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February 21, 2007

Pricing Risk
by Mike Shedlock

The USA Today is reporting Sacramento: The pressure's on sellers to lower their prices.

Here's an alarming fact about Sacramento's housing market: About one of every five existing homes on the market is a "short sale." That means the home is worth less than the value of the mortgage, and the lender is willing to accept less than full repayment of the loan to avoid foreclosure, says Tracey Saizan, president of the Sacramento Association of Realtors.

That, in turn, puts pressure on the remaining 80% of sellers, who have equity in their homes, to cut prices. The median price in the state capital, one of the most overheated metro areas during the real estate boom, fell 4.3% in December compared with December 2005.

"Sellers are having to give concessions and cut prices," Saizan says. "It's all about making the house show the best it can and aggressive pricing."

One in five sales is a short sale. That is pretty staggering. It will be interesting to watch this trend develop. What is clear is that lenders do not want those homes back. Equally clear is there are likely to be some huge tax consequences for forgiveness of debt some time down the road.

It seems to me that borrowers did not correctly price the risk of buying those homes. Many homes were purchased on a wing and a prayer without the income to support the purchase. Homes were bought for the sole reason that prices were rising and multitudes piled on in the belief that prices would rise forever. The fallout is just starting.

Subprime Lenders

It was not just buyers that mispriced risks. What were lenders thinking? It seems they weren't thinking much either. The Mortgage Lender Implode-O-Meter is now up to 23 US Mortgage lenders that have stopped subprime lending and/or gone bankrupt since Dec 2006.

The performance of subprime adjustable-rate securities issued in 2006 continues to deteriorate rapidly, and the default rate hit 4.62% in January, up 21% in just one month, according to a report by Friedman Billings Ramsey. The default rate of the 2006 origination year exceeds that of 2005 by 51.6% and that of 2004 by a "whopping" 137% at the same age, the FBR report says. The early defaults on 2006 originations have sparked massive loan buybacks and forced a dozen subprime firms into bankruptcy. In a previous report, FBR researchers warned that this book of business is rapidly deteriorating and that "higher default and loss rates may ensue."

Investor Risk

What happens when a high yielding dividend play suddenly declares it has no taxable income?

NFI provided that answer today.

NovaStar sinks 41%, leads subprime lender stocks down

NovaStar Financial (NFI) shares sank as much as 40% Wednesday, leading declines in shares of many subprime lenders as defaults mount among homeowners with poor credit histories. The decline came after NovaStar said late Tuesday that it may realize no taxable income from 2007 to 2011 and may drop its tax-friendly real estate investment trust status in 2008.

It also posted a fourth-quarter loss of $14.4 million, or 39 cents a share, compared with a year-earlier profit of $28.1 million, or 84 cents a share. "Earnings were indicative of the challenging non-prime environment and proved that no company will likely go unscathed," wrote Scott Valentin, an analyst at Friedman, Billings, Ramsey.

Valentin downgraded NovaStar to "underperform" from "market perform." Deutsche Bank Securities analyst Stephen Laws lowered his rating to "hold" from "buy."

The problems at NovaStar, based in Kansas City, Mo., are the latest in the subprime sector, where rising delinquencies and defaults and lower loan volumes are battering lenders. Many are losing money as investors such as Merrill Lynch demand that they buy back soured loans.

Wells Fargo (WFC), the largest subprime lender, said Wednesday that it is cutting 320 subprime jobs in Fort Mill, S.C. and Concord, Calif., saying loan volume may decline following a Feb. 16 tightening of its lending policies.

Supposedly this would "never" happen because home prices would just keep rising forever.

Leveraged Buyout Mania

Not having learned a thing about risk management from a multitude of subprime blowups, LBO Loan Rates are at Record Lows.

Henry Kravis and Stephen Schwarzman never had an easier time getting the lowest interest rates on loans from their bankers.

Just three months after borrowing $12.8 billion to pay for hospital operator HCA Inc. in November, Kohlberg Kravis Roberts & Co. and its partners negotiated a new loan with lower rates. Schwarzman, chief executive officer of Blackstone Group LP, is doing the same for a $3.5 billion loan that financed the takeover of Freescale Semiconductor Inc., the mobile-phone-chip maker.

Leveraged buyout firms are leading borrowers refinancing $64 billion of loans so far this year, more than in all of 2006, according to ratings company Standard & Poor's. Banks are giving in and reducing rates because corporate defaults are near all- time lows.

"This is the best loan market for borrowers I have ever seen," said Kenneth Moore, a managing director at First Reserve Corp., a private equity firm in Greenwich, Connecticut, that manages more than $12.5 billion and specializes in buying energy companies.

Loans for companies rated four or five levels below investment grade yielded an average 2.26 percentage points more than the three-month London interbank offered rate in the week ending Feb. 15, S&P says. That gap over Libor, a lending benchmark, was the smallest ever and compared with more than 4 percentage points in 2003.

Loans helped fuel a record $1.55 trillion in mergers and acquisitions in the U.S. last year, New York-based S&P said. So-called leveraged loans financed 57 percent of those transactions, the highest in seven years, it said. Leveraged loans are considered below investment grade and are rated below BBB- at S&P and Baa3 by Moody's Investors Service.

"There is clearly room to exceed the biggest loan deal ever done," Moore said. HCA's financing was the largest sold to investors.

Investor 'Influx'

More than 250 institutions purchased high-yield loans last year, compared with fewer than 100 in 2002, S&P says. Many of the investors are new to the market, including Boston-based State Street Global Advisors, which said in November it would start buying loans.

Little Risk

Lenders see little risk in giving borrowers what they want. An expanding economy is making it easier than ever for companies to meet their debt payments. The default rate on leveraged loans was 0.45 percent in January, the lowest ever, according to S&P. That compares with an average of 3.05 percent over the past 10 years, according to data compiled by Credit Suisse Group.

The U.S. economy will expand 2.7 percent this year, according to a survey of 69 analysts by Bloomberg News from Feb. 1 to Feb. 8. The anticipated rate of growth is 0.2 percentage point faster than a survey the previous month.

Too Complacent

Banks may be too complacent, according to CreditSights Inc., a New York-based debt research firm.

"The worst of loans are written in the best of times and that could well apply to the current lending boom," said Louise Purtle, an analyst at CreditSights. "Loan sizes are increasing, borrowers are becoming more levered, and the number and stringency of covenants is being reduced."

Borrowers in the U.S. this year have received or are seeking $16.3 billion of loans without so-called maintenance covenants, or restrictions such as quarterly limits on the amount of debt a borrower can have relative to earnings before items such as depreciation, interest and taxes. The amount compares with the record $24 billion for all of 2006, according to S&P.

'All About Control'

"Covenants are all about control," said GSC's Katzenstein. "With covenants, you can get concessions from the borrower such as an increased interest rate or fees" if they violate the terms of their loans, he said.

"The worst of loans are written in the best of times. Loan sizes are increasing, borrowers are becoming more levered, and the number and stringency of covenants is being reduced." I would say that about sums it up. But no one sees the risk because defaults are at record lows. Excuse me but weren't subprime defaults and foreclosures at record lows too before things starting blowing up just a few months ago?

I find this interesting too: More than 250 institutions purchased high-yield loans last year, compared with fewer than 100 in 2002, S&P says. Many of the investors are new to the market, including Boston-based State Street Global Advisors, which said in November it would start buying loans.

250 institutions are now plowing into junk right now when risk spreads are amazingly low. Of course that is not the proper way to look at it. The proper way to look at it is that risk spreads are amazingly low because so many institutional investors, some of them new to the market, have all decided they have to get in now. Is this the final panic attempt to get in before "It's too late"?

Whatever those institutions are thinking (if they are thinking at all) it's simply too late to go plowing into junk now, just as it was too late for flippers to be buying houses in December of 2005. But that's not stopping this train of thought: "There is clearly room to exceed the biggest loan deal ever done". Is that the idea .... to see just how insane things can get? If not, then what is the idea? Whatever it is, risk management sure is not part of it.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Michael "Mish" Shedlock is a registered investment advisor representative for SitkaPacific Capital Management. Visit http://www.sitkapacific.com/ to learn more about wealth management for investors seeking strong performance with low volatility.

Copyright © 2005-2008 Mike Shedlock

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