The Trickle-Down Could Get Ugly

Several places have reported that New Century has stopped taking loan applications. Their 8-K filed with the SEC also reveals their very limited funding capability. While it is tough to lose New Century and Fremont as outlets for subprime loans the real problems are the existing pipeline. Take this example:

My company is a correspondent lender which means that we close the loan in our own name using a warehouse line of credit after we have a clear to fund the loan from an end investor. This clear to fund is the investor’s OK that they will purchase the loan once the file is delivered to them. If a file is closed outside of guidelines or is incomplete they won’t purchase the loan. Smart companies are very deliberate in funding loans themselves as they can be stuck with a loan if they close it outside the guidelines of the end-investor. Of course, acting as a lending institution instead of a broker has many benefits that make up for this risk as long as it is properly mitigated through sound quality control procedures. There are safe guards throughout the process as well. Even your warehouse line gets in to the act identifying other investors that may be able to purchase the file if there is a problem at your identified investor.

Here is where the problem comes in. If you have a final clear to fund from a bank like New Century and you fund it; you expect that as long as you meet the guidelines of the file they will purchase it. You also feel comfortable that by delivering a good loan that there are other banks that will purchase it on the off-chance that something goes awry with that investor. You even check this fact based on the loan’s guidelines to ensure another outlet. But when New Century (a leader in subprime) craters, runs out of liquidity to purchase your loan, and then sets in motion a chain reaction that forces every potential lender to change their guidelines in response to the fall out you now have a loan that no longer fits other banks’ guidelines and the identified investor can’t buy your loan.

You now have a loan that is unsellable. This is a big problem because the loan you are now holding is probably sold to the borrower at an interest rate of between 6.5-8.5% and you are borrowing the money from your warehouse line at between 9.5% – 10.25%. So you are facing a loss while you hold it. Toss in aged loan fees, etc. and you have a very expensive loan. Warehouse lines are also only temporary credit lines so you need to find a home for the loan. This may mean taking it to a "scratch and dent" lender who will buy unsellable loans at a discount. This discount may be anywhere between 80 to 98 cents on the dollar. If you have a $500,000 loan being bought "scratch and dent" for 80 cents on the dollar you have a loss of $100,000 on that loan. Not a pretty picture for a smaller correspondent lender.

My company has one such loan – and we hope that we will be able to identify another home for it or that New Century will be able to lend just enough longer to purchase our loan. That’s not a great feeling. There are probably thousands of loans waiting, just like ours, to squeeze in with the last drops of liquidity available at New Century and get the loan off of their temporary lines of credit. There are shops smaller than ours, with less net worth, that are facing many loans that no longer have homes. 5 to 15 loans that are sold at a discount of even 5 cents per dollar will most likely bankrupt these smaller companies. You may well see (or may not, since they are not public and are small entities) hundreds of small correspondent lenders go bankrupt in the next 30 days as a result of this; unless New Century is able to resume lending.

We have more than just that going against us though. Imagine if you are a salesperson for New Century and you have one account (like us) that only has one loan in the pipe to get through; and you have other accounts that have 15 loans to get through; and you know that there is limited remaining funds for purchasing loans, whose loans are you going to try to get through? Well you certainly aren’t pulling any favors for the one loan shop – you are hoping that if New Century does resume that you’ll keep you big business providers by pushing their loans through first. It sucks, but I guarantee its going on right now – people are pulling favors for their favorite accounts to keep them happy. We’ll go to the very back of the line.

Now if all of these people can’t sell their loans anywhere they will all have to go to "scratch and dent" and that will create excess supply for the scratch and dent market – depressing prices of scratch and dent loans and increasing the loss that these correspondent lenders are going to have to take on each loan – exacerbating the problem.

Luckily, we moved away from New Century as a business partner over 3 months ago towards Countrywide. We recognized that we needed to be with stronger partners with more product offerings and more competitive pricing to stay strong in a down market. I truly feel for all of those small shops that only had New Century to sell to and are now scrambling to find a home for their loans. I hope that we can unload this one that we have one way or the other.

So if New Century does go down – and it looks bad right now, you will see a large flurry of shops closing down. It will be the break in the damn that shuts down the cottage industry of small correspondent lenders and small broker shops across the country. It will be massive and will happen extremely fast.