Friday, June 15, 2007

Bear Doesn't Sweat Subprime


By Laurie Kulikowski (TheStreet.com Staff Reporter)

Wall Street firms can't agree on what will happen next in the subprime mortgage market. Of the three brokerage firms that reported second-quarter earnings this week, Lehman Bros. (LEH) and Bear Stearns (BSC) -- the two with the largest exposure to the mortgage market -- seem to be encouraged by signs of improvement in the sector. Bear even said it plans to keep growing its mortgage operation, which was hit hard in the latest quarter. The company cited signs that business picked up this past spring.

As credit standards tightened on loans, "the beginning of the quarter was quite difficult and as we got into the quarter, April was better than March and May was better than April," said Sam Molinaro Jr., Bear Stearns' CFO. "What we're seeing are transactions are getting done. New vintage collateral is being well received in the market, spreads are tightening -- business is slowly improving."

Goldman Sachs (GS) , on the other hand, wasn't as optimistic. David Viniar, Goldman Sachs' CFO, said the market for loans made to homebuyers with subpar credit histories is likely to get worse before it gets better, according to the Associated Press. "The subprime business continues to be weak," Viniar said during a conference call for reporters. "We have not seen the bottom in the market. There will be more pain felt by people as it works its way through system."

Much pain has been felt already. Dozens of mortgage lenders that catered to subprime and Alt-A borrowers failed as consumers fell behind on their loans. The spike in defaults and delinquencies caused investors to stop buying bonds that were backed by the subprime mortgages. The sudden shift drove New Century (NEWCQ) , once the nation's No. 2 subprime lender, into Chapter 11 bankruptcy protection April 2.

Bond businesses at the big brokerage firms have taken a hit since securitization volumes of these loans have fallen. Several firms, including Lehman and Bear Stearns, which have origination businesses, were also hurt from a decline in subprime and Alt-A loan originations. Revenue from Bears Stearns' bond business dropped 21% in the second quarter from a year earlier to $962 million, it said Thursday.

Goldman said the same day that quarterly net revenue from fixed income, currency and commodities was $3.37 billion, 24% lower than the second quarter of 2006. The decline primarily reflected lower net revenues in commodities and weak results in mortgages -- particularly because of weakness in the subprime sector. Earlier this week, Lehman said revenue in its fixed income business dropped 14% from a year ago to $1.9 billion as a result of the sour mortgage market.

But Lehman's CFO Chris O'Meara also spoke of recovery in the sector. "Although we believe that the U.S. subprime business will continue to face headwinds for the near term," O'Meara said during a company conference call on Tuesday, "we are seeing some positive signs, such as gradual improvement in pricing power for lenders and a pickup in secondary-market investor activity, including for noninvestment grade positions." Bear Stearns also stumbled on Thursday. The company sold $3.8 billion in mortgage loans after hedge funds managed by the firm made large bets on the subprime market.

During the call, one analyst questioned the impact of the move to Bear Stearns' future earnings. But for the most part, Molinaro shrugged it off. "Our level of capital investment and exposure to the fund," he said, "is very modest and shouldn't have any material impact on results going forward."

Last year, Bear Stearns Residential Mortgage purchased the subprime mortgage origination platform of the Encore Credit unit of ECC Capital (ECROE) , an Irvine, Calif.-based REIT, for $26 million in cash. Molinaro said Thursday that Bear is now ready to bust out of its brief slump. "What we're doing right now is trying to hire a lot more salespeople, expand our sales relations and increase the volume of business that we're capable of putting through the platform," Molinaro said. "If volumes don't pick up -- if that's not successful -- we'll have to address the operating costs. But I think at this point the strategy is clearly on trying to drive more volume through the existing platforms."

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