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Subprime Shake-Out: Where Do We Go from Here?

Our take on the meltdown and three stocks that we believe will survive it.

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Over the past six months we've all seen article after article documenting the collapse of the subprime mortgage market. No doubt, it has been one of the headline stories of 2007. Nowadays, just uttering the word "subprime" can send some people into convulsions, while not so long ago the mention of subprime mortgages put smiles on many investors' faces.

Covering subprime here at Morningstar, my colleague Ryan Lentell and I are constantly asked a number of questions. What happened? What did we miss? What's going to happen next? And with all the uncertainty, where should investors put their money?

We don't claim to have a crystal ball showing us what the future holds for the mortgage market. But we are going to try to take a step back and answer these questions with the benefit of hindsight. Although sometimes we think we could write a book about what happened, we will try to be brief.

What Happened?
The subprime mortgage market rode the surging real estate wave over the last couple of years before being pulled down in the undertow as the real estate market slowed. As home prices surged--appreciating by almost 8% in 2003, 12% in 2004, and 13% in 2005 (according to the office of federal housing enterprise oversight's Housing Price Index)--delinquencies in subprime loans remained remarkably low. In fact, during this period total contractual delinquencies in mortgages securitized by  NovaStar (NFI), remained below 5%--astonishingly low relative to history. Compare this with the early 2000s, when delinquencies consistently ranged near 10%.

Looking back, we believe the default risk was masked by the rising housing prices for many. While real estate prices soared, homeowners who ran into financial problems could quickly refinance, pulling more and more equity out of their homes to pay their mortgages. However, as the housing market slowed, homeowners could often not refinance, as their house had not appreciated. Moreover, speculators looking to flip investments were left holding homes and were not prepared to make mortgage payments for an extended period of time. As soon as delinquencies ticked up last year, many investors quickly ran for the exits.

Because of the investor demand for subprime mortgages during the boom, originators such as  New Century Financial (NEWC) continually looked to increase production. It seemed like a perfect business. These companies originated loans and quickly sold them for a premium, presuming in the process that they were ridding themselves of the default risk. But this active market of risk-assuming investors most likely loosened underwriting standards, compounding the problem when the real estate market slowed, and early payment defaults--individuals missing one of their first mortgage payments--soared.

Prior to last year, early payment defaults had never been a major issue in the industry, as loans were rarely returned. For example, in 2005, New Century only reserved a mere $7 million for loans repurchases to cover the firm's $12 billion of loan sales during the fourth quarter. However, last year the tide changed. Mortgage sales generally carry representations and warranties that allow buyers to return loans if an early payment default occurs or if they discover any problems with the loan documentation--a stipulation that investors began taking advantage of in 2006. By our estimate, New Century will realize a charge in the vicinity of $400 million for loan repurchases for 2006--if the firm ever reports the year's financial results.

On top of the early payment default issue, delinquencies in subprime loans rose across the board as the real estate market slowed, tempering investor appetite for more subprime loans. Moreover, many mortgage originators--New Century included--had relied heavily on short-term financing, which quickly disappeared as loan performance deteriorated.

What Did We Miss?
New Century had a 5-star Morningstar Rating for stocks during its collapse. Why? Good question. Admittedly, the company was risky, hence our above-average risk rating. Indeed, we even recognized that delinquencies would rise. In fact, we had assumptions of increasing charge-offs built into our New Century valuation model. But we underestimated two things.

First, we missed the risk that early payment defaults posed. As we stated, early payment defaults had never been an issue before, and we just did not see that risk on the horizon until it was too late. The risk we saw was loans defaulting as they reset from the "teaser" rate to a fully adjusted rate--the interest rate borrowers will ultimately have to pay after their low teaser rate expires--after two years.

Second, we didn't recognize how quickly the company's financing would disappear. New Century had been a darling of Wall Street, supplying banks with loans to package into new collateralized mortgage obligations. However, once the first problems arose, the very firms that had benefited from the flow of loans were the first to turn off New Century's financing spigot, demanding their money back and effectively killing New Century. The firm was out of cash, could not fund many loans already being processed, and was eventually forced to file for bankruptcy.

Arguably, if New Century had relied upon long-term debt instead of short-term financing, the company would probably still be alive today. No doubt, it would be struggling, as early payment defaults, high delinquency rates, and a reduced number of buyers of subprime mortgages would be taking its toll. But, we believe that with access to cash, New Century might have lived to see another day and maybe even stabilization in the market.

The best thing we can do now--as in any situation--is to learn from our mistakes and minimize the likelihood of getting burned again. We are on the look-out for similar situations and will try to highlight these risks by writing about them in our Analyst Reports and by raising our risk ratings when we see problems. However, we are not going to bat a thousand. By default, specialty finance is risky business. We stress that diversification is a must, especially when looking at above-average-risk and speculative-risk companies.

What's Around the Next Corner?
The ultimate outcome in the mortgage market will depend on what happens in real estate--a scenario that's difficult to predict. But there are a few issues that we would be willing to bank on, one in particular being that excessive legislation only stands to make a bad situation worse.

There's been a lot of debate on Capitol Hill about the government's role in cleaning up this mess. While we understand the urge of the government to rush to the aid of mistreated and deceived borrowers, we aren't convinced that a government Band-Aid will be able to heal current wounds. We believe that the market's own tightening of credit standards and the subsequent forced exit of several mortgage players, particularly the irrational ones, will do more to fix the industry's woes than government regulation. That said, we were encouraged by the initial steps taken by government agencies and private institutions to provide liquidity to the market, allowing individuals to refinance as rates reset into loans they can afford.

We also agree with the proposed guidelines that borrowers' ability to pay on their loans should be measured against the fully indexed rate. One of the reasons for the present market condition, in our opinion, is that borrowers were measured based on the initial interest rate--an inaccurate, short-term, and ultimately meaningless reference point.

We further believe that consumers and lenders would be best served if the mortgage industry were monitored under one regulatory body. Right now, states hold the power to monitor the transactions of mortgage lenders operating within their borders, and this is not the most efficient or effective structure, in our eyes. However, we aren't blind to the fact that our ideas are probably just lofty dreams and that a central governing body would be nearly impossible to organize.

Our biggest fear is of legislation going too far--such as the proposed industry bailout or the elimination of entire classes of mortgage products--motivating lenders to sever ties with borrowers that are struggling to work out problem loans. We also caution the legislature against closing a door only to leave a window open. For example, a North Carolina law that disallowed the issuance of high-interest mortgages has only encouraged lenders to substitute more-innovative offerings that have either recreated the same problems or even created new ones for borrowers.

We believe the best course of action would be to educate borrowers rather than rebuking lenders.

Subprime Is Here to Stay
Despite the seemingly endless plunge the subprime mortgage market has taken over the past few months, we contend that this is a necessary and profitable business over the longer term. In 2006, $600 billion, or 24%, of total mortgage loans originated were subprime mortgage loans. Certain borrowers need these loans to own a home and are willing and able to pay up for the opportunity. We agree with  Merrill Lynch's (MER) CFO, Jeff Edwards, when he commented during the firm's first-quarter 2007 earnings conference call that subprime lending "is an asset class that will continue to be significant, both in the U.S. and worldwide."

We must caution that investing exclusively in subprime may not be the best alternative. The jury is still out on monoline subprime mortgage lenders like  Accredited Home Lenders  (LEND) and NovaStar. We stress that there is just too much risk in either of these, except for the most-speculative investors.

The Beneficiaries
So if we don't think investors should dump their money into monoline players, where do we see opportunities? In our eyes, firms that maintain a strong balance sheet with plenty of liquidity and a diversified business are the way to go.

Three names pop into our head almost immediately, two of which are trading at or near 5-star territory right now. Each of these firms has substantial mortgage operations, but more importantly they have strong balance sheets. No doubt, the near term will be choppy, but we believe that they should all benefit as irrational players exit the market.

Countrywide Financial (CFC)
Business Risk: Average
Economic Moat: Narrow
 Countrywide Financial is one of the dominant players in the mortgage space, operating a diverse business model with more than $200 billion in assets. We take comfort in the emphasis that CEO Angelo Mozilo and his team have placed on diversification following the housing slowdown in 2000-2001 into less cyclical, yet complementary, businesses, including banking, insurance, and capital markets.

Washington Mutual (WM)
Business Risk: Average
Economic Moat: Narrow
From its humble beginnings nearly 120 years ago,  Washington Mutual has emerged as a major player in the U.S. mortgage industry, but we believe that WaMu's diversified business platform will be the firm's ticket to ride. WaMu is known for its unconventional banking operations, which has propelled the firm as the leading U.S. thrift. We are also encouraged that WaMu is leveraging its banking business and its customer relationships to diversify its revenue stream, such as with its entry into the credit card industry.

Wells Fargo (WFC)
Business Risk: Average
Economic Moat: Wide
 Wells Fargo is the essence of diversification, with more than 6,200 banking and mortgage lending offices in the U.S. and abroad and $482 billion in assets. Despite being one of the largest mortgage originators and servicers in the U.S., we don't believe this exposure will be the bank's Achilles' heel. Wells Fargo operates more than 80 businesses, with the goal of serving all of its customers' needs by gaining 100% of their assets.

Ryan Lentell contributed to this article.

Erin Lash has a position in the following securities mentioned above: WFC. Find out about Morningstar’s editorial policies.