Could the sky really be falling in the subprime MBS space?
I tend to think so. Recently, we have had a flood of bad news hit the markets, first with HSBC Holdings saying that it had suffered some losses on some of it's subprime mortgage pools, and then New Century (NYSE: NEW) coming out saying it would restate earnings because of troublesome subprime loans that it had lent out.
The trainwreck was well on it's way. With the boom of the housing market, and these seemingly fly-by-night mortgage operations popping up all over the place, it comes as no surprise to me that the risky mortgage lending, all the tricks that were played - are now coming back down to earth like a huge meteor. And, my friends, I am afraid that it is just the beginning.
The first chart is an index published on Bloomberg outlining the Subprime Loan Delinquencies as a percentage of total mortgage loans out there.
The picture is startling, but as you can see, we had peaked earlier in 2002. But, that was just the tip of the iceberg. With the recent troubles in the subprime space, if major lenders had seen the iceberg coming back in 2002, they wouldn't perhaps today be feeling the pain at the +12-13 levels that this index is trading at now. Why are they feeling this pain NOW at these levels as opposed to the highs of 2002? My best estimate is that with the Fed having raised the rates to 5.25%, back in 2002, there wasn't as many ARMS (Adjustable Rate Mortgages) that were being reset to higher interest rates. Now, many of these people 5 yrs ago that took out 5Yr ARMS at historically low rate levels are having to wake up to their rates being reset at the current prime (and subprime is even higher) rates. Some people who were able to finance a 5% arm, are now seeing those rates reset at 10+%. Combine that with in 2002, when we weren't exactly finished selling the "Instant ARM in 10 minutes with no-doc", the amount of money gone into the prime and even subprime markets is what is hurting these firms now. Billions more now coming resettable, and thousands of Americans are waking up to find that their once $1000/month mortgage, which might have been comfortable to some people, a bit of a strain on others, is now $1500, $2000, $3000/a month. A person who was having a slight strain on their lifestyle at $1000 a month with a 5Yr ARM, is now paying almost 2x as much, and that is burying a ton of people alive. Combine that with a slowing housing market, people are now trapped in their homes of which they cannot sell, and they cannot afford the payments to live there. It's the perfect storm of the housing market that is finally hurling back to Earth. Yes, I think this time, the sky is falling. I expect that we're going to surpass the delinquency rates seen in 2002, and we are going to see a bloodletting in the MBS marketplace. It's not going to be pretty. Insurance for protecting against MBS pool defaults has gone up from $300,000 for $10M financed, to over $800,000 for $10M financed, and that has been since January when the contract was created!
Foreclosures are now up as well, take a look at this chart (Foreclosures as a percentage of total loans):
We're ticking up. And, I expect that this trend is only going to acclerate in the coming months? Why? As I stated before, there are a LOT of "creative" mortgages out there that are ticking time bombs. When these mortgages begin to reset, and the holders begin to wake up, they're going to be faced with serious financial strain. They simply cannot afford to pay the mortgage anymore. And then, we see delinquencies rise, and rise the foreclosure rate is slowly going to tick higher... and higher. The banks that lent the money out are going to be stuck with a glut of inventory in the coming couple of years as they foreclose on the properties. That is going to create a huge influx of supply, and we should start to see, based on my estimates, by as early as 2009, home prices begin to sharply decline. I suspect, that by 2010, many of the homes will be priced LESS than what it cost to build them. We will be in a truly inverted scenario. And, that will be the time for the financially equipped to dip in and buy. As supply surges, and people begin to panic during the housing downfall, prices will ineveitably have these homes at a discount to the "realized" value that they should be trading at.
The writing is on the wall. We're in for a rocky road ahead, and it's time to make some money. I do not own any positions (equity or derivatives) on any names I am about to mention, but I think they are worthwhile to begin looking at to capitalize on the housing "storm" that has been brewing for quite some time. Unfortunately, the sun is being hidden behind the clouds, and I think I see a F5 tornado on the horizon. Batten down the hatches, and get ready for the ride of your life! (Some of you poor MBS traders will probably be pulling 18 hour days pretty soon. I'd go on vacation now if I were you).
Bearish:
TOL - Toll Brothers - builds luxury homes throughout the country. One of the largest and most popular homebuilders out on the market now. 52wk Hi: 36.05, 52wk Low: 22.22.
KBH - KB Home - particularly of interest, they target the first time homebuyers, and people who are moving up from their first home. This is one of the areas that I believe many subprime people are in, and I would expect that they are going to get the brunt of this. The F5 is headed right for the KB ranch, despite their rosy sounding press releases. Dig deep folks, and uncover the termites! 52wk Hi: 71.28, 52wk Lo: 37.89. Currently trading at 51.97, so about $20 off it's highs. 1 Year total return is -21.12%. They also operate a mortgage company as well. What is Margaret Whelan at UBS thinking when she gave this stock a buy rating on Feb 5? She didn't see the HSBC or New Century news I guess? Margie, please email me if I'm wrong on this point. Ivan Feinseth at Matrix USA gave this one a strong buy, and apparently didn't bother to give a price target. You and Margie are the only 2 with a buy rating on this stock. Ivan, WHY is it a strong buy? Have you not seen the headlines in the past couple YEARS? ARMs are coming due buddy, and we have a whole new generation of people who are going to be moving back to apartments. That spells trouble for me, as a renter, because now demand for apts is going to raise my already exorbitant Manhattan rent even higher. Thanks fellas.
NEW - New Century Financial Corporation - Just got sued by Lerach. Has to restate earnings because of faulty subprime lending coming to roost at their shop. Looks like the F5 tornado just knocked the chimney off their new "no-doc" house on the edge of town. This has been an interesting story, here's the stats:
52wk High: 51.97
52wk Low: 16.15 (set on 2/9/2007)
YTD Change: -13.37, or -42.32%
S&P has a BB- rating on it. It's not even investment grade anymore. The house is falling apart in this one. Take a look at the chart.
Ladies and Gentlemen, fasten your seatbelts and get ready for the ride of your life!
-CBK
