The average U.S. consumer remains in good health, unemployment is low and job creation is strong. Therefore consumer disposable income still drives healthy demand for electronics, clothing and toys. Of course, a weak dollar helps keep the imported price of many of these goodies quite affordable. Nonetheless, there is a headline grabbing consumer undercurrent burdened with bad credit scores and heavily stretched credit card, car and home loans. After several years of manageably low delinquencies, these subprime or low FICO score consumers are beginning to be late on their payments or default at an increasing rate.

Recently, the stretched consumer has been partially responsible for the couple dozen subprime mortgage lenders that have shutdown since December or are no longer operating independently. Demands on the lenders to repurchase underperforming mortgages forced them to post enormous reserves – which dramatically reduced capital and operating liquidity – thereby placing them in financial peril. Amongst what used to be the top 25 subprime lenders:

  • #17 OwnIt, #19 MLN and #21 ResMAE have shutdown
  • #7 Ameriquest, #9 WAMU and #18 Aegis have shut some offices
  • #11 First Franklin, #24 Ecc/Encore and #25 Fieldstone have been acquired at sale prices
  • #3 New Century is restating earnings and #12 GMAC has had major layoffs at ResCap
  • #2 Household Finance, #6 Option One and #23 Decision One are rumored to be for sale

Many smaller subprime lenders are also facing similar scenarios. Expect subprime lenders to continue their descent. Along with them, subprime mortgage bonds are also suffering; yields are rising and investors are backing off.

Outside the subprime lending circles, however, most US businesses continue to perform well; consequently, the Fed will probably keep rates stable for at least the next three to six months. Corporate credit parameters have tightened slightly, but still remain historically easy and money supply has increased since the summer. Therefore, bond credit spreads will remain historically tight for the next five months, US Treasuries should strengthen during the first quarter and US equities, especially the mid cap indices, should continue to perform well across 2007.

Michael Ashley Schulman, CFA
Hollencrest Capital Management