Chances are that if you've been following the market recently, you've stumbled across the overwhelming coverage of subprime lenders and their less-than-optimistic future. Many on Wall Street are calling for reform (perhaps a bit late) in an industry that they claim has been mismanaged, is predatory, and could result in a failure of credit that would be of great detriment to the rest of the U.S. economy.
What is all the hype about?
To put it simply, the subprime-lending market focuses on offering mortgage-backed loans to signers whose general credit profile is suboptimal -- poor credit scores, recent foreclosures, and so forth. In exchange for taking on additional risk, these lenders are rewarded with a significantly greater rate of interest on such loans.
But all is not well.
A recent article in Fortune highlighted the disturbing trends in the industry today. First, according to Morgan Stanley, during the third quarter of 2006, 12% of these loans were delinquent, compared with 8% in 2003. According to LoanPerformance, by the end of 2006, subprime loans more than 60 days late surged to 13%, compared with 8% in 2005. Furthermore, according to RealtyTrac, foreclosures are 25% higher than at this time last year.
An equation for disaster?
When you take some of these alarming trends and match them against a slowing economy -- where unemployment could potentially surge -- the chances are that many more of these loans could fail. Additionally, many loans were made with adjustable rates. Now that their new (higher) interest rates are kicking in, lenders are discovering that many homeowners haven't properly anticipated the change. And with fewer loans originating in our slowing real estate market, we've got an uncertain situation on our hands.
This uncertainty has already wreaked havoc on the stock market. New Century Financial (NYSE:NEW) has dropped from $30 to $5 in a month. Accredited Home Lenders Holding (NASDAQ:LEND) is down about 45% to $16 after trading at about $29 a month ago, and others, such as Washington Mutual (NYSE:WM) and NovastarFinancial (NYSE:NFI), have been affected as well. Even General Motors (NYSE:GM) is exposed to this practice via its GMAC Financial Services subsidiary.
But as stock prices drop because of uncertainty, patient investors can be presented with opportunity.
Sifting through the wreckage
While there is more battering to come for the mortgage industry, this is when it's prudent to start building your watch list. That's in case investors panic and throw the baby out with the bathwater.
Case in point: Countrywide Financial (NYSE:CFC), the largest U.S. home-mortgage lender. Although I'm taking a wait-and-see stance here to see just how well the company can cope with late payments and a slowing economy, there are a number of factors that have piqued my interest.
A closer look at Countrywide
Countrywide is down approximately 18% over the past month. According to The Wall Street Journal, it has seen an increase in late payments in its subprime sector from 15.2% in 2005 to 19% in 2006. While it hasn't been hit nearly as hard as some of its brethren in the subprime industry, its stock is being treated as if it has been.
In 2006, the company netted about 48% of its pre-tax earnings from its mortgage banking segment. Of that, about 8.7% of its mortgage earnings were from non-prime -- or subprime -- loans. So on pre-tax earnings of about $4.3 billion in 2006, approximately $180 million originated from the subprime sector. While that's nothing to sneeze at, subprime lending represents a whole 4.2% of pre-tax earnings for Countrywide. In terms of investments, however, the company is fairly heavily tied to the performance of its non-prime securities -- which I'm obviously concerned about in today's situation.
A bit more ...
But after looking a bit more closely, I see that Countrywide has shifted its lending and investing practices higher up in the subprime market. See, the subprime market is not monolithic. Rather, it is structured on a grading system from A- through C. A- is the top, or most creditworthy, segment of the subprime market, and C is at the bottom.
According to analysts at Fox-Pitt, Kelton, Countrywide has undertaken efforts to decrease its exposure to these riskier B and C loans over the past few years. In fact, today, only 20% of Countrywide's entire subprime-lending element is below the A- rating. And when you take that in context with knowing than 9% of its loans last year were "subprime," it's safe to conclude that the vast majority of its loans are safe -- or at least safer than many from its subprime brethren.
That's why it's worth keeping an eye on Countrywide, as opposed to a more subprime-oriented company like Fremont General (NYSE:FMT). The market may end up pricing this stock as though it can expect huge losses, when in fact it will suffer only smaller ones.
The Foolish bottom line
Overall, I'm not going to say that the subprime-lending industry and Countrywide aren't in for a good shellacking in the days and months to come. Rather, what I'm trying to get at is that investors too often get caught up in the hype of a certain issue and kill investment ideas simply because everyone else is. And while I haven't been able to turn on the TV or browse the Internet over the past few days without some talking head telling me that this industry and these companies -- Countrywide included -- are bound to get pummeled, it's for exactly that reason I think we could get a deal.
See, the key to investing successfully is not necessarily to find the fastest-growing or most profitable stocks. Rather, it's to find the stocks the market has priced well below fair value. That's a strategy that Benjamin Graham espoused nearly a century ago and that luminaries such as Walter Schloss and Warren Buffett carried on.
As with the mortgage industry, it can get you into some pretty hairy situations. But the profits are there for those who can see through the panic.
Our own Philip Durell pursues the same strategy at his Inside Value service, and his recommendations are beating the market 19% to 13% on average. If you'd like to see the stocks he's recommending today for free, click here. There is no obligation to subscribe.
Fool analyst Nick Kapur owns no shares of any company mentioned above, although he may well be tempted by Countrywide should it get priced low enough. Washington Mutual is an Income Investor recommendation. The Fool has a disclosure policy.
