Interest Rate Roundup

Thursday, January 04, 2007

lessons from the subprime crack-up

The Boston Globe is reporting this morning that the sudden shake-up at Mortgage Lenders Network is causing some real trouble. Millions of dollars worth of mortgages, and several home closings, are falling through because MLN has decided to stop funding loans through its wholesale lending arm.

You might think this is sudden. You might be wondering: "How can a company whose goal it was to make $12 billion worth of mortgages in 2006 get into so much trouble, so fast?" But it's not really a surprise at all if you understand how this business works.

In short, many subprime lending outfits make loans, then sell them off fairly quickly, then use the influx of capital to make new loans. They rely on liquidity and quick turnover. They are not large diversified banks with billions of dollars of deposits at the ready to tide them over if the secondary markets shut down or seize up. If anything gets in the financing “gears,” and those gears seize up, thinly capitalized lenders can go from viable business to bankruptcy in a matter of months, if not weeks.

That's EXACTLY what happened in 1998, when the subprime lending industry last blew up due to an excess of high-risk, 125% LTV lending and a seizing up in the capital markets related to the Russian debt default and Long-Term Capital Management crisis. This time around, things aren’t that bad yet. But they could get that way if more, larger lenders start experiencing funding problems. Food for thought.


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