Is There Still Value in Subprimes?

 NovaStar Financial (NFI) is one of the most controversial stocks we cover. 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  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 . 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
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.

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.

The Bull Case
Ryan Lentell, Stock Analyst
Can NovaStar survive for the long term? If a significant downturn in real estate does not create a downward spiral in the economy, I think NovaStar might be able to skirt what some believe is a certain death. NovaStar has a number of characteristics that differentiate it from others in the industry. Moreover, if the company can pull through, I believe it could be worth $22 per share, well in excess of its current market value. As a survivor in the subprime industry, the company will no doubt benefit from reduced competition. It should be able to raise interest rates to borrowers and selectively underwrite loans from only the strongest subprime borrowers. However, I think investing in NovaStar stock is a highly speculative move, and purchasing the stock is only prudent for investors willing to risk losing everything.

Unlike many other subprime lenders, NovaStar has yet to breach a debt covenant causing a default or requiring a waiver on a short-term financing agreement. Currently, the firm is at risk of violating a covenant on one of its lending arrangements, but it hasn't yet been violated. This agreement requires NovaStar to earn money in the trailing six-month period. After losing $14.4 million for the quarter ending Dec. 31, 2006, NovaStar would need to earn an equivalent amount or more in the first quarter of 2007, which it is unlikely to do. Even so, this may not mean the end for NovaStar--I think that it's likely that the company might not have any money borrowed against this credit facility right now, as it has the right to prepay any amount borrowed in this agreement. On Feb. 28, NovaStar completed a $1.9 billion securitization, replacing short-term lending with long-term financing and greatly reducing the loans funded with short-term agreements. Also in February, NovaStar significantly reduced its origination volumes to only $386 million from $740 million in January. Lower production volumes should allow NovaStar to avoid utilizing the agreement in question and might allow the firm to survive the liquidity crisis.

Instead of selling its loans to third parties, NovaStar securitizes the majority of its loan production--retaining a residual interest in a pool of mortgages. Because of this practice, the company faces a much lower risk of repurchase requirements due to early payment defaults. In 2006, NovaStar sold $2.2 billion worth of loans to third parties, while it securitized more than $6 billion. Due to this structural difference, I think NovaStar's fate will be decided by the long-term performance of its loans. If the loans perform well, NovaStar will continue to receive cash from residual interests in its securitizations.

Undoubtedly, delinquencies have soared over the past year. By our calculation, contractual loan delinquencies of 30 days or more measured 9.5% in NovaStar's securitizations in February, shocking when compared with the 3.9% delinquency rate in February a year ago. However, this elevated delinquency rate is still in line with the 1999-2002 period; in fact, during that difficult period, delinquencies peaked at 14.5% in 2000. NovaStar has tightened its underwriting standards to help turn the tide of the increasing delinquencies, and we might already be starting to see the effects from this tightening. Our calculations show that delinquencies on loans in NovaStar's securitizations fell to 8.8% in March from the February high. Moreover, 30- to 59-day delinquencies as a percentage of delinquencies fell from 2.2% to 1.7%. If the company can keep delinquencies in line with levels seen in previous tough times, it might bode well for NovaStar's survival.

Although tighter underwriting is important to NovaStar's survival, the strength of the real estate market is critical. If real estate recovers, the prospects for NovaStar might be bright. While real estate could be in for a bumpy ride in the next few years, we recently saw one positive sign of stabilization in home prices. According to the National Association of Realtors, the median sale price for existing homes increased from $210,900 in January to $212,800 in February. Although the improvement was slight (and prices were still well below the $221,600 median level in December), if this trend continues, borrowers might once again be able to sell or refinance their homes to alleviate financial difficulty. March's existing home sales data will be published April 24, and we will be watching closely. If the ramifications from the shake-out in subprime are relatively contained and the real estate market is not depressed for years, NovaStar has a fighting chance of long-term survival. Subprime lenders have demonstrated their ability to earn money. While their loan portfolios may have high delinquency rates today, these loans are ultimately backed by hard assets--houses. If real estate does not collapse, subprimes still retain a good percentage of the initial loan value, even in default.

We have recently seen a number of large institutional investors moving into the subprime space, and the industry is likely to evolve rather than simply go away. The question is whether there will be a place for NovaStar.