They say the definition of insanity is doing the same thing over and over again, expecting a different result. It's hard to believe, but subprime lender New Century which is experiencing potential bankruptcy type problems from its subprime lending portfolio decided that the way out of its problems was to make additional subprime loans. In other words, they wanted to loan their way out of the problem. The logic of the madmen making policy at New Century is that if you have a billion dollars in loans, and 1% defaults, than you have a problem with $10 million in loans.



If however, you loan out another billion dollars quickly, and maybe, just maybe these new loans are okay, and how could they be, if the same fellows who made the problem loans are the same fellows making the NEW loans? You could theoretically now say that you have a $10 million problem with $2 billion outstanding rather than $1 billion outstanding, therefore your new default rate is ½ of 1%, instead of 1%.

Do you believe how some people think, and they wonder why the year-end bonus seems a little short? New Century's stock was $14.65 last Friday, it is now $3.87, and may be on the verge of a bankruptcy petition. We don't know if the lending institution is going bankrupt because they don't know if they are going bankrupt. This is what one means by using the term out of control. New Century is absolutely clueless as to whether the subprime borrowers they gave money to are going to be able to pay them back, on a timely basis.

What's true of New Century based in beautiful and delightful Irvine, California is true of all subprime lenders. These guys gave credit to just about anybody walking through the door when housing was booming, because THEY COULD, and they never looked back to see if it made sense. They operated under that famous managerial policy called – It Will Be Okay.

Even the Hedge Funds got Taken In

How would you like to be an investor in Greenlight Capital LLC? You are paying the manager 20% of your profits, plus 2% fees expecting alpha (extraordinary) type performance, and he buys a $160 million worth of New Century stock, that is now worth $14 million. Don't forget by the way, that most hedge fund managers use 6 to 1 leverage, which means this investment is sucking wind as they say.

Banks Walking Away

Citigroup which has been a major lender to New Century has walked away from committing to additional financing. Morgan Stanley always eager to lend a helping hand has picked up the slack. They already have about 1 ½ billion dollars in credit extended to the overextended subprime lender. Barclays Bank is responsible for a billion dollar credit line to New Century, and they think they are okay – SURE. My point is you are only okay when the check clears the bank, and not too many checks are clearing at New Century right now.

The lender believe it or not has in one year made loans totaling $60 billion. What does it mean for the rest of the industry? Other subprime lenders have publicly announced that they are OKAY. Really, do you really think anybody right now in the subprime industry has a handle on their EXPOSURE? The answer is NO; the whole industry is clueless as to where they stand right today, but they are working nights to find out.

At the same time they are making public statements that they are okay. If one child in the house has the flu, it is more than likely that the whole house is going to have a problem. A year ago, every mortgage broker in America was bending over backward to make a deal with anyone coming through the door to finance a house, condo, second home, or a new garage for a third car.

Twenty-two year old kids straight out of community college were putting on a suit and tie, and leasing a Porsche. They were calling themselves a mortgage broker making a $100,000 to $200,000 their first year in the business cold-calling telephone directories asking to finance just about any real estate idea you had in mind. It seems that it is an incontrovertible fact of business, that there's always a price to pay for easy money. It always comes home to haunt you.

As we speak, credit lines are tightening. Money is being cut off to the subprime lending institutions. It's going to get far worse before the turn comes. New Century is only the first to announce they have problems. There will be others. At first comes the cautionary statements, than the "we are looking into it statements", and finally "we have a problem but we haven't quantified it statements". It never seems to change, does it? Some people don't get it. They never get it.

Now the Federal regulators have stepped in, announcing a criminal inquiry into New Century's trading practices, and accounting issues. If you own any of the dominant companies involved in the subprime market, you had better be reassessing your ownership right now, because you didn't do it a month ago, when prices were a lot higher than they are today, and today they are a lot higher than they are going to be a month from now. These companies include:

Name of InstitutionLoans (billions)

Countrywide38

New Century34

Option One31

Fremont30

Washington Mutual29

First Franklin28

RFC26

Lehman Brothers24

WMC Mortgage22

Ameriquest21

These companies are responsible for a combined total of about $280 billion in subprime lending.

The REAL PROBLEM

A country, any country is run on consumer confidence. The consumer in this country has kept the economy going by spending based on wealth accumulation. Incomes are not up that much in the last couple of years, but what has happened is that real estate has skyrocketed. People took out home equity loans and spent the money. They are still left with the loan outstanding.

You compound the problem by having hundreds of thousands of people buy additional real estate properties that they never intended to live in. They were bought on speculation as they say, and when leverage is going your way, there is nothing more beautiful, but reverse leverage is about the ugliest financial circumstance you will ever see. It is a slippery slope that never ends well.

Our work at StocksAtBottom.com was leading us to believe that real estate in this country was in the process of bottoming, but this subprime problem adds an entire new dimension to the issue. Where will the continued prosperity come from to keep the economy going if not from increases in residential housing, where such increases are in the process of vaporizing until the subprime issue gets out of the way. As they said in the movie, Apollo 13, “Houston, we have a problem.”

Good bye and good luck,

Richard Stoyeck