Subprime Ground Zero, Part II

In Part 1 of this article, I discussed the recent bankruptcy filing of New Century Financial Corp. of Irvine, Calif., and the significant numbers of layoffs within the subprime mortgage industry. I noted that the economic ripples will spread and lap upon distant shores. In Part 2, we will look at some of the broader implications of the decline and fall of the subprime lending business.

Indirectly, a Green Housing Boom

There is one segment of the California economy that apparently has benefited greatly from the cheap home financing and minimal credit checks in the environment fostered by the subprime lenders. In fact, this effect gives a whole new meaning to the term “subprime.” “California is in the midst of a major boom in large-scale marijuana cultivation operations run from inside homes,” according to the LA Times in an article entitled “Busts Point to Boom in Indoor Pot Farms.”

Marijuana seizures have quadrupled in just the last three years, according to officials authorized to speak on behalf of the U.S. Drug Enforcement Administration. Many of the seizures have occurred in what are considered middle-class homes and upscale suburbs of Los Angeles and Sacramento. Gang-related pot growers have taken advantage of cheap financing and the general lack of background documentation of borrowers, receiving loans cynically known in the trade as “liar loans” to acquire homes and then remodel them as indoor greenhouses.

The common practice of these urban plowboys has been for the new homeowners to black out the windows and install ventilation and lighting systems. After settling in, the drug growers use sophisticated growing, watering, and fertilizing equipment to cultivate as many as four crops per year in their otherwise humble, subprime abodes. This output equals or exceeds the yield from traditional outdoor pharmacological agriculture and lacks the danger posed by the discovery of the pot plants via DEA air surveillance or itinerant hikers and campers. “I am not talking about the Cheech and Chong marijuana cultivation of two plants in someone’s closet,” stated DEA agent Gordon Taylor. “I am talking about organized crime groups who are purchasing homes in our communities and creating marijuana factories.”

So as not to attract the attention of neighbors, some drug-growing subprime borrowers have hired gardeners and other employees to perform landscaping work, take out the trash, do maintenance on the houses, turn lights on and off, and otherwise give the indoor pot houses that “lived-in” appearance. And doubtless, of all the subprime borrowers who took out loans to purchase real estate, it is probable that the pot growers are the least likely to miss their mortgage payments and suffer a foreclosure. In that case, their investment might really go up in smoke.

What Is a Laid-off Subprime Lender to Do?

But indeed, if not growing marijuana, what is a laid-off subprime lender to do? Many, not surprisingly, are seeking other employment within the mortgage lending industry. Lending money and getting paid for it, after all, is what they know how to do. Like the steelworkers in Pittsburgh of old, or the autoworkers of Detroit in the past generation, they pray for the return of the familiar old mills and factories in a sort of “cargo cult,” as the anthropologists call it. But then again, who is to say that the real estate market of California will not be good to these hopeful, if unemployed, mortgage brokers if only they wait long enough. Overall, California real estate has been a great investment over the past two centuries or so.

Then again, if the scientific reports of global climate change are to be believed, the U.S. Southwest may be entering a prolonged period of drought, less availability of water in any form, and higher average temperatures. Knowledgeable experts on water availability and use patterns are already discussing California’s “perfect drought” — a combination of low rainfall in the Southland area, long-term dryness in the Colorado River Basin, and far-below-average snowpack in the mountains. The immediate answer, of course, is to divert water supply from California agriculture to California urban and suburban water usage.

Perhaps the California almond growers, for example, should take a page from the playbook of the pot growers. They can take out a subprime mortgage and buy a house in the Los Angeles suburbs and then black out the windows and grow almond trees indoors, under electric illumination, using the water that was diverted from large-scale agriculture. OK, I am just kidding.

But I do happen to know that they are hiring down at Circuit City. According to the LA Times, Circuit City has laid off most of its higher-paid salespeople nationwide in an effort to, as the saying goes, “cut costs” in the face of stiff competition and falling sales. (Makes sense, right? If sales are falling, fire your best salespeople.) The good news for the laid-off Circuit City employees is that they can apply to get their old jobs back, but the bad news is that the work comes with lower rates of pay. One laid-off employee, for example, who is now suing Circuit City for age discrimination under both federal and California law, noted that she was formerly earning $15.13 per hour, but now must compete to get her old job back at a rate of pay that is estimated to be less than $10 per hour. And if she does not want the job, then there are, surely, a bunch of laid-off subprime mortgage processors who will leap at the chance to rake in that kind of subprime dough.

Not All Feel the Troubles

But amidst the economic carnage and human hardship, not all here in SoCal are feeling the troubles. We learned the other day that Ray Irani, chief executive of Occidental Petroleum Corp., headquartered in Westwood, adjacent to pricey Beverly Hills, took home more than $460 million in compensation in 2006. This certainly ranks among the largest paydays in business history for any executive at any publicly traded U.S. company. Mr. Irani’s compensation outdistances even that of Lee Raymond, former CEO of ExxonMobil, who cleared in excess of $300 million in his last year as great helmsman of that well-integrated oil company. I have never been an oil company CEO, but I hear it is nice work if you can get it.

To place Mr. Irani’s pay in perspective, something over $270 million of the $460 million package came from the exercise of 900,000 options on Occidental shares in 2006, with another $93 million accruing due to associated share distributions and dividends. These underlying options were awarded in 1997, when Occidental stock was selling for less than one-fifth its current price and oil was selling for nearly $10 per barrel.

So a rising tide of oil prices certainly has lifted Mr. Irani’s tanker. (Actually, for $460 million, Mr. Irani could buy a few of his own oil tankers, if he could find a shipbuilder who could deliver on the orders.) And to his credit, Mr. Irani was personally instrumental in positioning Occidental and facilitating its entry into the lucrative oil development business in Libya. This is a long-term plus for the company. So maybe the guy is actually worth the $460 million. That is a lot of dinars, but I have no hard feelings. I don’t own any Occidental stock, and it is not my money. And now Mr. Irani gets to pay taxes on it.

Perhaps because Mr. Irani was feeling flush, he used his role as a member of the board of directors at KB Homes (of Westwood, Calif., by the way, just across the street from Occidental’s headquarters building, which certainly saves on travel expenses) to select Stephen Bollenbach as that company’s new chairman. Mr. Bollenbach replaces former KB Homes boss Bruce Karatz. Mr. Karatz was forced out under a cloud, after reports surfaced that he had backdated stock option grant dates to favor himself and other top executives. KB Homes, an upscale home builder, subsequently restated seven years worth of financial results. It is a good thing that people on the KB board, like Mr. Irani, understand that stock option stuff.

Lessons Learned

I began Part 1 of this article with a reference to my Navy days. Another thing that I learned in my time in the Navy was that after every significant operation, you catalog the lessons learned. So what are the lessons to draw from all of this?

First, the wheels are coming off the subprime mortgage business, and things are falling apart for a lot of people in and close to the lending industry. So for future reference, if you are going to be part of a speculative financial venture that loans money to so-called “borrowers” who cannot repay, then be sure to get yourself into the top executive suites. When all else fails, seek bankruptcy protection in Delaware.

Second, as we also noted above, Circuit City is laying off its best salespeople in the face of falling sales. That is what I call the triumph of capitalism. Speaking of capitalist triumphs, it sure is good to be the CEO of a major oil company. And you probably will not do too badly as the CEO of an upscale home building company. Just don’t sell too much of your product to subprime borrowers, who have a high probability of not being able to pay the mortgage. But you might be OK if you sell the houses to subprime buyers for the purposes of growing pot indoors. Those kinds of people will probably pay the mortgage, but if they get caught growing pot, the DEA will apply the forfeiture laws.

And finally, whatever you do, don’t get caught backdating your stock options. Make sure that you have your friends do it for you.

Best wishes from California, where it is dry and getting more so.

Until we meet again…
Byron W. King

April 12, 2007

The Daily Reckoning