US mortgage liquidity crisis at hand

The largest U.S. mortgage provider has weighed in regarding the troubles of the subprime market that we’ve been talking about here for the past few weeks. According to the CEO of Countrywide Financial Corp., the problems in the subprime market have already started to spill over into the mainstream mortgage sector.

“This is now becoming a liquidity crisis,” and “it’s going to get uglier,” Mozilo said on CNBC television.

In the four weeks since Craig started this discussion and raised his concerns about the subprime space, this is what has happened to some of the stocks the were at the vanguard of the subprime market:

Accredited Home Lenders has been cut from $25.22 to $3.97 (First Call’s aggregate price target for the ten research analysts following the stock was a mere $28.43 at last report)
New Century Financial has fallen from $17.10 to $1.66
NovaStar is down from $15.98 to $3.43
Triad Guaranty has been trimmed just a snick from $49.82 to $40.82

Naturally, I’m not suggesting that money managers should follow blogs for stock ideas, long or short (although Craig did beat The Toronto Star by over 3 weeks, for example, but not the Globe). But this recent episode does give us some confidence that we aren’t necessarily wrong to back off from time to time when we see a competitor doing a deal on terms that appear to assume at lot less risk then we forsee in a given situation.

If you don’t price for risk, and take into account historical default rates as well as sound lending practices, you’ll never survive a single economic cycle.

There is a warning in this retail subprime mortgage episode for corporate borrowers, however. For those would-be borrowers that are turning to private debt funds (or hedge funds playing the lender role) that rely on substantial amounts of leverage from third party banks, watch out. If those banks (primarily U.S.-based) that specialize in lending to finance companies begin to cut back on the credit they provide to your prospective lender, which in turn provided that credit to your company (backed by a bit of their own equity), you can imagine how fast your credit facility will get called in that scenario.

In our case, each of Wellington Financial’s loans is 100% backed/funded by institutions such as pension funds, life insurance companies and federal crown corporations; our Limited Partnership Agreement doesn’t allow them to cancel our outstanding portfolio (ie, remove that capital and force us to pull loans) or reduce our existing funds outstanding, regardless of what happens in the credit markets. While we have the right to use 20% leverage (provided by a bank), versus the 200-400% leverage from 3rd parties that some in the industry are utilizing (ie. each venture debt or sub debt loan is made up of between $2 to $4 of 3rd party debt for each $1 of their own equity), any leverage is always irrevocably backed by our LPs.

But if you’re borrowing from a firm that needs banks to keep it liquid, and the liquidity crisis referred to by the Countrywide CEO continues to leak into other areas of the financial markets, the music could stop playing for you just as quickly as it has for the shareholders of New Century, Accredited, et al.

Never hurts to do due diligence on anybody whose financials are private, just as your lender does on you. And if you think the liquidity crisis in a sector of a foreign economy unrelated to your business won’t effect your business, just ask CIBC’s shareholders how distant it all is: the Commerce’s (CM-TSX) market cap shed $350 million yesterday alone. Their exposure to US subprime? Rounding error. But trouble in the credit markets causes tightening at the rest of the sector as well, and earnings can’t grow if credit doesn’t continue to flow/grow at the chartered banks.

A $7 billion hedge fund can go bankrupt and no one notices, but the credit markets and securitization conduits are different beasts altogether. To quote Gordon Gekko: “I don’t like losses, Sport!” Same goes for the multibillion $ institutions that provide liquidity to the capital markets.

No one in a bank credit department or risk management group ever got fired for not losing his/her institution money.

MRM