Cash In on the Subprime Crisis

One of the most amazing investments of all time arose from the ashes of fraud. In 1964, a commodities trader attempted to corner the soybean oil market. He built a huge number of tanks, bought a pile of low-cost oil futures, and filled his tanks with oil.

American Express (NYSE: AXP  ) had a division to loan money to businesses based on their inventories. It lent this trader money based on his millions of pounds of oil. Everything was great, until inspectors discovered that the tanks were filled with water, not oil.

When the fraud was revealed, American Express plummeted 50% to as low as $35. That's when Warren Buffett stepped in. He didn't just open a small position. He put a full 40% of his partnership's portfolio into American Express. It was a gutsy move that paid off. By 1967, shares were trading at $180.

The opportunity today
The moral of the story isn't that you should dump 40% of your portfolio into your favorite stock. It's that you can make great money by being smart during a crisis. And, conveniently, we have a crisis developing right now.

Almost all the players in the subprime market have been hit in the last month. New Century Financial, Novastar Financial (NYSE: NFI  ) , and Fremont General (NYSE: FMT  ) have suffered the worst carnage. But even lenders as diverse as General Electric (NYSE: GE  ) , Countrywide Financial (NYSE: CFC  ) , HSBC (NYSE: HBC  ) , and General Motors (NYSE: GM  ) have been affected.

I think it's too early yet to dive into the subprime lenders. But it's clear to me that this industry will still be around in 10 years. This crisis will clear the marginal players out of the industry, leaving greater opportunities for the survivors. Now is the time to begin researching who has the best chance of survival.

Finding the winners
To start with, look at liquidity and lending standards. A liquidity crisis will cause some of these lenders to fall to zero. So focus your efforts on understanding companies' balance sheets. What sort of assets does the company have? Cash is best. Liquid securities are second best. Assets like deferred tax liabilities and goodwill are worthless in a liquidity crunch. What are the company's responsibilities and exposures with respect to its collateralized loans?

Examine debt covenants and maturities. Even if the business is cash-flow positive, and you believe it can weather the downturn, its lenders may not let it. If the company defaults on its debt covenants, it could be forced into bankruptcy. If the business has a large debt maturity that it needs to roll over, the market may not be liquid enough to get the deal done. Or, the terms of the new debt could be significantly worse than the old.

Focus on the lenders with the highest lending standards. The companies with the lowest default rates have the best chance of survival, both because fewer problems will arise and because other companies will be more willing to do business with them.

The Foolish bottom line
During this crisis, huge opportunities will emerge, but the risks will be significant as well. So, do your research early to be ready to identify opportunities as they arise. Our Inside Value team will also be on the lookout for the best bargains. We've already got some ideas. If you want to piggyback on our research, or just read about the values we see now, you can get a free trial here.

When it comes to crises, Fool contributor Richard Gibbons is one of those glass-half-full guys. He does not have a position in any of the stocks discussed in this article. The Motley Fool has a fascinating disclosure policy.

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