Is It Time to Buy Subprime?

With subprime mortgage lenders in crisis mode, I am frequently asked if there is a screaming buy, a company that is being unfairly penalized because it's in the same business as New Century Financial, Novastar Financial (NYSE: NFI  ) , Accredited Home Lenders (Nasdaq: LEND  ) , and a host of now-bankrupt smaller players.

A 50-bagger in half a week
To be blunt, I wouldn't touch subprime mortgage lenders -- even though I know there will be some survivors. Even so, like most people, I sometimes get an urge to use my psychological "Vegas money" to take a flyer. After all, consider Accredited Home Lenders; I could have bought shares on March 13 for less than $4. Just three days later, shares were trading hands for more than $13 -- a three-bagger in three days! Better still, I could have bought options for $0.25 and had better than a 50-bagger in three days.

So why didn't I make that bet? First and foremost, I am an investor, not a speculator.

Second, you have to understand that these companies are not in control of their own destinies. Climbing delinquencies in their sold mortgages trigger provisions that allow the buyers to require the mortgage lender to buy them back at full price. Now imagine that you have to buy back 100% -- when the value is now 85% -- on a deal where you were only making a very small percentage in the first place. My colleague Bill Mann characterized subprime mortgage lenders as "a thin sliver of equity sitting on top of a hydrogen bomb of debt." It doesn't take too many deals to be put back to the mortgage lender before shareholders' equity is eaten up.

The other problem is that most of these companies exist at the will of the large investment banks who lend them the money so they can make their mortgage loans in the first place. These are known as warehouse loans, and if those lenders cut off the spigot, there is no new business. That's what happened to New Century and at least 25 other smaller subprime mortgage lenders.

The Foolish bottom line
There may very well be some subprime mortgage lenders that will survive and will eventually be good investments, but unless you have the time to go through the prospectuses of their mortgage sales, you cannot be sure how much of their business is at risk.

Even then, you still don't know the level of future delinquencies -- I believe subprime and even prime mortgage woes are set to rumble on for a while. You might do better to focus on inherently strong companies such as British bank HSBC Holdings (NYSE: HBC  ) or Washington Mutual (NYSE: WM  ) , which are temporarily suffering from subprime flu.

Related Foolishness:

Philip Durell is advisor/analyst of Inside Value. You can view his favorite value stocks for new money with a free 30-day trial of Inside Value. Philip does not own shares of any company mentioned in this article. Washington Mutual is an Income Investor recommendation. The Motley Fool has a disclosure policy.


Read/Post Comments (0) | Recommend This Article (121)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 524371, ~/Articles/ArticleHandler.aspx, 9/2/2014 12:50:20 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement