The earnings shocks that rattled Aames Financial and Cityscape Financial could spread throughout the home equity and subprime mortgage sector, a report by Standard & Poor's Corp. warns.
Like Aames and Cityscape, subprime lenders in general may be failing to accurately evaluate the quality of their loans, and the underassessments could soon lead to a spate of earnings disappointments and writedowns, the debt rating agency concludes.
Competition and other factors "could be severe enough that even the best companies may be impacted," said S&P analyst David M. Graifman.
At issue is how the companies have assessed the riskiness of their loans. Potential missteps will affect lenders' excess servicing receivables, which is money they expect to receive through the securitization of their loans. The excess spreads, or returns, that subprime lenders rely upon will be undercut if loans prepay sooner than expected or must be written off.
S&P's assessment is not going over well with subprime lenders who say they are capable of correctly evaluating the loans they make. "We are very content with what we're seeing from an actual standpoint," John Hess, vice president at United Companies Financial Corp., Baton Rouge, La. "Our loan portfolio is performing as expected."
But S&P, which has put Aames' debt on the CreditWatch list for a possible downgrade and rates Cityscape's outlook "negative," said the potential trouble extends beyond those two firms.
If S&P's assumptions panned out, lenders would face hits to their capital and earnings. The consequences would not necessarily extend to securities investors, because bonds tied to subprime loans are often protected by outside guarantees.
Nor would the situation necessarily spark immediate downgrades by S&P, because the agency has already factored potential problems into the below- investment-grade ratings it has given most of these companies.
But increased competition and prepayment fears place subprime lenders under increasing pressure, Mr. Graifman said. S&P might downgrade the companies' debt "if economic or business conditions intensify to the point where the value of excess servicing receivable becomes impaired beyond a manageable level."
Ultimately, the subprime industry, like the banking industry, will be forced to consolidate, with larger lenders better positioning themselves through enhanced systems and economies of scale, S&P said.
