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Generational Dynamics Web Log for 12-Mar-07
New Century, country's second largest subprime mortgage lender, close to bankruptcy

Web Log - March, 2007

New Century, country's second largest subprime mortgage lender, close to bankruptcy

Analysts with rosy predictions are getting closer to jail.

New Century Financial Corp., the nation's second-biggest subprime lender (behind first place Countrywide Financial Corp.), said on Monday that it's defaulting on loans to lenders, and can't make the required payments.

For an ordinary person, this would mean personal bankruptcy. For New Century, it may well bankruptcy as well. However, keep in mind that old saying, "If you owe the bank $10,000 and can't pay it, then you're in trouble; if you owe the bank $10,000,000 and can't pay it, then the bank's in trouble."

In New Century's case, the "banks" include Morgan Stanley, Citigroup Inc. and Goldman Sachs Group Inc. They may get together and come up with a plan to keep New Century in business, or they may divide up New Century's assets. We should know by the end of the week.

Monday's New York Times has an article making the intriguing comparison between the current mortgage loan situation and technology stocks in the hi-tech bubble that ended in 2000:

"On March 1, a Wall Street analyst at Bear Stearns wrote an upbeat report on a company that specializes in making mortgages to cash-poor homebuyers. The company, New Century Financial, had already disclosed that a growing number of borrowers were defaulting, and its stock, at around $15, had lost half its value in three weeks.

What happened next seems all too familiar to investors who bought technology stocks in 2000 at the breathless urging of Wall Street analysts. Last week, New Century said it would stop making loans and needed emergency financing to survive. The stock collapsed to $3.21.

The analyst’s untimely call, coupled with a failure among other Wall Street institutions to identify problems in the home mortgage market, isn’t the only familiar ring to investors who watched the technology stock bubble burst precisely seven years ago.

Now, as then, Wall Street firms and entrepreneurs made fortunes issuing questionable securities, in this case pools of home loans taken out by risky borrowers. Now, as then, bullish stock and credit analysts for some of those same Wall Street firms, which profited in the underwriting and rating of those investments, lulled investors with upbeat pronouncements even as loan defaults ballooned. Now, as then, regulators stood by as the mania churned, fed by lax standards and anything-goes lending."

The implication is clear that the analysts who wrote these recent "upbeat reports" are going to be in serious trouble. More and more, we're seeing articles on "predatory lending" that blames the lending institutions themselves. But we're also seeing articles directed at other people, such as investors who collude with builders by purchasing a home at inflated prices, obtain a mortgage fraudently, and then split the proceeds with the builder.

But we've also seen an increase in articles that target analysts and economists. The most visibly ridiculed among these people is David Lereah, the chief economist at the National Association of Realtors, who predicts a housing upturn no matter what the data says. As an aside, recent press reports indicate that the spring, which is normally the best home selling season of the year, has been extremely disappointing for the real estate market analysts. It will be interesting to see if Lereah and others finally change their tunes.

However, the NY Times article quoted above hints that a much wider range of analysts are going to be investigated and targeted by prosecutors.

The article says that "bullish stock and credit analysts for some of those same Wall Street firms, which profited in the underwriting and rating of those investments, lulled investors with upbeat pronouncements even as loan defaults ballooned." In other words, these analysts published upbeat reports so that their own firms would make more money. This has implications of civil or criminal fraud.

However, government employees will be targeted as well: "Now, as then, regulators stood by as the mania churned, fed by lax standards and anything-goes lending."

So we have several groups of people -- lending institutions, analysts, regulators, investors -- all of whom are going to be investigated for criminal practices. And each of these groups will be saying, "It's not my fault -- it's the other groups' fault."

I've quoted this passage before, but it's worth repeating. John Kenneth Galbraith described what will happen in his 1954 book, The Great Crash - 1929, as follows:

"[Before the crash], to the normal needs for money, for home, family and dissipation, was added, during the boom, the new and overwhelming requirement for funds to play the market or to meet margin calls. Money was exceptionally plentiful. People were also exceptionally trusting. A bank president [was] unlikely to suspect his lifelong friend the cashier. In the late twenties the bezzle grew apace.

Just as the boom accelerated the rate of growth, so the crash enormously advanced the rate of discovery. Within a few days, something close to universal trust turned into something akin to universal suspicion. Audits were ordered. Strained or preoccupied behavior was noticed. Most important, the collapse in stock values made irredeemable the position of the employee who had embezzled to play the market. He now confessed. ...

Each week during the autumn more such unfortunates were reveled in their misery. Most of them were small men who had taken a flier in the market and then become more deeply involved. Later they had more impressive companions. It was the crash, and the subsequent ruthless contraction of values which, in the end, exposed the speculation by [financial firms] with the money of other people. Should the American economy ever achieve permanent full employment and prosperity, firms should look well to their auditors. One of the uses of depression is the exposure of what auditors fail to find. Bagehot once observed: "Every great crisis reveals the excessive speculations of many houses which no one before suspected."" [pp. 133-35]

Galbraith's point was that there were many criminal activities going on before the 1929 crash, but nobody cared, as long as everyone was making money. But once the crash occurred, any irregularity was viewed with suspicion and led to an investigation. These investigations turned up many cases of embezzlement -- people who had "temporarily borrowed" money that wasn't theirs to invest in the stock market, and then got caught in the crash.

By the way, this may be an additional reason why investors keep enlarging a bubble after it's increasingly clear that the bubble will be bursting. As I explained in my previous article, about how increased investor risk aversion leads, strangely enough, to higher stock prices. This is caused by the increased availability of money and a belief by the investor that he can get out of the market in time to avoid getting caught.

However, Galbraith's point about embezzlement provides additional reasoning: As credit becomes more and more available just before a crash, more and more people get over their heads in debt. Thus, investing in the stock market becomes an act of desperation, because the investor has to make enough money, before the bubble bursts, to pay off his creditors. Thus, "temporary" embezzlement becomes a tempting expediency. The investor may even reason, "Well, I'm already looking at bankruptcy and homelessness, so I really have nothing to lose by embezzling money."

So we can assume that there's lots and lots of embezzlement going on today. Perhaps you, dear reader, have embezzled some money in the hopes of escaping a desperate situation; or, if not you, perhaps the person sitting at the desk next to you. What history has shown is that it's a lot more common than people think, especially in these times of huge bubbles about to burst. Basically, normally honest people are so far in over their heads, that they believe that they've already lost everything and have nothing more to lose. These crimes are mostly not being investigated yet, but the level of investigations is going to increase, with absolute certainty.

And what does the public think of the analysts, investment firms, and regulators who allowed all this to happen?

Think back to 2000, when the Enron scandal began. At that time, much of the public wanted to see every corporate CEO, even the ones who had been honest, go to jail.

Or, better yet, think back to my own favorite example, the bankruptcy of the French Monarchy in 1789 that led to the French Revolution. In the Reign of Terror that followed, any person who was an aristocrat, a relative of an aristocrat, a friend of an aristocrat, a servant of an aristocrat, or even had a resemblance to an aristocrat, would be tried and quickly convicted and sentenced to the guillotine.

As I've said before, if you're an economics expert, journalist, investment broker, mortgage lender, analyst, regulator, pundit or politician whom the public decides is blameworthy for the major coming crisis, then I suggest that you'd better have your underground bunker picked out, because people are going to be coming after you, and the guillotine is going to seem mild compared to the punishment that they're going to want to inflict on you. (12-Mar-07) Permanent Link
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Generational Dynamics Web Log for 12-Mar-07 New Century, country's second largest subprime mortgage lender, close to bankruptcy

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Generational Dynamics Web Log for 12-Mar-07
New Century, country's second largest subprime mortgage lender, close to bankruptcy