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Our Updated Take on Financial Stocks--Page 3

We still see opportunities amid the turmoil.


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Product of Easy Money
The bottom line resulting from all of these activities was easy money. Home prices shot up in the United States and elsewhere around the globe as easy loans were extended to more and more borrowers ill-prepared to afford these highly levered purchases. Separately, corporate defaults dropped to historic lows as nearly any zombie company could find capital somewhere, somehow. Commercial real estate prices took off as lending standards loosened, allowing higher loan-to-value ratios and lower rent-to-interest coverage metrics. The private equity boom also reached amazing heights with less equity in each successive deal and even negative interest coverage toward the peak of the cycle. Commodity speculators and hedge funds in general were able to borrow from their prime broker to enhance returns, which layered even more leverage into the system. Most players that ran into trouble in any of these markets were likely to refinance their way out of trouble, allowing lenders to largely avoid bad debts during the upcycle.

The Fallout
All of these trends are self-reinforcing on the way up and work until they don't. The most stunning example of these general trends imploding arrived with early payment defaults on subprime loans beginning in the second half of 2006, making it clear that underwriting standards had deteriorated to ridiculous levels. A couple of quarters later, higher default rates began translating into increased lending losses as home price appreciation merely decelerated in some formerly hot markets and the costs of foreclosure mounted.

As the market became more aware of the magnitude of the problem, several troubling trends emerged. The asset-backed paper market shut down across many asset classes as the ultimate investors lost trust in the players along the securitization chain, especially the underwriters and the ratings agencies whose models quickly failed along with widespread asset price declines. At this point, shaky subprime lending institutions such as New Century and its smaller peers, which were completely reliant on the securitization markets and short-term loans from Wall Street, began to fold up shop.

Unfortunately, the resulting downward trends are self-reinforcing as well. Lower asset prices mean marginal borrowers aren't as easily bailed out by refinancing, leading to forced sales and losses for the lender. Worsening defaults and severity of loss led lenders to pull back even further, which naturally leads to additional defaults as it becomes more difficult for marginal borrowers to refinance and for buyers of the shaky assets to fund a bid.

As the leverage house of cards tumbles, the impact has been widespread and recurring. We've witnessed busted hedge funds such as those at Bear Stearns that employed massive leverage to invest in mezzanine CDOs backed by lower-quality subprime residential mortgage tranches. We've seen housing finance pull back to Fannie Mae, Freddie Mac, and FHA stamped loans, as well as a select few portfolio lenders, who are charging a premium for very tightly underwritten loans. We've seen credit card and auto delinquencies begin to tick up from recent low levels and those lenders begin to pull back from their riskiest customers. We see signs that corporate defaults are likely to move higher, as credit spreads have spiked dramatically for riskier corporate credits. We also see evidence that the market is anticipating busted leveraged buyouts from recent vintages, as some of the more troubled loans are trading far below par.

Mitigating Factors
The good news is that there are several mitigating factors that have quickly emerged. The Fed has acted quickly with substantial easing of monetary policy and massive liquidity injections, all in an effort to shore up asset prices and jumpstart risk-taking among lenders. While LIBOR rates initially remained at abnormally large spreads over Treasuries, potentially indicating a lack of trust among banks, a series of massive equity capital infusions into large global commercial and investment banks--largely derived from the Middle East and greater China--helped bring some relief to those concerned about bank failures, and systemic and counterparty risks. Merger and acquisition activity also served as a prop for confidence, as evidenced by  Bank of America's (BAC) play for Countrywide, which served to quell mounting doubts in the marketplace about this sizable mortgage bank. And most recently, the government acted on a fiscal stimulus package that should provide a temporary boost to GDP and give the government-sponsored housing enterprises additional degrees of freedom in serving some of the more troubled (higher-priced) housing markets.

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Matthew Warren does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.