This column was originally published on RealMoney on Feb. 15 at 2:21 p.m. EST. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.
Every market participant knows that the subprime mortgage industry is struggling and that many marginal players are being shut down. In the past several months, 22 subprime mortgage companies have been closed or acquired. The cost to insure against losses in subprime loans has soared.
And most people who own a house, live in a house or want to buy a house think they know everything about real estate. However, that doesn't mean they should go all-in shorting these mortgage stocks now. While short interest in the group is tremendous, I believe short sales are now too late.
I want to go through why I bought some shares of
after its recent decline from above $30 to below $20,
sparked by a warning of an unexpected fourth-quarter loss.
I'm not suggesting this trade, as I believe owning these shares involves far too much homework for nonprofessional investors. Instead, I'd like to use it as a talking point for why the short thesis may have run its course for these names.
New Century was the second-largest originator of subprime loans in the third quarter, with $13.8 billion (behind
). It's also a large servicer of subprime mortgages, although not in the top 10. In addition, New Century is a real estate investment trust, which means that it must distribute more than 90% of its taxable income to shareholders but that it's not taxed at the corporate level.
Given the recent news at the company, its competitors and the market in general, I asked myself three questions: Will this company survive? What is its "true" book value? What can it earn off that book value in 2008 and beyond, after the subprime crunch abates? Let's try to answer them.
With most lenders, survivability is about confidence in whether it will retain its funding during times of distress. New Century stated it had cash and excess liquidity of $350 million (not a tremendous amount) as of Dec. 31. It does have substantial room (multiple billions) in its warehouse facilities, which are lending arrangements with firms like
that agree to finance New Century's originations until New Century can sell or securitize those loans.
Because New Century's current financials will require restatement, it is likely in violation of covenants on those facilities, but there may be room for negotiation, as Wall Street probably wants to keep the major players standing. Surely, the eventual investors will want the ability to put defaulted loans back to their originator.
Generally, if a lender is to be shuttered, it happens quickly. This is intensely speculative, but I believe New Century has already passed the point where if it were to be closed, we'd know. I believe even plain survivability could prompt a rally in the shares.
True Book Value
To calculate this, I start with Sept. 30 numbers and then adjust for writedowns. Stated equity in the third quarter was $2.06 billion. Subtract $95 million of goodwill, which is an intangible asset. Divide by the fully diluted share count of 56.5 million for $34.82 per share. The company stated it is making two major adjustments.
First, it is writing down its residual assets. For New Century, these are retained interests in its securitizations. Its valuation is based on the assumptions it made when the loans were originated and packaged. Default rates, prepayment rates and the like factor into the equation. We all know the market has worsened, so I estimate a 50% writedown. (This is more punitive than most sell-side analysts have estimated, but I think it is prudent.) This results in an after-tax writedown of $1.19 per share.
Second, it needs to record a reserve for early payment defaults. In the second and third quarters of 2006, it misapplied an accounting rule and did not adequately reserve for these defaults. Some have speculated that as many as 10% of loans originated are or will be in early payment default status -- that is, missing one or more of the first three to six payments, triggering a repurchase request from the warehouse lender and/or securitizer to the originator.
On a Feb. 14 conference call,
Accredited Home Lenders
, 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.
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.
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. Joe Capone is a managing member and founder of SMaRT Financial Partners LLC. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Capone appreciates your feedback;
to send him an email.