A Warning of Things to Come

Sub-prime mortgage lender Accredited Home Lenders issued an earnings warning yesterday morning, citing three main reasons for their disappointment:

"-Origination volume and loan submissions have not increased as much as the company anticipated and continue to be adversely affected by a combination of pricing competition and product contraction that has been prevalent in the market throughout 2006.
-Whole loan premiums and securitization returns are under more pressure than previously anticipated, caused a decrease in whole loan investor appetite for certain products, as well as changes in credit standards and equity requirements promulgated by the various rating agencies.
-Delinquency from production periods in 2005 and 2006 has risen above previous expectations, which requires the company to further bolster its reserves to prudently value the loan portfolio and potential exposure."

They claim not to have anticipated these developments, but all three were predicted by many commentators.

-Even in good times the Ponzi business model employed by most of the mortgage banking industry required ever increasing loan volumes to keep default rates down. New loans typically don't go bad as fast as bad loans, so the rapid growth rate of the sector helped hide the truth about the quality of their holdings. Now that the sector is having trouble growing, reported default rates are on the rise and profits are evaporating.
-The market for mortgage backed securities grew far too rapidly, and the supply of easy credit had to end. Now there are far fewer suckers out there who want to buy securitized sub-prime loans because the housing market has turned and foreign investors and portfolio managers are recognizing more of the risks.
-Imaginary profits were boosted by low reserve allowances. Their loss estimates were based on default patterns during the housing boom, not during normal times or a housing bust. As they have to increase reserves to cover real losses, their imaginary profits of the past turn to today's losses.

Most lenders are trying their hardest to postpone the bad news to keep their stocks afloat and their credit ratings intact. The situation is surely much worse than they are willing to admit. The mere fact that that more of them have started to give warnings is an indication that things are getting really bad in the industry.

(Additional problems in the lending industry were desribed in an earlier post.)


What is happening in the mortgage industry gives a good indication of what will soon be hitting the entire economy. Just as the mortgage lenders required an exponential increase in lending to preserve an illusion of prosperity, our economy has required exponential credit expansion and borrowings from foreigners to preserve the illusion of economic strength. For the past half century (and especially since the Reagan years), we've cycled through various sources of credit expansion, from government and industry to consumers, and finally to the pure speculation of hedge funds. Our main funding sources, aging baby-boomers and foreign central banks, are reaching a limit in their willingness and ability to extend credit, and the borrowers are reaching a breaking point with regards to debt service.

According to Moody's (and just about every other reporting source out there) defaults and delinquencies are up shaply this year. That's what happens to problem borrowers when they reach the limits of their ability to borrow. As it is happening to many homeowners, it will happen to many companies, many leveraged investors, and eventually the US government.

I cannot believe that Accredited's managment didn't see this coming long ago. When the company eventually fails, leaving shareholders with nothing to show for their investments, the executives will still retain the millions of dollars worth of compensation they've collected over the past few years. Likewise, when the US economy is brought back down to size, the financial industry executives who created great systemic risk and politicians who squandered the nation's wealth will most likely be living comfortably on their profits and pension benefits. Because our system compensates managers based on short term objectives, we get short sighted policies that have eroded our financial strength.

It isn't difficult to understand why Accredited is in trouble, nor is it difficult to understand why the US economy and government is in trouble. The difficult part is figuring out what the rest of us can do to protect ourselves when things really get ugly. (So far the short list includes paying down your debt and reducing exposure to risky investments.)