Default Risk Hurts Financial Stocks

People have been talking about the debt problem for years, and the mortgage debt problems that stem from rising adjustable mortgage rates for months, but last week (finally!) financial sector investors were forced to acknowledge something might be amiss. California-based sub-prime mortgage lender, New Century Financial, securitized millions of dollars of these sub-par loans but couldn't get rid of the paper fast enough. The fine print on those securitizations forced New Century to take back loans that went into default within six months of issuance, and as a result the company reported it will have to report a loss in 4Q 2006. As a result, the stock tumbled 36%. Barron's reminded its readers that it first highlighted the risks New Century was taking in an October 11, 2004 article. The stock has lost 67% of its value since then.

HSBC, the UK's biggest bank, acquired Household Finance in a distress sale a couple of years back, and then used Household to make all number of risky mortgage loans to borrowers who didn't used to qualify for mortgages based on the borrowers' poor track record of paying people back, paltry income, and the over-sized price tags on the homes involved.

Last week, HSBC was forced to admit that over $10 billion of shareholder money lent to sub-prime borrowers in the U.S. mortgage business wasn't likely to get paid back after all, even after reposessing and re-selling the homes in question. The Sydney Morning Herald reported on "How HSBC Bet the Household and Lost." Not all is lost, though. HSBC bought Household in 2003 for $27.7 billion, so last year's misadventures only cost HSBC about 37% of the purchase price.

HSBC executives believe they've got their arms around the problems at Household, while still admitting that the problems were about 20% worse than they'd calculated a couple of months back. CEO Michael Geoghegan vowed that, "the buck stops with me" and then fired the CFO of HSBC Finance Corp. Let's hope HSBC doesn't hold the mortgage on the recently departed CFO's house.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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