We’re still not nearing a housing bottom, or an improving lending market.

Just ask companies like Lennar, KB Home, and DR Horton, who still don’t see this mythical housing bottom. Or, just ask Mortgage Lenders Network USA, which just filed for Chapter 11 protection, becoming yet another casualty of the lending market in a slowing housing market.

As for the lending market, we were so bearish on the sector that we recommended Death Cross Trader readers load up on New Century Financial (NEW: NYSE) put options two days before the stock fell $14+. While readers already cashed out with 89% gains on the first half of the position, they’re still holding the second half, watching as the stock craters even more.

Among the worst hit lenders are the sub-prime lenders, or those companies that make loans to borrowers with less than perfect or poor credit histories. While sub-prime lenders charged higher interest (two or three points higher than prime lenders) as insurance for the higher risk the borrower represented, rising foreclosures have left the sub-prime industry facing substantial fallout risks.

Sub-prime lenders could offer adjustable or teaser rates to those with bad credit. Loans like this made up 23% of the U.S. mortgage market in 2006 as compared to the 8% in 2001, according to Yahoo! News. And it’s now a big problem, as one in five sub-prime mortgages are now ending in foreclosure, according to the Center for Responsible Lending as mentioned by Yahoo!.

I’d love to sit here and jump on the bullish housing bandwagon that dominates Wall Street. Really, I would. But I’m not a fan of flushing my money down the toilet.

In reality, the housing market has not bottomed. Sub-prime lenders are doomed. You can continue to listen to the delusional madness pouring from the mouths of Street analysts, and the mainstream press, or you can listen to the homebuilder CEOs and the sub-prime lenders that have gone belly up because of a weak housing market.

It’s your choice. But I’d go with the latter, though.

Even JP Morgan’s CEO, James Dimon, is bearish on the sector, saying, “Mortgages are the one area of sub-prime lending where ‘we really see something taking place that looks like a recession’…”

That’s just an inkling of the tumultuous future for sub-prime lending.

MortgageDaily.com believes “The sub-prime sector still has another year of tough times ahead.” That’s supported by Countrywide Financial, which says, “We’ve got another eight, nine, 10, 12 months of headwinds. You’re seeing 40 or 50 (sub-prime companies) a day throughout the country going down in one form or another. I expect that to continue throughout the year.”

A recent Center for Responsible Housing report projects that “2.2 million borrowers will lose their homes and up to $164 billion of wealth in the process.”

Even MarketWatch.com has reported, “Signs of credit deterioration from the slowing U.S. housing market have already shown up in recent results of other banks as more borrowers fall behind. Foreclosures jumped 35% in December versus a year earlier, according to recent data from RealtyTrac. For the fifth straight month, more than 100,000 properties entered foreclosure because the owner couldn’t keep up with their loan payments, the firm noted.”

Better yet (at least for those on the short side), there’s still plenty of negativity that hasn’t been priced in. We’re looking for further downside for six companies with connections to sub-prime lenders. Some have already fallen $3 to $4 in a week. Others like NEW fell $14+ in two days.

But one thing’s for certain — the worst is not over for sub-prime lenders.

Take care,
Ian Cooper
February 20, 2007

Investing in the Declining Lending Market was originally featured in the Penny Sleuth.