Next Domino to Fall: Builders, Mortgage Insurers, Prime Lenders or GSEs?

The subprime lenders are probably high risk shorts right now (if you can find shares to short). Sure, most of them are probably going bankrupt, but they've already been beaten down and there will probably be some wild, dead cat bounces along the path to zero. Get too exposed to the group and margin calls could force you out. Then there's always the chance that some private equity manager playing with other people's money will want to buy out a company to preserve somebody's NAVs.

I suspect that other housing related sectors are probably the better play right now. Possibilities include:

Home Builders
For the financial sector, the quickest way to solve the housing problem would be to cut off credit to the homebuilding industry. Even after the recent steep declines in permits and starts, the builders are still building far too many homes. The inventory glut is what will be forcing home prices down the fastest. That is what will turn small losses on foreclosures into big losses on foreclosures. Early signs show that builders are starting to worry about their financing. If Wall Street gets it's act together, then builders could face a huge credit crisis on short notice.

Mortgage Insurers
Before piggyback loans became the rage, almost all low LTV (loan to value) loans required mortgage insurance. The rise of the piggyback didn't hurt the mortgage insurers, but it did cut into margins and make the market more competitive. MIs are sort of the first line of defense against defaults, as they pay off when borrowers default. As such, they should be the first ones feeling the pain with defaults on the rise. MTG is the biggest pure MI play, as most of the others are involved in multiple real estate based business models.

One protection the MIs may have is that they can claim fraud on many of the defaults that lenders try to make claims on. Perhaps this is why the stocks are still close to their highs. As the bubble continues to deflate, however, I don't think that they'll be able to find enough fraud to escape their highly concentrated exposure to defaults.

The Government Sponsored Enterprises (GSEs)
Fannie Mae (FNM) and Freddie Mac (FRE) are basically humongous mortgage insurers. The value they add is the guarantee that they'll make good on any defaults by borrowers. "Agency Debt" issued by the GSEs are seen as extremely safe securities. The GSEs would have to be wiped out by a massive wave of defaults and the US Government's $2 billion dollar backing would have to be exhausted as well for Agency Debt to begin defaulting.

Whether or not Agency Debt defaults is not what matters to GSE investors and shorts. Every mortgage they've purchased and securitized that defaults and results in a loss cuts into Fannie's or Freddie's equity. The recent rise in defaults should cut into the value of FNM and FRE shares, although neither one has fallen very far. Of the two, FRE is probably worse off, because they are smaller and have some exposure to the subprime market.

Prime Lenders The main differences between prime and subprime loans are the interest rates and the credit scores of borrowers. The higher rates on subprime loans probably are a major factor in their being the first to experience a big increase in defaults. However, declining home prices will eventually hit prime loans as well. Indeed, having a high credit score often allowed a borrower to buy even more home than they should have. In many cases (I expect) prime loans will result in even larger losses than subprime loans. Those losses are just a little further down the road. All types of banks and mortgage lenders are at risk here. Countrywide, Washington Mutual, Wells Fargo, even Citigroup could take huge hits on losses in all types of mortgages.

Good ideas all, Rodger.

I dunno... I see the short-side  as a spoiled game already.... the point of safe entry is long gone.

The time to safely set up shorts was 12-18 months ago.  We're playing the "catch the falling knife" game now.  The 'soft economy' angles I am in are chugging along nicely, but I'm not excited about adding to them in greed.  Once momentum takes hold, it's all to easy to be deceived into the group-think, and get suckered into holding through a reversal.

There's sure to be more blood (and many bodies) yet.... but shooting them out of the air in mid-fall... riskier than I like to play (I am a brutal "lie-in-wait" hunter... not so much a grab-n-go opportunist...)

I'm ready to go long on defaulted bailouts.   Looking for setup scenarios on bottom-reversal opportunities now.

Yo, Dave:

I dunno... I see the short-side as a spoiled game already.... the point of safe entry is long gone.

Only the sub-prime short-side is potentially spoiled here - I'll gladly ride the positions I entered months ago because the capital gains aren't worth taking profits, but the risk/reward on new shorts isn't worth it, especially when other sectors are looking ripe for a fall.

The 2000-2002 decline came in stages, with one sector at a time giving up the ghost and going through a major collapse. I rode B2Bs down early on. Later I caught a nice ride on cable company ISP shorts. At another point I rode a group of Sprint-PCS puppet companies down the tubes. I've been waiting a long time for another bear market to come along so that I can do the same thing even better with the ideas I've been developing.

Lenders, builders and retailers are the broader sectors I've been focusing on, and there are plenty of smaller groups within those sectors. The names I mentioned at the start of this thread are just one part of what I've been looking at.

Here's what I blogged today:

Ka-Boom!!!

Over the weekend, it seems, many people finally got wise to the fraudulent ways of the sub-prime lenders:

NEW down 68.87%
NFI down 40.88%
FMT down 32.38%
IMH down 32.05%
LEND down 25.99%

A one-day dive like that doesn't happen often to a group of stocks. But then, these are strange times in the financial markets, and the housing sector has made for a great game of chicken among fund managers. The truth was out there for anyone who payed attention to the warning signs:

http://rebalancing.blogspot.com/2007/02/subprime-timebomb-explosion-continues.html
http://rebalancing.blogspot.com/2006/08/sub-prime-time-bomb-detonated-today.html

A lot of people had the courage and sense to short these guys and have done very well. It's more interesting, however, to look at who has been buying these stocks since the time bomb first detonated back in August.

Top 10 institutional holders on 12/31/06:
1. Hotchkis & Wiley 3,948,100 shares
2. Greenlight Capital 3,494,700 shares
3. Morgan Stanley 3,022,884 shares
4. Goldman Sachs 2,640,127 shares
5. State Street 2,116,121 shares
6. New York State Teachers 2,011,750 shares
7. Citigroup 1,937,351 shares
8. Barclays Global 1,618,618 shares
9. Deutsche Bank 1,362,819 shares
10. Vanguard Group 1,257,444 shares

Top 10 for shares purchased during Q4 2006:
1. Ivory Investment Management
2. Wesley Capital Management
3. Jacobs Levy Equity Managment
4. New York State Teachers
5. UBS
6. Chicago Equity Partners
7. Merrill Lynch
8. Two Sigma Investment Managment
9. BNP Paribas Securities
10. Tewksury Capital Management

SC 13 filing in 2007 indicating more purchases:
Cititgroup 2,845,700 shares held on 2/19/07, an increase of over 900,000 shares when they should have known better. Citigroup has a huge sub-prime lending division of it's own, after all.

Many months ago I read an interesting businessweek article that explains why Citigroup, Merrill Lynch, UBS, Goldman Sachs and Deutsche Bank are all getting burned on New Century and others (GS is in the top 5 holders for NFI & LEND as well):

"More surprising, banks are also regularly agreeing to buy huge blocks of stock from trading clients even when they know they will likely lose money on the trade. It's a high-risk, low-reward endeavor designed to keep clients coming back to pay for more lucrative business in the future. Some executives estimate the dollar volume of such transactions has doubled in the past few years. Yet banks have barely broken even on about 30% of their big block trades this year, according to Thomson Financial (TOC ). That's because the share prices often fall during the time they hold the securities on their books. Even so, "banks are falling all over themselves to bid on blocks," says T. Rowe Price's Brooks. "It's not for the faint of heart."

The sub-prime time bomb is just the first is just the first stage in a chain reaction that will engulf many portions of the financial sector. Look for prime lenders, mortgage insurers, the GSEs, savings and loans, commercial banks and investment banks all to experience their own implosions. They may not all get wiped out entirely or as dramatically asthe sub-prime players, but the damage will be extensive.