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Understanding Subprime Fire

No investor is unaware of the impact that the subprime mortgage crisis has had on US financial and non-financial businesses of late. Even more worrisome is the fact that many investors look to these battered and bewildered companies as perceiving value after losing 20, 30 or 40% of their valuation from historical highs.

Subprime, by definition, means that banks or lending institutions are lending funds to individuals with higher risk (bankruptcy), poor credit history and providing products (loan, mortgages, LOC) with less than stringent lending, underwriting terms and conditions. This results simply in a much higher degree of risk than more traditional borrowing practices. These agreements were also structured in a way that would increase the interest rates on the principal later in the payment period to make up for the initial discount.

So banks and other companies lent money to people to buy a home that reduced the safety of lending practices and the costs to borrowers would increase later to make up the lost interest and extra risk the lender was taking on. Seems ok, right? Everything was fine until lenders found that people couldn’t make their payments on the mortgage anymore at the subprime interest rate OR when the rates began to rise over the term of the agreement. The banks lowered their mortgage rates because people couldn’t afford them at prime or above to start. Add to that a housing market where the value of homes is decreasing and that very few individuals put down more than 20% equity as collateral into these homes at the time of purchase and VOILA!!! Crisis

But can’t the banks just take the homes away from these people and keep them for themselves like they traditionally have? Sure, but the problem again is “WHO” is going to buy a house when the market is depressed to begin with? If home owners placed 15% equity into their home and the price has now fallen 25%…well the bank just lost 10% on the house they own right off the bat when they take over the property. Add in fees, reselling costs and everything else and what looked like a good idea in the beginning sure backfired to blow up in their face pretty quickly.

But the banks, mortgage companies and other corporations have already taken losses on all of their subprime exposure right? Uh, not really? The next problem is that if the housing market continues to slump, prices continue to slide and even more of these mortgages default at subprime rates…then the problem begins to snowball into an avalanche. When there’s no one to buy this glut of homes on the market how can holders of the mortgages evaluate an accurate or conservative value? It’s great if you can sit on the property for 5-10 years to break even, but with shareholder pressure increasing for companies to realize losses sooner than later, many of these corporations are in a whole world of hurt…and now.

Any experienced firefighter will tell you that no matter how large or small, every fire makes them a little bit nervous. In a situation where your own life or the lives of others hangs in the balance of your decisions, you can never be too careful or think you know with 100% certainty that you’re doing the right thing without first considering all risks.

One of the first lessons they teach any rookie is to understand that the behaviour of fire is routinely unpredictable and something you never underestimate regardless of your individual or collective experience. At times investing requires the need to be a little more like a firefighter. Even when the smoke clears, the walls have been scorched or everything appears to be alright; danger can lurk in areas that appear unaffected or influenced by the earlier disaster.

In my view, some investors are viewing these subprime exposed stocks as homes with their roofs on fire. The fire doesn’t appear to be spreading, the foundations of the company are still well intact and although some renovations or house cleaning is needed the value remains maintained.

From my value perspective I am slowly walking backwards as investors line up to take advantage of the fire sale and move in once the roof stops smouldering. But remember that fire has a dangerous way of being unpredictable and requiring more caution than sometimes the situation warrants. When a fire starts on the roof of a building, ambers can fall between the walls and start burning through. What ends up happening is that it eventually makes its way into spaces under the floor and begins burning beneath your feet. By the time the floor weakens the structures enough, you’re falling through as the house collapses around you. This is often one of the largest concerns for any response to a fire by firefighters. No matter how sturdy the structure appears, they always know to look deeper and sniff it all out.

Even one hot coal left unattended can pose a massive threat for potentially starting a chain reaction that results into something much bigger. Fire may give you a sense of control when contained or extinguished, but complete certainty is something that few people understand. If you’ve ever had a fire in your home, you’ll learn quickly that the fire department has little interest in preserving the aesthetics of that home. They’ll rip into walls, lift up the floor and get into the structure in an attempt to ensure that no danger exists to the remainder of the home that’s hidden from view.

Canadian investors should also be reminded that the Canadian dollar is also another concern (which hit $1.10US early this week before pulling back slightly). Although it may appear as I’ve mentioned before as an opportunity to strengthen the buying power of US securities; an investor should still ask themselves if they would buy the same company if the dollar was below par? $0.90/US, $0.85/US? A dangerous investment is still dangerous regardless of how much purchasing power you have over it. Speculation should never be a part of assessing fundamentals, but some of these US darlings that Canadian investors are flocking into have just as much chance of depreciating further as they do to appreciate – especially when you consider what point in the market cycle we find ourselves. No bull market is immune from a fundamental shift in supply/demand. It appears that many large institutions have thrown caution to the wind in an attempt to drive returns without considering any or all risks.

Add to all this that subprime appears to be much larger than most investors realize and you’re left with a much riskier situation. Projections have suggested that as much as $1-1.5 trillion (YES TRILLION) may be the entire global exposure to these mortgages. If we only attribute a conservative default rate of 20% to this value we get around $25 billion – we’re way over that amount already at this point! Figure it out: either defaults are up or the full exposure to this segment of mortgages is much larger than these companies are revealing. Some might be writing these losses down overly conservative, but my guess is that the situation is much worse than it appears to be.

For me, I’m keeping my distance and remaining cautious at this point in the market cycle. I’m well aware that where there’s smoke, you’ll often find fire. I’m not suggesting that there’s zero value in any of these companies, only that understanding the full extent of the facts is an important tool in determining which investments are quality value vs. quantified risk. I would much rather be a fire inspector in this situation examining a home once its deemed safe for entry than someone walking into a situation where the margin of safety is unknown.

“It’s not what you know, but what you do with that knowledge young man. When questions on valuation are louder than the fundamental answers, you’re better to sit quietly instead of straining your voice. It’s not much use to you later if you use it all up now.”

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{ 2 comments… add one }
  • FourPillars November 10, 2007, 12:04 am

    I think you have the facts wrong about banks lending at prime – that rate is only for secured variable loans. If you get a fixed mortgage it will be for a rate below prime. I’m not sure about the current rates but I think you can get a mortgage for less than 6%. I got 5.2% a few months ago back when prime was 6.0%.

    Regardless – great post!

    Mike

  • Nurse B, 911 November 10, 2007, 9:07 am

    Thanks for the feedback Mike. Suggestions or advice on how to re-word that part?

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