one case, to continue to make payments on a Mercedes Benz that were in access of the mortgage payments the borrower was foregoing. :-<

The picture that's emerging from all these stories is of a mortgage industry that is based more on fantasy than reality, and that is sadly in need of reform and, in some cases, of closer scrutiny from regulators before the U.S. economy faces a 21st century version of the S&L crisis of the late 1980s (cost, ~ $150 billion) that helped sink the U.S. economy into a recession and, by the way, brought a booming real estate market to its knees.