Hedge Against Market Risk With Default Servicers

By Glen Bradford

What is portfolio insurance? A method of hedging a portfolio of stocks against the market risk by short-selling stock index futures.

Let's settle for just hedging against market risk. Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market-risk factors.

So let's assume that the stock market goes down 50%. Granted, this is unlikely to happen with the seemingly inevitable monetization of the deficit. But if the market tanks, housing will fall.

What's going to happen to the foreclosure market? Do you think more people would be able to afford their homes? Do you think that interest rates could get lower to finance homes at lower monthly payments? Do you think that the economy would improve? Probably not. All signs point to more foreclosures, short sales, etc.

The only way that I see out of this trap is to print enough money to justify these higher prices. We're on that road, but it's going to take a while.

While we wait, I advise taking a look at default, foreclosure, short-sale servicing companies to hedge against the market risk. Fannie Mae ( FNM), Freddie Mac ( FRE), and Bank of America ( BAC) are going to need these services badly. As for now, it is my understanding that there are temporary industry-wide problems. Rumors indicate a mortgage moratorium that is supposed to end by the end of the third quarter.

The Dolan Company ( DM) is trading with a forward P/E of around 9.10, suggesting earnings are going to increase over 50% year over year. They acquired DiscoverReady in November of last year and, in my opinion, historical operating income instead of historical net income should be used to forecast the future, in this case.

Altrisource Portfolio Solutions ( ASPS) is trading with a P/E above 20, is getting upgraded by analysts, and recently acquired The Mortgage Partnership of America. That said, note the rough $3.2M in EBITA that was acquired through the MPA and the more than doubling in properties under management from January through March of 2010.

Lender Processing Services ( LPS) just pulled off a glowing quarter amidst a period impacted by sluggish industry trends. Trading at an estimated P/E of 9.10 for 2010 makes this one inexpensive as well.

DJSP Enterprises ( DJSP) recently captured Richard D. Powers from Altrisource. It's also been pummeled down over 60% from its 52-week high, has more than 1.4M shares short, lowered its 2010 guidance, and by my metrics, is trading at a forward P/E of 3.8.

As home prices go down, insuring your home becomes less expensive. As stock prices go down, buying an insurance policy the traditional way becomes more expensive. You can play the traditional game or you can come up with one that works better. I remember my trip to the Chicago Board Options Exchange specifically for the cognitive disconnect described above.

At the time of publication, Bradford was long DJSP Enterprises.

At the time of publication, Bradford was long DJSP Enterprises.

Glen Bradford is the CEO of ARM Holdings LLC. He's pursuing an MBA at Purdue University and gained recognition by trading his entire tuition in the stock market as well as that of his roommate. He intends to not lose money for his clients by buying the most undervalued companies that are making money and set to make more money that he can find. In March 2009, he was quoted for saying, "Uncertainty will certainly work for me."

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