A $100 Billion Fireworks Display
By
Graham Summers
July 30, 2007
Everyone loves a good explosion.
When the subprime sector first starting making fireworks back in January and February, we were as excited as anyone else – anyone, that is, who didn't own subprime mortgages – to see the industry light up like the Fourth of July.
At one point, I was even chronicling the number of subprime lenders that had gone belly up on a week-by-week basis. Today, the number is 102: truly incredible, considering we're only counting the last eight months or so.
And still the fireworks continue. But nobody's enjoying them. The Dow's recent plunges of 200 and 400 points were related to concerns that the subprime meltdown may reach into other types of mortgages, such as Alt-A or adjustable-rate mortgages (ARMs).
Most recently, Fed Reserve Chairman Ben Bernanke declared that damage inflicted by the subprime defaults could reach $100 billion. "A lot of the subprime mortgage paper is not, you know, as good as was thought originally," Bernanke told Congress.
That testimony came less than one week after two Bear Stearns hedge funds went broke, losing $1.5 billion due to their overexposure to subprime loans. Bear Stearns is usually held in some regard by the industry, so it's strange to see two hedge funds once worth $16 billion prove themselves to be failures at both hedging and diversification: the two most central tenets of hedge funds.
The credit rating agencies paint an even bleaker picture. Standard & Poor's cut the credit rating on 418 mortgage-backed securities worth an estimated $3.8 billion from AAA to BBB. Mark Zandi, chief economist of Moody's Economy.com recently told listeners on a teleconference that of the $2.5 trillion in Alt-A, jumbo interest-only, and option ARMs, "approximately $1.4 trillion is at serious risk of default."
Anything related to real estate – lenders, homebuilders, banks, etc. – is down. And at some point in the near future, it will be time to start sifting through the wreckage for survivors.
The insiders and investing legends already are.
When you take a look at the yields and the price-to-earnings multiples, it's not difficult to see why...
Name |
P/E |
Yield |
Insiders Bought |
Legend |
Colonial Prop |
8 |
7% |
$25 million |
N/A |
Newcastle |
7 |
12% |
$13 million |
David Dreman |
Winthrop Rlty |
10 |
3% |
$4 million |
Arnold Schneider |
JER Investors |
9 |
12% |
$542,000 |
David Dreman |
In no way am I suggesting you rush out and buy these companies. But those yields and earnings multiples are pretty enticing. However, as Bernanke has warned, we may see those earnings and yields shrink as the lending sector and its peripheral sectors drop more.
Even if the yields and earnings don't shrink, you could still see the shares drop even further.
So rather than running headlong into the sector, I suggest poking around these companies' balance sheets. If you can find the reason why these guys are all piling in, then you've got some excellent buy candidates for when the sector forms a bottom.
But whatever you do, don't lower your investing standards to chase a fat yield or an appetizing earnings multiple. It never pays to lower your standards when it comes to investing.
Just look at the subprime sector.
Good trading,
Graham
