Who's to blame for the slow-motion disaster of the subprime lending industry? Today's excellent front-page Wall Street Journal article (subscription required) on the collapse of mortgage company New Century Financial deftly captures the catastrophe. In the past decade, a host of new lending companies have sprung up and expanded well beyond the capacity of their inexperienced, nouveau riche managers. Operating in a déclassé market sector—subprime home loans=used cars—cheesy managers, sleazy mortgage brokers, and their Wall Street enablers created a credit bubble. As in prior bubbles, executives focused on short-term compensation and rewards (parties, Porsches, etc.) rather than on building sustainable businesses. And, the subtext goes, because these guys were outside the financial- and capital-markets mainstream, the damage caused by their demise will be limited. It's a classic case of dumb money.
But it turns out there was plenty of smart money in this dumb money business. Sure, upstart lenders and naive foreigners have gotten burned by subprime loans. But many of Wall Street's best and brightest, the investors and firms lauded in Barron's and Institutional Investor for their superior investing acumen and unrivalled ability to gauge and manage risk, are waist-deep in the business. What's dismaying about the subprime failure is that so many Wall Street aristocrats and establishmentarians, caught up in the housing-credit bubble, threw their money into these iffy operations in 2005 and 2006, and now are paying the price.
Let's meet some of the biggest losers.
1. David Einhorn of Greenlight Capital is a youthful hedge fund manager with a well-deserved reputation as a shareholder activist, a value-hunting investor, and all-around good guy. (He donated his huge winnings in last year's World Series of Poker to the Michael J. Fox Foundation for Parkinson's Research, where he serves on the board.) In 2006, Einhorn built a significant position in New Century, the huge subprime lender, and then demanded (and won) a seat on that company's board of directors. In recent months, New Century has essentially imploded. The stock closed Friday at $3.21, down from about $40 a year ago, and is likely headed lower given this morning's announcement that its lenders won't provide it with funding. Einhorn's 3.5 million-share position, worth about $140 million last year, is worth about $11 million at today's prices. Last week, he quit the board. (This list of insider transactions suggests that Einhorn hasn't sold any shares recently.)
2. ResMAE, which offered truly exotic mortgages, attracted investments from some of the nation's most-respected private equity and hedge funds. In 2003, TH Lee Putnam provided seed capital of $25 million. In July 2005, TPG-Axon investment, a $3 billion investment vehicle founded in 2005 by ex-Goldman Sachs wunderkind Dinakar Singh, and the huge private equity firm Texas Pacific Group, invested $100 million in the company. Less than two years later, on Feb. 13, 2007, ResMAE filed for Chapter 11. Last week, hedge fund Citadel Investments agreed to acquire ResMAE for $22 million.
3. In recent years, Merrill Lynch, the huge investment bank that has long been involved in packaging mortgages for sale, has made a concerted effort to get directly involved with subprime lending. It took a 20 percent stake in OwnitMortgage Solutions, a startup subprime lender that closed last December. Aside from losing its investment, Merrill was listed as Ownit's largest unsecured creditor: The bankrupt firm owed Merrill $93 million. And Merrill could also be facing more subprime woes. Last September, when cracks were already appearing in the subprime market, Merrill paid $1.3 billion for subprime lender First Franklin Financial Corp. At the time, the company said it expected "the acquisition to be accretive to its net earnings and earnings per share by the end of 2007," meaning it would add to profits. But as this CNNMoney article suggests, analysts are now concerned that the acquisition may not pay dividends any time soon. The stock of Merrill Lynch is off about 12 percent so far this year.
4. Morgan Stanley, a direct descendant of the firm started by J.P. Morgan, has long been regarded as the ultimate white-shoe Wall Street firm. Last August, it spent $706 million to acquire Saxon Capital, the 14th-largest subprime lender in the United States. The same day, Saxon reported quarterly results showing a healthy profit of $8.65 million for the quarter that ended in June 2006. Morgan Stanley was clearly buying a moneymaker. Oops! By the time Morgan Stanley completed the acquisition in December, Saxon had lost considerable steam. In the 2006 third quarter, Saxon lost $26.5 million. Soon after the acquisition closed, Morgan Stanley fired a bunch of employees and said Saxon would no longer lend directly to consumers. It's a safe bet that had Saxon remained independent, it would be available for sale today at a price considerably lower than $706 million.
Given the problems emerging in the sector, it's hard to feel bad for these large, well-heeled investors. They were greedy for big subprime mortgage profits, and that greed has hurt them. But unlike the clients of subprime brokers, the executives at the funds and firms that made these losing investments won't be losing their homes. And unlike the executives and employees at many subprime lenders, they won't be losing their jobs. But their bonuses for 2007 might be in jeopardy. And as a result, they might be forced into a subprime summer rental in the Hamptons.