Editor's note: This column was submitted by Stockpickr member Winston Kotzan.

The house of pain still has a long way to play out for the mortgage market. Even if the

Federal Reserve

pumps liquidity into the market or lowers interest rates, it could take months for the impact to be fully realized in the financial markets.

In the next few months, expect to see more distressed hedge funds and lending institutions as assets are re-evaluated for their true worth. With the demise of the two subprime funds at

Bear Stearns

(BSC)

, we have learned that even AA-rated securities are not safe in this environment. The financial industry is currently plagued with bad credit in disguise.

The credit crunch will likely lead very soon to tighter lending standards, making it more difficult for property owners to obtain loans for refinancing or to purchase new real estate. This will cut off many potential buyers of real estate in the U.S. and perpetuate the cycle of declining home prices.

Adding to the crunch is the fact that many adjustable-rate mortgages, or ARMs, issued in the last few years are due to reset from their initial low teaser rates to much higher payments. According to

Barron's

, "Over the next year and a half, monthly mortgage payments on some $600 billion of subprime mortgages will be rising sharply for already financially strapped borrowers, as the loans reach the dreaded two-year reset date." When this jump in monthly payments hits the fan, it is certain to cause more waves of payment defaults.

During the housing bubble when home prices were strong, lenders were able to handle defaulted mortgages simply by reselling the home for an appreciated price. Now, with home prices falling, it grows impossible to recover the full value of the loan.

Even worse, most lending institutions that securitized mortgages and sold them on the open market as collateralized debt obligations, or CDOs, are contractually obligated to repurchase those securities if the underlying mortgages default. These repurchase provisions are what sunk

American Home Mortgage

(AHMIQ)

and

New Century Financial

(NEWCQ)

.

Where the Hurt's Likely to Continue

Since it appears that we have not seen the end of the subprime-mortgage repercussions, it's not too late to make money on these stocks! Here are three companies that I believe may be brewing the next financial meltdown:

MGIC Investment

(MTG) - Get MGIC Investment Corporation Report

: This company is in the business of providing insurance for home mortgages. When a borrower defaults on a mortgage, MGIC takes up the bill. Many home buyers who are unable to scrape up the 20% down payment on their home's value are required by their mortgage lender to purchase this type of insurance.

A concerning number of mortgages insured by MGIC are in the subprime and A-minus traunches. The 2006 10-K shows that 181,141 of its 1.28 million insured loans (14.1%) fall in this troublesome category. This figure does not include insured bulk transactions, which contain various mixes of subprime credit quality.

Of the $47 billion of value insured by MGIC, 23% covers ARMs and 17.2% covers Alt-A mortgages. Some mortgages may classify as both ARM and Alt-A.

As the housing credit market worsens, I expect MGIC to face unprecedented liabilities. Already, its ratio of delinquency losses to premium revenue has skyrocketed from 44.7% in 2005 to 76.7% in the most recent quarter, and it is likely to worsen. Earnings per share for the most recent quarter were 93 cents a share, down from $1.74 a year ago.

Perhaps a worse blow could come from its C-BASS joint venture, a business that invests in subprime mortgages and of which MGIC has a 46% stake. Earlier this year MGIC agreed to purchase

Radian Group

(RDN) - Get Radian Group Inc. Report

TheStreet Recommends

, a deal that would have completed its ownership of C-BASS. But because of C-BASS' uncertain credit status, on Aug. 8 MGIC announced that it will back out of the merger.

Radian Group contends that MGIC is obligated to proceed with the deal, and it will not let MGIC walk away without a fight. At the moment, the future of this deal is unclear. Merger or not, an implosion of the C-BASS business would be a hurtful blow to MGIC as it contributed to roughly 15% of its 2006 net income.

IndyMac Bancorp

(IMB)

: I checked this lender's recent 10-Ks for an analysis of the kinds of mortgages it recently issued. To my surprise, I found that over the last several years IndyMac has brewed a dangerous cocktail of exotic mortgages. Since 2003, this company issued an estimated $153 billion in various adjustable-rate mortgages. Many of these are hybrid ARMs, which may very soon reset from their initial low-interest teaser rates to much higher payments.

IndyMac has also issued a huge number of interest-only hybrid ARMs and pay-option ARMs. Since these types of mortgages do not reduce principal and may even produce negative amortization, IndyMac will face huge losses if it is forced to foreclose on properties with depressed prices in the housing market.

I noticed that management euphemized the nasty "ARM" word in its 2006 10-K by referring to the account as "intermediate term fixed-rate loans." Perhaps management is aware of the impending accident waiting to happen if homeowners cannot afford the higher interest rates when the ARMs reset.

Below is a table I compiled from IndyMac's annual reports describing the types of mortgages issued by IndyMac since 2003.

Most concerning are the repurchase agreements on the mortgages IndyMac securitized for the open market. If customers begin to default on payments, IndyMac will be required to repurchase those securities. If only a portion of that $153 billion is in default, IndyMac will likely not be able to cover it with its current $618 million cash on hand.

During the first half of 2007, IndyMac was forced to repurchase $443 million in defaulted loans. It seems that it was able to fund much of this repurchase through a $491 million issue of preferred stock on May 30. I consider this the equivalent to putting a band-aid on the situation, and it only digs IndyMac closer to bankruptcy as it pays the 8.5% yield on this newly issued stock.

MBIA

(MBI) - Get MBIA Inc. Report

, like MGIC, is an insurer of debt. Although it does not exclusively deal with mortgages, according to the company's Web site, the company has a direct exposure to $5.1 billion in subprime mortgages as of June 30.

Despite the fact that this exposure is through AAA-rated bonds, we have learned from the Bear Stearns hedge fund collapse that with the current market conditions, even these high-level investment grade securities are no longer safe. A presentation entitled "Who's Holding the Bag?" given in May by hedge fund manager Bill Ackman contends that MBIA does not have the financial reserves to withstand a catastrophic event on its insured subprime securities.

In a June 24

Barron's

article, MBIA's management denied that its subprime exposure poses a major threat to the company. However, I would regard this denial with caution as management has a history of using creative accounting to cover steep losses.

The

Barron's

article points to a transaction in 1998 where MBIA disguised a loan to cover a $170 million loss as a phony reinsurance deal. It was later uncovered by a

Securities and Exchange Commission

investigation that the company secretly paid back the reinsurance loan through separate deals.

Also, Ackman's presentation notes other accounting irregularities, such as accounting standards that accelerate the recognition of deferred revenue. This has boosted short-term performance as compared to GAAP and inflates book value.

Most disturbing is the recent departure of several MBIA executives. On May 30, 2006, CFO Nicholas Ferreri resigned. On Feb. 16, 2007, Neil Budnick, president of MBIA Insurance, resigned. That same day Mark Zucker, the head of Global Structured Finance, also resigned.

Could MBIA be silently bracing for the unraveling of some unexpected subprime problems? We will see how this plays out in the very near future.

At the time of publication, Kotzan was long Bear Stearns stock and IndyMac puts, short MBIA and MGIC Investment stock.

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