Fed Chairman Ben Bernanke voiced concern about the subprime mortgage market in his congressional testimony on Wednesday. The Fed Chief said that, on the whole, household finances appear solid but "the exception is subprime mortgages with variable interest rates, for which delinquency rates have increased appreciably." Indeed, shares of the major subprime lenders have been under pressure for months on concerns about the risk of delinquencies and defaults. These stocks plunged last week when one major lender warned that its losses from bad loans were much larger than expected. However, on Wednesday, shares of the major subprime lenders saw a bit of respite and their next move could indicate whether the concerns about the mortgage market are justified or overblown.

Mortgage lending is an important topic for investors because, not only can bad loans hurt the profits of financial institutions that hold shaky loans, but the trend also has implications for the economy as a whole. According to Fed Chairman Bernanke, "Several credible reports say that we are facing a tidal wave of defaults and foreclosures, which could strip these families of their major, if not their only, source of wealth and long-term economic security." The main concern is in the subprime market, which is when money is lent to borrowers with less than perfect credit.

Indeed, amid historically low interest rates and booming home prices, subprime lending boomed in recent years and many individuals were approved for loans that they probably would not have been able to obtain five or ten years ago. Now, as the Federal Reserve has instituted a series of rate hikes and the variable rates on subprime loans begin to rise, many borrowers simply can't make the payment. The problem is compounded by the fact that real estate values are far from their highs the homeowner can't sell their properties at a price sufficient enough to pay back the mortgage.  

Shares of the subprime lenders have been under pressure amid concern about mounting delinquencies, defaults, and foreclosures. Figure 1 shows the price action of Accredited Home Lenders (LEND), Fremont General (FMT), and New Century (NEW). All three of stocks have been cut in half since the Spring 2006. The sector was hammered on February 8 when Europe's HSBC, one of the largest players in the subprime market, warned that its number of bad loans in the US has increased. Bad debt provisions are expected to be 20% higher than analyst expectations, which is due largely to the US subprime market, according to the bank. NEW plunged 36.2% on the news. FMT and LEND tumbled 11% and 6%, respectively.

Figure 1: LEND, FMT, NEW Daily Charts

However, on Wednesday, shares of the lenders were able to find some buying interest despite the cautious comments from Chairman Bernanke. While some of the gains are probably related to short-covering, the group moved higher after Accredited Home Lenders reported a fourth quarter loss of $37.8 million or $1.49 a share. The good news apparently: the company "has stopped making some types of riskier loans as the market for low-end mortgages showed signs of a mini credit crunch," according to MarketWatch (Accredited Home Stops Making Riskier Loans by Alistair Barr, February 14, 2007). LEND added 3% on the session; FMT added 3% to an 11% gain on Tuesday; and NEW added 6.2%, which follows an 8% rally the day before.

So, while some of the gains are no doubt driven by short-covering, other players might be stepping in to buy some of the subprime lenders now that they have been seriously battered and bruised. The buying might be based on the view that these stocks have fallen far enough and the concerns about the subprime mortgage are overblown. That, however, remains to be seen.


Frederic Ruffy
Senior Writer & Index Strategist
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