Mortgage Lenders and the Deflating Housing Bubble

The first raging housing bubble of this millennium has clearly deflated and the debate has now shifted to whether housing is nearing a bottom. A couple of months ago, I got a chance to talk to an industry expert who held a senior management position at one of the largest US banks before starting his own mortgage company, as he has experienced multiple real estate cycles. I was trying to determine if the home builders I mentioned in my article "Housing Sector in Pain" could go lower or had reached a bottom.

This expert told me that, in the few decades he has spent in this industry, he had rarely seen the kind of euphoria that accompanied this housing bubble and his outlook was still bleak. He told me that mortgage lenders who had a large portfolio of sub-prime and exotic loans such as interest only loans or adjustable-rate-mortgages [ARMs] could be in a lot of trouble in this downturn and specifically asked me to look for signs of "regulators" stepping in to review their portfolios and restrict their lending activity. As you can see from this Wall Street Journal article:

"Federal bank regulators have been stepping up their scrutiny of residential mortgage lending by large banks".

Based on this conversation, I decided to also look into mortgage lenders in addition to the home builders as potential candidates for put options.

Many mortgage lenders and banks do not retain the mortgage loans they originate on their books. They repackage these loans and sell them to other companies like the huge Freddie Mac or Fannie Mae. One of the biggest mortgage lenders, Countrywide Financial (CFC) not only originates residential mortgage loans, it also buys repackaged loans. With delinquencies rising in formerly hot markets like California and Las Vegas, some mortgage lenders like Accredited Home Lenders (LEND) have lost close to half their value over the last year just like their home builder brethren. However Countrywide Financial has held up amazing well in this housing downturn and was in fact close to its all time high last week until an analyst downgraded the company on Friday. Even after the correction in its stock price on Friday, the stock is only off about 7.2% from its all-time high it set in May 15, 2006.

So why has Countrywide held up so well? Apart from the fact that the company generates well over $2 billion in year in earnings and has a single digit current P/E of 9.23, there is also speculation that Bank of America (BAC) may acquire Countrywide Financial. As the acquisition of mortgage lender Golden West Financial by Wachovia (WB) shows, there is always the possibility of banks acquiring mortgage lenders even in this challenging environment. According to Reuters, 99% of Golden's lending portfolio consisted of ARMs and its principal loan product was an option ARM.

A little over two weeks ago I placed an order to buy May 2007 puts on another mortgage lender New Century Financial (NEW) but unfortunately my order was not fulfilled. New Century Financial was mentioned in my November article, "Hedging The Economy", and is already up 44% since we added it to the model portfolio. As an alternative to New Century, I picked up the July 2007 $42.5 puts for Countrywide Financial last week and after the analyst downgrade on Friday, these puts are already up 27%. I plan to continue holding these puts as I expect further price declines in Countrywide as it faces a tough 2007. While the possibility of an acquisition by BAC cannot be completely disregarded, I believe the probability of this occurring is slim.

Apart from LEND, NEW and CFC, other mortgage lenders and banks that are on my watch list include:

* IndyMac Bancorp (NDE)
* ECC Capital Corp (ECR) - exposure to California
* NovaStar Financial Inc. (NFI)
* Fieldstone Investment Corp. (FICC) - writes a large number of interest only loans
* First Horizon (FHN)
* Corus Bankshares (CORS) - loans to condo developers
* SunTrust Banks, Inc. (STI) - exposure to Florida
* City National Corp (CYN)

Comments

[3Sigma:]

Asif--take a look at the insider sales at Countrywide:

finance.yahoo.com/q/it...

Their corporate officers are dumping this stock at an astounding rate; clearly they share your negative outlook on their company. At the same time, the CFC corporate buyback policy is supporting the stock price. According to the most recent 10-Q, "the Company intends to repurchase $1 billion to $2 billion of its common stock in the fourth quarter of 2006 financed through the issuance of enhanced trust preferred securities."

2006 Dec 13 01:18 AM

[Asif Suria:]

Thanks for bringing that up Colin. I was aware of the insider sales but did not get a chance to mention it in my article.

2006 Dec 13 11:50 AM