Investors have turned cold on the home equity sector.
A massive writedown last week by Green Tree Financial Corp. was taken by many as evidence that the same problems that devastated the subprime auto sector this year could bring down the entire subprime group.
Stock prices dropped throughout the sector, and though prices have recovered slightly, few investors are looking at subprime mortgage companies as long-term holdings.
"I invested in all these companies when they had their initial public offerings," said one portfolio manager at a Piper Jaffrey conference this week in New York. "Now they're just trades."
Increasing competition in the past 18 months is now taking its toll, and not in the way that skeptics had first thought it would.
Some had feared a loosening of credit standards. But a worse problem for Green Tree and other lenders has been prepayments, which force them to radically restate accounting assumptions.
Prepayment rates in some subprime mortgage companies' loan pools are as high as 40%, with borrowers often refinancing less than two years after taking out their loans.
Delinquency rates are also skyrocketing for some lenders, and the ensuing foreclosure losses will be more than triple what had been expected, say industry experts.
"Most companies are only assuming a 50 basis-point loss rate," said Christine A. Reich, managing director of Ocwen Financial Corp., a West Palm Beach, Fla. distressed-asset specialist. "But we're projecting actual loss rates of 180 to 210 basis points."
Gain-on-sale accounting, which enabled subprime lenders to dangle strong earnings growth before investors, is now coming back to haunt the sector. The accounting tool allows lenders to book profits on the returns from loans-and therefore earnings-before the loans are paid off. Now that several companies, including Green Tree, Aames Financial, and Cityscape Financial Corp., have been forced to restate earnings, investors seem to have lost faith.
"These companies are trading at five times earnings," said the portfolio manager, "because no one believes the earnings. We're just waiting for the writedown."
At the conference, lenders' presentations concentrated on proving that they were conservative in their gain-on-sale assumptions, and had set aside adequate reserves for prepayments and losses. But the market wasn't buying it.
"If anyone had told me 12 months ago that we would grow earnings per share by 50%, and our stock would still be at the same price, I wouldn't have believed them," said Marc Turtletaub, chief executive of Money Store Inc., Sacramento, one of the largest home equity lenders.
But for Mr. Turtletaub and his peers, the worst is true. The air seems to have gone out of the sails of the home equity sector-and observers think the industry may never completely recover.
"The economics of the industry aren't getting any better," said Tom Foley, analyst with Moody's Investors Services, New York. "All these assumptions are based on a great economy and stable interest rates-and that's not necessarily going to hold true for the next 10 years."
Mr. Foley is also predicting additional writedowns in the first quarter of 1998, and a possible famine of capital funding. "There may be a day when debt or equity deals can't be done," he said. "If a company is not cash- positive, it may have to find someone to buy it."