Subprime Concerns Again!

18 Jul

The concern from the subprime market continues to spill over into the stock prices of companies such as Countrywide Financial (CFC) and others. Countrywide has been the subject of frequent posts and that mainly is because (1) I own the stock so I’m watching it and (2) subprime concerns have caused its price to bob around well under intrinsic value for some time now. And now its share price is back under $35 apiece amidst renewed subprime concerns (less than 10% of its business was subprime).

The latest news regarding subprime is that two Bear Stearns hedge funds that specialized in subprime mortgage-backed bonds have ended up virtually worthless. Much of the reason the funds went down so fast was likely due to the leverage employed, as the index that tracks subprime loans originated in the 2nd half of 2006, the ABX “BBB” 07-1 index, fell to nearly its lowest level ever over the last couple days.

This is a classic illustration of the market being irrational longer than one can remain solvent. Yet these funds were probably using “risk controls” that considered the probability of such an event as so miniscule that they ignored it (based on the dubitable “proof” of historical data or simulations heavily contingent on multiple assumptions). Turns out the risks were higher than the so-called models told them. Looks like they opted to be precisely wrong rather than approximately right.

Over the past few years, anyone could sell a mortgage. Just get in touch with GMAC, provide the documentation they want, and get paid a fee based on each mortgage obtained for them as a broker. GMAC (and many others) in turn would package the loans together and sell them to investors. So the accountability was really lost at each stage while the packaging, or securitization, process mysteriously turned a group of loans into investment grade despite the dubious characteristics of its individual constituents. Downgrades in these bonds over the past few weeks have called into question the quality of the underlying loans and hit these two funds very hard.

I think underwriting standards today are likely to have improved overall (yet, even though its only anecdotal, I still see advertisements touting “no down payment” loans available). But overall, going forward, the lax lending standards have likely subsided and overall loan quality has probably improved (that is, until the next boom period for housing). For originators whose loans are sold through securitization, the bigger players are the ones that will benefit long-term as smaller competitors are shaken out. This includes Countrywide, Wells Fargo (WFC), and other large banks such as Bank of America (BAC) and Washington Mutual (WM).

Full disclosure: Long shares of all companies mentioned.

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