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While Friedman Billings Ramsey (NYSE:FBR) is a well known regional investment bank, their entire capital structure, and indeed valuation, is based solely on their status as a mortgage originator in the sub-prime space.

As of Jul 26 2007, FBR sold an 80% stake in its First NLC Financial Services, LLC (NASDAQ:FNLC), sub-prime mortgage origination subsidiary. This measure has limited FBR’s exposure to sub-prime losses from this subsidiary to an additional $18mn in capital required to aide in the divestiture.

Further, FBR currently holds $6.05 bn of mortgaged backed securities and $3.7bn of loans on its balance sheet. All in FBR has $11.3bn of assets and $10.1bn of liabilities leaving a book value of $1.01 bn or $5.83 per share as compared with a current share price of $4.42. FBR now essentially trades at a 10 year low. At the current Price / Book of .76 FBR actually represents a case where a modern value investor can indeed invest with Benjamin Graham’s preferred margin of safety requirement, asset coverage in excess of equity.

Of course, given the mortgage melt down currently gripping the nation, this 32.9% margin of safety could disappear. However, the remarkable fact to be noted is that a 32.9% margin of safety can be had at all in this day and age. The case for investing in FBR is simply that this venerable brokerage firm with an 18 year track record will not “blow-up”.

Certainly, FBR would not be the first Wall Street firm to go the way of the dodo but during any given market crisis the odds of a particular bank going under is low. Beyond mortgage-backed securities held at FBR’s HoldCo the firm has another valuable asset in its FBR Capital Markets, the subsidiary which conducts the firms corporate finance and capital markets activities, this too could be sold off were the situation to become dire.

While the sub-prime situation does appear to be severe and FBR was a particularly egregious offender, lending in the over heated markets of California and Florida, the current 32.9% margin of safety for equity holders and the overwhelming likelihood that FBR will live to see another over heated real-estate market make this stock a buy.

In order to make the risk/return profile of this distressed situation more commensurate the Jan 2009 $7.5 call options [OFTAU] appear to be a superior investment as compared with the equity. After all, should FBR blow-up the equity and the options will both be worth zero but should FBR survive to see a time with less concern over sub-prime woes it is highly unlikely that its shares will not recover from their current 10 year low at $4.42.

Disclosure: Author is long FBR

Source: Friedman Billings Ramsey: A Contrarian Dumpster Dive