360 Degrees of Subprime Lending

Profitability

I will say it upfront: I don't expect any pure-play subprime originators to make money in 2007. This is a cyclical business, and cyclical companies don't usually make money in the trough. That said, the consolidation of this business, the permanent growth in nontraditional mortgages and New Century's scale suggests to me that 15% return on equity (pretax) is possible as we move into 2008 and 2009. I will provide updates on this in the future as we see the landscape unfold.

Bottom Line

At $20, or two-thirds of my adjusted book value estimate, short plays here seem risky. As this market turns, I expect shares of New Century and its peers to come close to book value. I also expect short-sellers to cover and move elsewhere.

A great security to look at is the ABX-HE (BBB-) 06-2, available on markit.com for individual investors. This is an index of BBB- rated securities of subprime originated loans in late 2006 and a good "fear gauge" for subprime. As many have discussed, these securities were in free fall, well below where the index components traded, but people want to hedge. The index made a small turn upward yesterday.

It's too soon to see if fear is permanently abating, but the easy money has been made shorting. I'm focused on trying to buy the right securities for the turn.

At the time of publication, Capone and/or his fund was long New Century, although positions may change at any time.