Finding a Gem Amid the Subprime Debacle

After the refi boom of 2003, mortgage lenders were forced to get creative to keep their loan volume steady. New riskier products such as interest-only & stated income loans allowed those with credit difficulties the ability to purchase a home. If these products weren’t risky enough, subprime specialists were bringing in barrels of cash by lending to those with credit scores in the 400s. Why take all the risk? High risk = high margins.

But in recent weeks, several lenders have warned what many observers had been predicting for months:

• Borrowers that took out interest-only loans have been unable to make payment after the “teaser” period runs out.
• Companies that allowed borrowers to “state” their income (without verification) now realize that applicants grossly exaggerate their income over 50% of the time.
• And worst of all, defaults in the subprime arena have been much higher than expected forcing a record 1 out of every 200 American homes into foreclosure.

It's been an ugly couple of weeks for the mortgage sector. The hardest hit have been those subprime specialists such as New Century & Accredited Home Lenders who have seen their funding caught off after warning of massive defaults. Their charts say it all:

From an investing perspective, view this as a healthy cleansing of the weaker mortgage companies. When the dust settles, the stronger lenders should emerge with less competition as more subprime shops go into bankruptcy.

The pressure has been felt industrywide, even affecting those companies with minimal subprime exposure such as Countrywide, Washington Mutual, American Home Mortgage & Suntrust. This recent selloff presents a great opportunity to invest in these oversold cash cows.

American Home Mortgage

My #1 recommendation would be American Home Mortgage. AHM has seen its shares halved to $19 in the last month despite having less than 1% subprime exposure. In an Operations Update last week, AHM released its pipeline data showing only 5% of its loans having credit scores less than 620.

In addition to being oversold, AHM has amazing fundamentals.

• 4 P/E Ratio
• Operating Margin: 46%
• 20% insider ownership
• $400 million in cash (40% of market cap)
• Return on Equity: 22%
• 2006 EPS: 4.96/share

And most important of all, because AHM is a REIT, it must payout a certain percentage of its income in the form of dividends. During this 50% fall in share price, AHM has seen its dividend payout rise to 19%! If you’re afraid this dividend will be cut, consider that AHM has been steadily increasing its payout every quarter and has over $400 million in cash.

In summary, the selloff has left AHM with excellent appreciation potential and an eye-popping yield of 19%. With less competition after this subprime reshuffling, the stronger lenders will emerge more powerful than ever.