by Gregory J. Hindy, John G. Loughnane
For more than a decade, use of the term “subprime” was confined largely to market participants who created and propelled the mortgage industry. In the summer of 2006, a few economists began to broadcast the word, sounding the alarm of an overheated subprime industry and an impending housing crisis that would inflict widespread economic pain. Not many heard it at first, but over the past year, the alarm has grown so loud that it has become impossible to ignore.
The housing market that boomed in America for a decade was well into a slowdown by the beginning of 2007. In the ensuing months, a flurry of subprime lenders, overwhelmed by rising defaults by borrowers with poor credit records, folded or commenced bankruptcy proceedings. The Chapter 11 filing of New Century Financial Corp. in April 2007 grabbed the biggest headlines. The pain quickly spread beyond the subprime lenders.
In the summer of 2007, two large hedge funds managed by investment bank and brokerage Bear Stearns shut down as their complex subprime mortgage-related investments plummeted in value. Within a year Bear Stearns itself was on the ropes. Over the past year, numerous major financial institutions have announced billions of dollars in losses and write-downs directly attributed to the collapse of the subprime market.
This article provides turnaround professionals and financial players with a short summary of the history and structure of the subprime market, a brief analysis of the causes of the subprime crisis, and a discussion of opportunities for turnaround professionals in matters precipitated by the crisis.
The American Dream
In the early 1980s, short-term interest rates rose and long-term rates declined. This situation posed major problems for thrifts that were collecting lower interest rates on home loans than they were paying depositors. Relief came in the form of tax reform that allowed thrifts to sell their loans. The only buyers at the time were a couple of Wall Street firms that bought the home loans; had them stamped by Ginnie Mae, Fannie Mae, or Freddie Mac; repackaged them as bonds; and sold them to institutional investors as the economic equivalent of U.S. government bonds. Once the home loans were stamped and payment was guaranteed, the risk of a defaulting homeowner became economically irrelevant.
By the mid-1980s, the game was truly on. Wall Street firms began to generate their own loans to the housing markets, providing themselves and their mortgage traders with a steady flow of deals, the raw materials they needed to create mortgage-backed securities. The only change between then and now was the complexity of the mechanisms used to create the mortgage-backed securities — and the number of participants looking to grab a piece of the ever-expanding pie.
Home ownership has always been a staple of the American Dream. A confluence of circumstances occurred in the new millennium that ushered people into a new age of home ownership and staggering debt. The stock market rode a technology wave and, despite some corporate scandals, remained fairly strong. As a result, more Americans had more money than ever before.
Interest rates were at historic lows; housing prices were rising and would continue to rise to a crest of appreciation never seen before. There were plenty of buyers willing to take on huge debt, and an overabundance of mortgage products being hawked by — in many cases — less than candid mortgage brokers, who had a seemingly limitless supply of available cash to lend and a wide array of mortgage products. It was the perfect storm.
Each year from 1997 through 2001, about $150 billion in subprime mortgages were issued. That number began to climb in 2002 to $200 billion. By 2003, more than $300 billion in subprime mortgages were issued. By 2005 — just two years later — the number more than doubled to in excess of $600 billion. Growth was flat in 2006, and by 2007, the market had receded to pre-1996 levels — less than $150 billion in subprime mortgages were issued.
The prevalence of subprime mortgages can be attributed to a radical change in the business model of residential mortgage lending. Prior to the new millennium, prospective homebuyers had to demonstrate convincingly their financial wherewithal to fiscally conservative lenders.
That scenario changed during what could be called the Securitization Era. There was an increased securitization in mortgages, including subprime mortgages. There was also an increase in the number of independent mortgage brokers. Emphasis was placed on deal flow rather than on creditworthiness of borrowers. “Low-doc” and “no-doc” loans, which carried few requirements in the way of application documentation, became common.
Higher loan-to-value ratios were used so borrowers could buy bigger, better, nicer houses with less money down. Adjustable-rate mortgages were used so that buyers could get into homes they otherwise could not afford.
The reason for this was simple: those who were herding borrowers into these questionable deals — the independent mortgage brokers — had no incentive to care. They were paid commissions on the volume of loans they originated. No mortgage broker complained if a buyer needed to refinance every few years when a mortgage adjusted: more closings translated into more fees for the brokers.
The original lenders were less concerned with the financial wherewithal of their borrowers than ever before because their loan portfolios did not stay on the books. Wall Street was uninterested in the creditworthiness of borrowers or loan-to-value ratios because it would buy the mortgages, package and securitize them, and then sell the instruments to investors. Ultimately, the market would bear the risk of the recklessness of the process.
This model worked beautifully until interest rates rose, property values leveled out and even began to decline, and mortgages adjusted, triggering defaults on the subprime mortgages issued between 2003 and 2006. Suddenly, the once well-oiled machine ground to a halt.
In simple terms, securitization in the subprime mortgage arena involves pooling residential home loans and turning them into bonds (mortgage-backed securities). The purpose behind securitization is to increase the amount of money available to borrowers and to improve liquidity in the credit markets.
Typically, a transaction worked like this: a borrower who wanted to buy a house consulted a mortgage broker, who assisted the borrower in submitting a loan application to a lender and recommended a variety of mortgage products, most of which were adjustable-rate. The lender provided money to the borrower and in return took back a mortgage.
As part of the securitization process, the lender then creates a trust, to which it sells its rights under the mortgages, including its right to receive the principal and interest payments. The trust, known as a special purpose entity (SPE), then owns the loans. The SPE is typically bankruptcy remote and exempt from taxes. It allows the lender to treat the transaction as a loan sale and insulates investors from liabilities of the lender. The SPE controls the collateral and receives the principal and interest payments from the servicer.
Once the SPE owns the mortgage loans, it then issues securities collateralized by the mortgage loans or, more specifically, by the principal and interest payments, as well as the underlying property. The underwriter or investment bank buys the securities from the trust and resells them to investors. The borrower’s monthly payments are sent to the mortgage servicer, who remits to the SPE, which then forwards payments on to the investors. The investors receive the principal and interest payments.
The process works until there is a break in the chain, which began to occur when the subprime loans issued from 2003 through 2006 began to adjust.
Countless adjustable-rate mortgages climbed to higher rates, and many borrowers could not afford the resulting higher payments. Worse, they could not refinance because interest rates had risen while their property values declined, leaving little or no equity in their homes. Borrowers stopped making monthly payments, defaults occurred, and mortgage-backed securities became worth much less because there was no revenue stream and the amount owed was greater than the collateral.
The implications of the subprime meltdown have been far-reaching. The fallout includes a rash of litigation and a tightening of credit impacting not just the subprime market but also the whole economy. The American consumer, unable to rely on increasing home prices or easy access to mortgage financing, is being pummeled, which has affected certain retail segments and other sectors.
The credit crisis has already thrown off an enormous amount of litigation. There have been numerous bankruptcy filings, including New Century, and putative class action litigations focused on alleged securities fraud and Employee Retirement Income Security Act (ERISA) violations, as well as numerous criminal investigations by the U.S. Department of Justice, the Securities and Exchange Commission (SEC), state attorneys general, and others.
As of mid-March, more than 400 civil lawsuits had been filed against participants in the subprime mortgage market, and nearly 40 related criminal investigations related to subprime were underway. In addition, there have been about 75 bankruptcy filings relating to subprime.
A credit crunch has emerged affecting many markets that have nothing to do with subprime mortgages. For example, financing costs for numerous nonprofit entities, including hospitals and educational institutions, spiked dramatically this winter.
Historically, these institutions relied on the auction rate securities market to refinance long-term debt obligations by issuing short-term bonds on a regular basis through auctions held at scheduled intervals. The auction market was a stable source of reliable liquidity and cheap financing, enabled in part by guarantees issued by certain bond insurers.
The subprime debacle thrust significant risk on bond guarantors. At the same time, Wall Street firms that helped enable the workings of the market began to suffer dramatic losses. For the first time, the regular auctions began to fail, and numerous nonprofits saw bond interest rates shoot up to levels never previously seen.
The unprecedented increased costs of short-term borrowing led many nonprofits to seek to restructure or refinance the long-term debt. Commercial banks have been called upon to provide credit enhancement in the form of letters of credit. These unexpected costs will burden many entities with unexpected and unwelcome debt.
The tightening of credit also has thrown a wrench into buyout deals sponsored by private equity. In late March, two Boston-based buyout firms, Bain Capital and Thomas H. Lee Partners, filed suit against six banks in an attempt to force them to close on the financing of a $19.5 billion buyout of Clear Channel Communications. As widely reported in the media, the buyout firms contend that the banks reneged on their finance commitment due to the worsening credit markets.
Under the original deal agreed to last summer, the banks were to provide about $22 billion for the contemplated $39.2 billion acquisition of Clear Channel. The banks, which vigorously deny the accusations, reportedly in this market would face significant losses if they are forced to complete the deal as originally agreed. Buyers of slices of the loan probably do not exist or would be willing to purchase only at discounted prices.
Another industry unrelated to subprime that has been dramatically affected by the credit crunch arising from the subprime debacle is the student loan financing market. Demand for private and government guaranteed student loans slumped badly after the subprime collapse. That caused several lenders, including CIT Group Inc. and Northstar Education Finance Inc., to exit the business entirely.
First Marblehead, a Massachusetts-based company in the business of underwriting, packaging, and securitizing student loans, reportedly last issued student-loan bonds in September 2007. A Massachusetts nonprofit organization called The Education Resources Institute (TERI), which provided guarantees of student loans that First Marblehead originated, commenced Chapter 11 on April 7.
Within three days, plaintiffs’ lawyers filed a securities class action lawsuit in the U.S. District Court for the District of Massachusetts against First Marblehead and certain directors and officers alleging material misrepresentations “concerning the performance and quality of First Marblehead’s securitizations, its ability to perform additional securitizations, TERI’s ability to adequately guarantee [First Marblehead’s] student loans, and the Company’s financial results and its ongoing operations.”
In addition to these impacts on other markets, the subprime crisis also has taken its toll on the American consumer. Accustomed to not saving and living day to day, and reliant on easy access to credit, the consumer has been confronted with a new reality: stagnating or falling home prices and a major disruption in the supply of easy home mortgage and home equity loans.
The result has not been pleasant for several sectors. Homebuilders, of course, are struggling, as are firms that supply them. Also in the crosshairs are retailers of furniture, jewelry, and electronics. Chapter 11 filings in the past several months included Alpha-Omega Jewelers, Bombay Company, Domain Home Furniture, Friedman Jewelers, Levitz, and The Sharper Image. Other chains, such as Linens ’n Things, are reported to be on the verge of filing. Still others, such as Ann Taylor, Foot Locker, and Zales, will be closing hundreds of stores over the next several months.
On the Front Lines
The term “subprime” is now ubiquitous. Turnaround professionals will continue to be on the front lines of the fallout of the subprime collapse for quite some time. Work will focus not just on subprime participants but also on a variety of other industries and markets that are suffering the secondary and tertiary affects of the subprime collapse.
Significant litigation, tightening credit, and a contracting economy will create challenges for many companies and financial institutions. Restructuring professionals will be instrumental in helping clients weather the storm to realize the highest value possible during challenging times.