Subprime Ground Zero, Part I

"NEVER TURN DOWN a combat assignment," said one of my old Navy commanding officers. "It is bad for your career," he noted. Bad for your career? So is dying. But what the man meant was that a combat assignment is "good" for your career if you live to tell about it. It is even better if other people talk about it.

This human desire to approach the fray is not exactly a new concept. I have read that the ancient Trojans would march off to battle with people encouraging them to "come back with your shields, or on them." So when Greg Grillot asked me to investigate the subprime lending meltdown, I had in mind one particular event here in Irvine, Calif.: ground zero. Almost instantly, I was in my car and driving down Interstate 405 (also known as "the 405"). My destination? Easy, really. Just look for the mushroom cloud and ride to the sound of the guns.

New Century, New Bankruptcy

On Monday, April 2, 2007, New Century Financial Corp. became among the latest of the subprime mortgage lending companies to file for bankruptcy protection. We knew that this was probably in the cards, if not inevitable. I discussed the prospect of New Century filing for bankruptcy in a previous article in Outstanding Investments. The New Century people have spent the last month or so preparing for the bankruptcy filing, and as we shall discuss below, it shows.

What was of immediate interest, at least to this Peak Oil correspondent, was that New Century, based in Irvine, filed for bankruptcy protection in distant Delaware. It is not as if there are no federal courts and federal bankruptcy jurisdiction in the Southern District of California. And there are certainly many capable bankruptcy judges, trustees and lawyers in Southern California who could handle the process. But the New Century filing is reflective of a legal phenomenon called "forum shopping," in which large-scale cases, particularly cases with national economic implications, tend to wind up in either the Delaware bankruptcy jurisdiction or the Southern District of New York (i.e., Manhattan). It is true. You can look this up.

Just as cities and regions compete with each other to host major sporting events like the Super Bowl, so do federal court jurisdictions develop reputations as the "go-to places" for certain kinds of high-profile litigation. Thus, the Delaware and Manhattan jurisdictions are well known for their institutional friendliness to what are called "prepackaged" bankruptcies ("prepacks" for short), meaning bankruptcies in which much of the outcome is already predestined, if not known to a legal certainty by the corporate insiders, their key lenders and their counsel. These sorts of bankruptcies are kind of like professional wrestling, except that, by comparison, wrestling is not fake.

So when it comes to the prepacks, bankruptcy court is often just a brief and convenient whistle-stop on the railroad. That is, the bankruptcy process offers a sheltered watering hole, safe from the creditors and complete with a healthy measure of "automatic stay" euphoria. This is where the common shareholder suckers are put off the train, the unsecured debts are discharged like yesterday’s coal ash, and the title to the high-value freight changes to friendly hands, if it is not so situated already. Accordingly, there is often great interest, both personal and legal, for the key managers and stakeholders of the debtor company to hold the right ticket and to steer their corporate bankruptcy to the safest locales, which are the switching yards with the most accommodating station masters. Presently, these comfortable venues are the southern and northern terminuses along what we might call the "Delaware & Hudson Valley" line.

Yes, I know. The New Century bankruptcy is not technically a prepack, but then again, the New Century bankruptcy has been over a month in preparation. There are no accidents in this world, comrades, and there are a lot of eventual financial and legal outcomes that are already designed into the New Century bankruptcy in (ahem) that "certain way." And on Tuesday, April 4, 2007, in the course of the "first-day motions," the Delaware bankruptcy judge pretty much granted everything that New Century and its lawyers requested. The "debtor," as they say, is "in possession." There is new money on the table, with all of the necessary "super-priority creditor" protections. The paychecks will come on time for most of the New Century senior management. And the best of the assets will get sold and transferred to the right people (or at least to the right kind of people). So clearly, in this world it pays to be the right kind of person. And don’t you forget it.

Somehow, I doubt that many of New Century’s subprime loan customers, who will eventually find their ways into the bankruptcy courts of this fair land, will encounter similar legal deference, if not this particular shade of red carpet. But I digress.

Back to Irvine

Let us return to Irvine, where New Century filed other another kind of legal paperwork last week. While its attorneys were busy in the federal bankruptcy district for Delaware, New Century handed out about 3,200 pink slips to its employees in California. Later in the week, I witnessed some of the scene as I gingerly drove past the New Century headquarters building, like a tank driver of the glorious Red Army warily approaching the rubble of the Reichstag in 1945. A small cadre of shellshocked staff was carrying boxes of whatever it could salvage from the smoldering ruins.

It was not as if the graffiti were not spray-painted, figuratively, at least, all over the walls of the Irvine campus of New Century. Many New Century employees knew far in advance that the ax would fall. But still, as anyone who has ever read and absorbed the meaning of A Tale of Two Cities could tell you, the sharp blade always makes that repugnant physiological thud when it lands. Then, during the French Revolution, as now, on the cusp of economic calamity and Peak Oil disaster, we live in what are both "the best of times" and "the worst of times." Can you tell the difference?

"We were a go-go company, and I was a go-go New Century company man," stated one former employee to a roving Peak Oil correspondent, in all likelihood not realizing the rhetorical parallels with the self-promotional propaganda that characterized life and progress in the former Soviet Union. "Up until February, I was making mid-six figures. I bought a house and two cars and my kids were in private schools. Now I am a subprime borrower myself. I am going to lose everything." Everything? That is a lot to lose. Not to revel in another man’s misfortune, but what was this guy doing in a job the business model of which was premised on issuing mortgage loans to people without the money or income to pay them back?

Another former New Century man told the Los Angeles Times, "I don’t know what to do now. Maybe I can sell cars. People might not be able to afford houses, but they can always buy a car." Always? Don’t count on it. Nearly 40% of automobile purchases in California have some sort of home equity loan tied up with them, according to the New York Times. And alas, this poor soul probably has not heard of Peak Oil. The automobile business may not be the best place to work in the not-so-distant future. And if he goes from working the beats of the housing lots to pounding the pavements of the parking lots, over the long term, he will only be hurling himself from the employment frying pan into the Peak Oil fire. Perhaps he should consider a career of installing solar water heaters.

And still another former foot soldier of the depleted ranks of the New Century army had this to say: "I’m getting out of this business. I am going to get a job selling liquor. No matter how bad things get, people will always drink." Yes, that is probably true. People will drink, but even getting drunk will cost more in the future. The world is already embarked on a crash program to turn its food supplies into ethanol with which to run a ubiquitous and obsolescent personal transportation system, much of which enables people to commute to their subprime bungalows in the distant suburbs and exurbs. And the price of food is skyrocketing, as we at Agora Financial have noted for quite some time, and as the Wall Street Journal highlighted in a front-page article on April 10.

So going forward, there will simply be less corn available to distill into whiskey, and much of that corn will be of the genetically modified type, which I swear makes the hooch taste different. Genetically modified plants may also be responsible for the recent mass die-off of agriculturally necessary bees, according to a recent report in the German magazine Der Spiegel. This is another topic for another time.

A Leaking Sector of the Economy

Nationwide, the mortgage lending industry has laid off well over 21,000 employees since Jan. 1 of this year, according to figures published by the U.S. Department of Labor. This is up over 345% from the same time frame last year. "A whole sector of the economy is leaking," states John Challenger of the outplacement firm Challenger, Gray & Christmas.

3,679 of those lost jobs were in California in the first quarter of 2007 (thus not including the 3,200 New Century layoffs that occurred on April 3). Other well-known names in the subprime lending industry whose ranks are thinner due to recent layoffs include Ameriquest Mortgage Co., Fremont General Corp., and WMC, a unit of General Electric Co. And this thinning of the ranks is just in the "LA Weight Loss" arena of the California Southland. There are comparable stories from other formerly white-hot subprime mortgage markets, such as Florida, Northern Virginia, and Boston.

In the separate category of construction employment, the early handicapping is that over 70,000 of such jobs will vanish in the about-to-be not-so-golden state of California within the next two years, according to Ryan Ratcliff of the UCLA Anderson School of Business. "Each…finance job is worth at least two construction jobs," due to the higher pay scales of the white-collar position, according to Mr. Ratcliff. So the economic ripple effects will spread and, like many waves, lap upon distant shores.

In Part 2 of this article, we will follow some of these waves to some of those distant shores.

Best wishes from California.

Until we meet again…
Byron W. King

April 11, 2007