Too Late to Short Subprime

On a Feb. 14 conference call, Accredited Home Lenders (LEND Quote), a well-run company that makes similar loans, said it was conservatively predicting 2% of loans originated would be in early payment default. If we take 2% of New Century's 2006 originations and write them down by 20% (remember: New Century itself does not lend 100% of home values), that results in a writedown of $2.18 per share. Adjusted book value is $31.45.

I want to be more conservative, though. Tighter underwriting guidelines, less origination going forward (it said it would originate at least 20% lower in 2007 than in 2006) and possible litigation reserves for shareholder lawsuits could take another $1.45 off book value after tax. Therefore, I use $30 for adjusted book value.

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.