After Financing the Housing Boom, Wall Street Shuts Off the Spigot

New Century's collapse illustrates how the residential real-estate market was fueled through generous credit. Now that the flow of cash has been stopped, more than two dozen subprime lenders have been forced to close shop.
By: Gregory Zuckerman: The Wall Street Journal Online
On a March 6 conference call, New Century Financial Corp. Chief Executive Brad Morrice seemed hopeful.

Increased defaults were hammering loans the company had made to less-creditworthy home buyers, and its lenders were preparing to declare it in default. But Mr. Morrice told bankers from Citigroup Inc., Goldman Sachs Group Inc. and its nine other Wall Street lenders that he had a plan to secure new financing so he could keep his mortgage business going. He just needed a little time.

Hours later, the bankers began formally terminating lending agreements that had provided $8 billion to New Century - pushing the nation's second-largest mortgage lender to risky "subprime" borrowers (behind HSBC Holdings PLC's HSBC Finance Corp.) to the brink of bankruptcy.

By extending generous credit to subprime lenders, Wall Street firms financed the borrowing binge that helped fuel the housing boom. Those firms now are turning off the money spigot. They see more borrowers having trouble paying off those mortgages in a slowing economy, which has made investors less willing to pour money into the sector.

More than two dozen subprime mortgage lenders have closed shop, and there is concern that the defaults could spread to other types of risky loans and to less-risky mortgages, exacerbating the housing market's slowdown and possibly weighing on the economy. Accredited Home Lenders Holding Co., a subprime lender, recently was forced to sell $2.7 billion of loans at a big discount to meet lenders' demands for more collateral.

Worries about defaults in slightly less-risky mortgages also have hit shares of companies that specialize in them, including Impac Mortgage Holdings Inc., where loans with overdue payments more than doubled last year, and IndyMac Bancorp Inc.

Subprime lenders sell many of their loans to Wall Street banks, which package them into securities to be sold to bond investors. The appetite for these bonds grew when interest rates were falling and investors wanted high-yield alternatives. The riskier the customer, the higher the interest rate, so subprime bonds were in demand.

Though banks make money lending to subprime companies, packaging the bonds produces hefty fees - an estimated $2.3 billion last year, up from about $500 million five years ago, according to Thomson Financial data. Fees for other services added to the windfall.

No Money Down

New Century, which declined to comment for this article, was one of Wall Street's biggest subprime customers. Founded in 1995, the Irvine, Calif., company had mortgages totaling almost $60 billion last year, up from $6 billion five years ago on the strength of no-money-down loans and other edgy products. Mr. Morrice, one of the company's founders, became CEO last July.

Before things fell apart recently, Wall Street's relationship with subprime lenders was close. New Century executives spoke at conferences hosted by Wall Street firms, including a Morgan Stanley gathering in New York City last June.

An early sign of a chill in that relationship came when subprime lender Ownit Mortgage Solutions Inc. defaulted on its credit line in mid-November. J.P. Morgan Chase & Co. gave the company a month to come up with additional capital, and Merrill Lynch & Co. demanded that Ownit buy back poorly performing loans. Ownit declared bankruptcy within weeks.

By early December, subprime-bond investors were getting nervous. By one measure, the cost of insuring against default on some of the bonds jumped 50% in a week as demand for such protection spiked. The price of New Century's mortgages was dropping on Wall Street.

At a January industry conference in Las Vegas, New Century executives tried to calm investors. They "stressed that they're making better loans now," a person who met them says. "They were reassuring everyone."

In February, New Century mortgages that had been worth $8 billion fell by more than $300 million within days, someone familiar with the matter says. The result: More lenders demanded additional collateral, also called margin, from New Century, including Goldman and Credit Suisse, people familiar with the matter say. Banks also invoked terms allowing them to demand that the company buy back loans if borrowers failed to make payments.

The company's cash was dwindling quickly. Adding to the company's woes were revelations about accounting problems, plans to restate 2006 earnings and post a fourth-quarter loss, and a Securities and Exchange Commission inquiry.

New Century was running out of options. It was unable to get new financing and in violation of its existing lending agreements, in part because it was low on cash. So the company convened the March 6 conference call with its 11 lenders. Mr. Morrice, the CEO, was joined on the call by New Century board member David Einhorn, who runs Greenlight Capital, a New York hedge fund that owned 6% of the company's stock, which by then had fallen 70% in two weeks.

Mr. Morrice informed the bankers that New Century's available cash had dropped to $40 million, down from the $100 million he had reported to some of the bankers a day earlier and from $350 million at year end, a participant on the call said.

The CEO told the bankers he was working with Mr. Einhorn and Bear Stearns Cos., another Wall Street firm, on a plan to stabilize the company's operations. The banks were holding New Century mortgages as collateral for $8.5 billion worth of loans. Under the plan, the banks would return those collateral mortgages to New Century so it could cobble them together into new bonds that would be sold to raise money.

The proceeds would allow the company to repay the 11 lenders and continue generating new mortgages.

Mr. Einhorn told the bankers that his firm would consider buying the riskiest of the new bonds, which otherwise might have few takers given the sinking subprime market. The Bear Stearns bankers expressed hope that they could make the plan work.

Shocked Bankers

The bankers listened without indicating whether they'd help. In private meetings after hanging up, some expressed shock at New Century's precarious state, given its depleted cash supply. "That told us the situation was more dire than we thought," says a banker on the call.

That night, Citigroup moved forward with a decision to declare New Century in default. Others followed. The next day, Mr. Einhorn resigned from New Century's board. Though Morgan Stanley agreed to a $265 million loan, it demanded as collateral a loan portfolio worth even more, and reversed course a few days later and cut off additional financing.

On March 12, New Century announced that it couldn't pay its creditors and that all lenders had halted financing. The New York Stock Exchange suspended trading in New Century shares as a filing for protection from creditors in federal bankruptcy court started to seem inevitable. (The stock now trades on the Pink Sheets at $1.11 a share, down from the 52-week high of $51.97.)

The woes of New Century and others in the subprime industry aren't necessarily bad news for Wall Street. Some firms are shopping for battered mortgage lenders' bargain-priced assets.

"What we're seeing [is] a good opportunity for us around the subprime space," Lehman Brothers Chief Financial Officer Christopher O'Meara said March 14. Goldman and Bear Stearns executives also have expressed interest in finding subprime opportunities amid the wreckage.

Morgan Stanley, which had loaned $2.3 billion to such companies, says its subprime business was a "significant contributor" to robust first-quarter profits. The firm made some good trades betting that subprime woes would deepen, hedging their exposure to the market, and had collateral to back up money it loaned to now-struggling subprime companies, people familiar with the matter say. Even New Century's expected bankruptcy filing presents an opportunity: Lazard Ltd. has been hired as a restructuring adviser to the company.

"Shed no tears for the titans of Wall Street," Kathleen Shanley, an analyst at bond-research firm Gimme Credit, wrote in a report. Its title: "Never Bet Against the House."

Wall Street's Exposure

Wall Street isn't yet free of risk from the mess. If it drags down the economy or weighs too much on the housing market, the banks will feel pain like everybody else. The firms also could see losses if the value of mortgages they accepted as collateral falls too far or if their risk-hedging strategies weren't up to snuff.

And burned investors and borrowers could sue the Wall Street banks, arguing that they shouldn't have allowed things to get out of hand. A lawsuit seeking class-action status, filed on March 19 in federal court in California, includes Morgan Stanley and Bear Stearns as defendants, alleging that they included false statements in documents describing New Century's plans to sell new preferred shares of itself to the public.

Morgan Stanley declined to comment on the suit. Bear Stearns didn't respond to requests for comment.


- Randall Smith contributed to this article.