Is There Still Value in Subprimes?

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NovaStar Financial NFI is one of the most controversial stocks Morningstar covers. The subprime mortgage lender rode the wave of the housing boom over the past few years, and it is now struggling to survive the storm in the subprime mortgage industry--a storm that already forced industry stalwart New Century Financial NEWC into bankruptcy. NovaStar's stock price has plummeted from more than $30 per share in early December to approximately $5 per share today. Right now, NovaStar's long-term prospects are up in the air. It is unclear whether the company can survive the mortgage malaise, stave off liquidity problems, and emerge as one of the few stand-alone players in the industry.

As part of every stock analysis we perform at Morningstar, we lay out the bull and bear cases. Since NovaStar continues to grab headlines, we thought it would be worthwhile to further detail our thinking on the company's prospects as the subprime shakeout continues. My colleague Matt Warren argues that NovaStar has a poor chance for recovery, and I offer a more optimistic scenario.

Background
NovaStar shares started tumbling in February when the company released its 2006 results and reported a loss in the fourth quarter. It took a write-down on residual securities backed by subprime loans that were not performing as well as in the past, and the firm provisioned for additional loan repurchases because of early payment defaults. Furthermore, management stated that the company was considering dropping its real estate investment trust status in 2008. This shocked many income-seeking investors who enjoyed NovaStar's large dividend. Moreover, the company stated that the decision was in part because it projected having little taxable income from 2007 to 2011, understandably startling all investors. However, the company did not mean it would not earn money or have positive cash flow. The shortcoming in taxable earnings (which reduces the advantages of the REIT structure) is expected due to a difference in how earnings associated with its off-balance-sheet securitizations are accounted for under IRS standards and generally accepted accounting principles.

NovaStar also faces an ongoing liquidity crunch in the subprime mortgage industry. Liquidity in the industry has dried up as delinquencies have soared. Investment banks have been actively making margin calls on warehouse lending agreements. Meanwhile, investors in whole loans and collateralized mortgage obligations have been much more selective. NovaStar recently announced that it had received a capital injection of nearly $100 million in new debt arranged by Wachovia WB. Additionally, it announced ongoing negotiations to restructure all lending arrangements with Wachovia and the hiring of Deutsche Bank DB as a financial advisor as it explores strategic alternatives. By every account, NovaStar is struggling to survive the current crisis, and its long-term prospects are up in the air.

The Bear Case
By Matthew Warren, Stock Analyst
The music has stopped in the subprime mortgage industry, or, at the very least, the record player's needle is stuck in a deep scratch. It was quite a wild party that has now entered the hangover phase. Mortgage money was easier to get than it has been for quite some time, and subprime lending grew from being a small fraction of the market into a substantial piece of total originations in recent years. There was little need for liquidity from Fannie Mae FNM and Freddie Mac FRE, when nameless and faceless investors--desperately reaching for a little extra yield--were willing to buy any and all mortgage paper served up by the investment banks, which often served as intermediaries in these formerly lucrative transactions.

As outsized gains in house prices, employment, and earnings growth masked risky or even downright sketchy underwriting behavior, some industry players reached lower and lower to get the next deal done and pocket another commission. We've all seen the e-mail and fax ads trumpeting loans requiring no down payment, no proof of assets or income, and not even the requirement to fully cover pesky interest payments anytime soon. More than one mortgage banker surely told their clients that they could simply refinance their way out of any potential problems or higher payments down the road when the recently popular two-year option adjustable-rate mortgage would reset. Inevitably, problems stemming from this type of behavior surfaced as home price appreciation has slowed or reversed, depending on the locale. In fact, the market took abrupt notice as many loans went bad with nary a payment made and as delinquencies shot up dramatically in an otherwise healthy economy with low interest rates and unemployment.

Some are now claiming that lenders are overreacting as they tighten lending standards. I would argue that this process has only just begun and that the subprime market will soon be back in its rightful place as a small fraction of the larger mortgage market. A firm that has survived the shakeout thus far, choosing to aggressively take share in a rapidly shrinking market, could turn out to be the proverbial sucker at the poker table. Given the numerous bankruptcies and various other pullbacks and exits from the subprime lending table, existing homeowners facing painful payment resets will have a much harder time finding affordable refinancing. And with foreclosure-related auctions increasingly competing with professional homebuilders and much-less-savvy "investors" who are forced to blow out their high-cost (and high-risk) inventory, it would be surprising to see rising home prices bail out those in trouble.PAGEBREAK

Even if NovaStar chooses to pare back lending with dramatically tighter underwriting standards and wait for the secondary market for subprime loans to calm down, it is quite possible that past underwriting mistakes will join forces with a deteriorating market environment to wipe out the residual value of the previously issued mortgages that are so prominent on NovaStar's balance sheet. If the economy and employment picture take turns for the worse or home price declines accelerate, even a gift from the Fed in the form of lower short-term rates could be largely offset by widening bond spreads as previously eager investors steer clear of these often-junky loans. While the potentially large payoff from NovaStar stock that could occur in the much-heralded "soft landing" scenario might seem appealing, there is an army of termites undermining the framework behind this argument more and more with each passing day. While many of these concerns are already reflected in the stock, bankruptcy and the possibility of worthless equity claims are more than a remote possibility.