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What hasn't been said about the current implosion in the sub-prime mortgage market? Not much, but if you're interested, I recommend Gretchen Mortgenson's column in the NY Times from last weekend. It provides a great explanation of the ramifications for the housing sector and the US economy.

History will note that lax oversight and poor risk management were the two most important contributing factors of the recent turmoil. Other factors include: cheap money resulting from artificially low rates, lax underwriting standards that allowed less creditworthy borrowers to purchase a home with no equity, little proof that they could manage the debt payments, and poor understanding of loan terms.

As Alex Pollack wrote in Monday's Wall Street Journal, mortgage lenders and hedge funds relied too heavily on mathematical models and financial "innovation" in their attempt to mitigate the risk of default and loss for these loans.

Smaller lenders, forced by larger banks to buy back bad mortgage debt, don't have the capital to absorb the losses and could declare bankruptcy. I do not foresee a large scale panic and credit crunch because of the amount of capital now seeking to buy these distressed loan portfolios.

However, a general fear of future, but yet to be declared, defaults could create short term problems as investors flee risky assets (equities and some non-Treasury debt). Where were the regulatory agencies to monitor this faulty underwriting activity? I don't have many answers.

Rosy Past, Uncertain Future

Prior to the last decade, the two Gov't sponsored mortgage entities, Fannie Mae (FNM) and Freddie Mac (FRE), provided the main market to which banks and lenders could sell the mortgages that they originated, providing some structure to underwriting standards. Banks sold their mortgages to FNM/FRE; FNM/FRE then bundled them into pools and sold them to large investors as bonds (securitization).

They weren't perfect, but profit was a secondary consideration. High credit standards and "liquidity" for mortgages - in providing a market for banks to unload their loans and thus encouraging them to help make home ownership and obtaining mortgages easier - best defined their objective.

As banks and brokerage houses grew in size and new capital sources entered the market (hedge funds, etc.), these participants now possessed adequate capital to replace FNM/FRE as the middleman and eventual holder of the mortgage. Unfortunately, securitizing mortgages and their derivative offshoots became so lucrative, and the risks so "understood," that many institutions relaxed their loan criteria.

FRE/FNM began reaching for profit themselves and initiated questionable activity in the mortgage market. Fed Chairman Ben Bernanke discussed this a few weeks ago, and his push will result in new standards for both FNM and FRE.

In late February, FRE finally announced that it would reduce its purchases of sub-prime loans to discourage lenders from underwriting them. Unfortunately, this may have unintended consequences in the short term - it could provide greater barriers to affordable home ownership by reducing the general availability of credit to borrowers.

We'll need to see how this develops. Despite the large banks' claims of adequate capital reserves and little need for oversight, I'm sure that the US government, as well as the states themselves, will attempt to reestablish their influence in the mortgage market.

Stocks to Watch

In waiting for the dust to settle, I would closely monitor the shares of these larger banks that truly possess strong capital bases, including two of Berkshire's (NYSE:BRK.A), (NYSE:BRK.B) recent holdings, Wells Fargo (NYSE:WFC) and US Bancorp (NYSE:USB). WFC maintains a large mortgage portfolio with sub-prime comprising 10-20% of these loans, but their reserves should easily cover any losses. As far as I can determine, USB has significantly reduced their mortgage exposure.

WFC yields 3+%, USB 4.4%, and both stocks will likely be unfairly discarded in any continued sell-off. The dividends should provide support for the shares, and both firms possess excellent management, competitive advantages of scale and product depth, high returns on assets, and bright futures.

Position: Long WFC, BRK.B

WFC vs. USB 1-yr chart:

Source: Stocks To Watch During the Subprime Mess: Wells Fargo, US Bancorp