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Sunday, March 11, 2007

Is the subprime crash a potential investment opportunity?

If you haven't heard, the subprime market is having a tough go of it, lately. Somewhere between two and three dozen subprime lenders have closed their doors over the last several months. Even for those who haven't gone belly up, yet, things are looking ugly. Subprime lender New Century Financial's stock is down 93.8% from its peak. Accredited Home Lenders is better off, but still down 73.8%.

What is subprime lending? Basically, it's the business of making loans to people who've been deemed less credit worthy. Such loans are provided at higher interest rates in hopes that the lender can make enough money off higher interest payments to make up for the inevitably higher level of defaults inherent with less creditworthy customers.

In normal economic conditions, these lenders make a ton of money. But, when economic conditions sour, such loans can turn out looking like earthquake insurance sold with insufficient premiums. But, wait, you may be thinking, the economy isn't doing poorly and interest rates haven't spiked. The things that usually make such loans go south aren't happening.

So, what could be happening? When something is too good to last, it doesn't. Such has been the case with making loans to folks who can't make the payments. Unfortunately, loans have been made to people where little proof was required to indicate income, called no document or "liar loans." And, loans were made at teaser rates that were set to adjust at preset times to much higher rates, and those loans are resetting. And, some companies, like Countrywide Financial, made loans where people only had to pay the interest on their loans, and even paying the interest was optional! Meanwhile, each of those lenders were booking profits as if the borrowers were paying interest and principal. What a mess.

Such situations seem to spell opportunity, at least usually. When headlines are screaming that the sky is falling, it usually means that opportunity is knocking. But, I must admit, I'm not sure this is such a good opportunity. How much of a mess is this? Will it spread to Alt-A and prime loans (the next two levels up in credit quality)? How would housing price declines affect this? Do the lenders have enough financial backing to survive a downturn?

If you can answer all these questions, I think you can invest in the subprime lender of your choice. I know a lot of smart value investors who are or have done just this. I'm not following them, though, because I can't get my arms around the accounting and assumptions for such loans. I understand, theoretically, how such companies make money, but where the rubber meets the road is in knowing their lending, servicing, default assumptions are valid even in high-stress situations. I just don't know enough to make that bet with conviction.

In addition, interest rates are still low and the economy hasn't fallen into a recession. What if that were to happen over the next year or two? How would the lenders do if housing prices decline, as they have been, and unemployment goes up? Those are a bunch of tough questions to answer.

Investing in subprime lenders, or even undiversified home lenders, seems a little like selling flood insurance at premiums that won't cover a 100 year flood. Its only a matter of time before lenders become over-zealous in lending to unworthy credit risks, and that leads to trouble when the credit market turns.

Investing in a subprime lender right now is like catching a falling knife. If you do it right, you make off like a bandit. If you don't, you're going to end up bloody.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

10 comments:

Anonymous said...

With subprime lending institutions closing their doors..doesn't that mean there opportunities in related businesses like payday loans and cash advance....stocks like CSH have good solid growth potential even without the subprime crash..and I think this should help them.

Mike Rivers said...

I can't say I know much about cash advance and payday loan businesses. However, I am worried that a subprime crash may lead to congressional reaction, hitting the payday loan and cash advance folks. There's no doubt that such businesses produce solid growth, but they may be put under the yoke of legislaters who believe the whole field has been tainted.

Chuck Moore said...

Thanks for the concise explanation, Mike... an excellent way to describe what's happening (to the laymem of the world, like most of us...)

CoachingByPeter said...

It is also important to know information about your location's flood risk to have an idea on how much water might get into your place. Info can be avail in floodplain management office or building department. Anyone can be a victim of financial difficulties because of the damages that brought about by flooding.

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