what's the deal with subprime lending?

[sylar]

i have a question about subprime lending stocks. it appears that they've been getting hammered by analysts for a long time now. so much that unless a company is heavily diversified into prime loans, like mortgages or something, it's likely to have lost over 50% of its value YTD. on the other hand, subprime is a lucrative business, and they are constantly the targets of takeovers for a larger bank.

stocks in question are here. what's your call on these? are they ready for a comeback, or is this sector done?

http://finance.google.com/finance?q=...+hmb&hl=en

recently, NovaStar (NFI) has been on a big roll. mainly i've been watching this slice of the market for about a month and had the sense to put a little bit into NFI call options purely for risk-reward reasons (risk $1.50 to win $7.50). they are still a takeover candidate because one of their competitors was bought out recently, and also they secured $1.4B for mortgage-backed loans which would add another $75-100M to their annual revenue.

anyway, please post your opinion. it would help if you are familiar with subprimes, and/or know why it's fallen out of favor on Wall St.

[Evan]

High yield borrowers had defaulted at unbelievably low rates for the past few years. This drove up the valuations of subprime lenders quite a bit. The recent crash was really just a regression to the mean. Subprimes are significantly different than regular lenders because their loans are not garaunteed by Fannie Mae/Freddie Mac.

As far as predicting who will get bought when, I can't help you.

[jumbojacks]

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had the sense to put a little bit into NFI call options purely for risk-reward reasons (risk $1.50 to win $7.50)

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Just curious, but when everyone thought they could go busto, what made you think the probability that they wouldn't was better than ~17%?

[Evan]

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had the sense to put a little bit into NFI call options purely for risk-reward reasons (risk $1.50 to win $7.50)

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Just curious, but when everyone thought they could go busto, what made you think the probability that they wouldn't was better than ~17%?

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I think a better question is how you figured out there's an exact amount you stand to "win" by purchasing a call option.

[sylar]

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had the sense to put a little bit into NFI call options purely for risk-reward reasons (risk $1.50 to win $7.50)

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Just curious, but when everyone thought they could go busto, what made you think the probability that they wouldn't was better than ~17%?

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I think a better question is how you figured out there's an exact amount you stand to "win" by purchasing a call option.

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first of all, there are only a few ways for these companies to go busto. because they close, service and sell high interest loans, they could be losing money if their borrowers all go bankrupt, but that should be taken care of by their model and their bankroll (how many loans they can close vs. the risk). there could be downturns, fines, court cases, but one of the reasons why this is lucrative, is because it's a pretty constant business model. because these are subprime, they are also less dependent on the bond market. their returns still outperform those types of investments, and they benefit from a stronger stock market and economy because people pay their loans off more often.

looking at NFI, from what i can tell, they went from $17 to $10 overnight, because they expected no taxable income from 2007 to 2011. this sounds much worse than it is. basically, this means that their portfolio of loans is close to their expiration, and all revenue that they get is not-taxable. they needed to get their act together and start closing more loans, which was helped by the fact that the subprime market had started to come back, as evidenced by their activity in loan securitization. what came after is a series of announcement from NFI which were not reflected in their stock price at the end of may. they got loan securitization for $1.25B in december, then $1.9B in february, then another $1.9B in may. also in april, they announced that they MAY still sell themselves, which is a very likely event (30 other lenders had been acquired in the previous year, due to the slowing market).

basically, the way i see it currently, the company went from $15 PPS to $7.5, on some relatively cyclical activity, during which a lot of its competition had been eliminated. two different things may happen. NFI could have a breakout year and sign a bunch of new loans and make a load of money. or they could start seeing an uptick in the market and sell themselves at a premium to the highest bidder. i thought $15 is closer to their price, and the 7.50 call option price was $1.50. good for 4-1 odds. fwiw, i got the january 08 option, because i am a novice, and i don't like options that expire soon.

[hawk59]

You need to learn how they make money and what their earnings mean, from your post it doesn't seem like you really know what is going on. Especially the comment about how there are only a few ways they can go busto, since in reality the performance of the mortgages they originate aren't even the most likely thing to bankrupt them. There a few important points I will bring up and you should study them further.

First is that almost all mortgage originators use gain on sale accounting, you should look that up but what it essentially means is that when a mortgage originator reports their earnings they are not reporting cash they have received, what they are reporting is the net present value of their residual holdings in the mortgages that they have securitized and sold to MBS investors. The residual value depends on many assumptions, and those assumptions can prove to be wrong down the road. If the assumptions are wrong then the mortgage originator will have to restate earnings, which is something that many of them have done. When they restate earnings that would also reduce book value by the amount of the restatement(and many people use book value to value financial companies).

Second, is that they can be at the mercy of their creditors and the securitization market. If they can sell 98 of ABS for 100 in loans and hold a residual that they value at 4 or so then they are OK. If the securitization market sours and they can only sell 90 of ABS for 100 in loans then they will face a big cash crunch, this can be out of their control to some extent. Also, they use what is called a warehouse facility to finance their loans that they originate before they are sold off, the warehouse lenders can demand more collateral which happened in several cases this year too.

Third, this probably won't be nearly as big a factor going forward as it was but if a mortgage originator sells off or securitizes a mortgage and the borrower defaults in the first few months then it is deemed to be the originators fault and they will be forced to buy back those loans and will face a big loss. This is one of the contributing factors that forced New Century into bankruptcy.

[sylar]

thank you. this is what i need to know/find out about. all the stuff i am missing because i don't know enough/anything about the business.

[pig4bill]

You just haven't been paying attention earlier in the year. Tons of defaults, followed by funding sources pulling out, followed by margin calls, followed by liquidating of portfolios at huge losses. Oh, and there are a few Federal fraud investigations taking place for good measure.

[B00T]

see NCEN for what not to do

[sylar]

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You just haven't been paying attention earlier in the year. Tons of defaults, followed by funding sources pulling out, followed by margin calls, followed by liquidating of portfolios at huge losses. Oh, and there are a few Federal fraud investigations taking place for good measure.

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i am sitting here reading up on all this stuff, and reading your responses. thanks for pointing it out. luckily, it appears that NFI seems to have weathered better than most other lenders, but i was definitely missing a lot of stuff.

what is the general consensus? is this area too risky to invest in, or are subprime stocks currently at a nice discount?