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Breaking Down the Financial Breakdown

Aug 18, 2007
The stock market is gyrating like a yoyo, and with each down stroke it's heading lower. What's an investor to do? Let's start by dissecting the cause-it's not as simple as a slowdown in housing or defaults in the subprime market, and these are unrelated (for the most part) events.

The housing market was headed for a correction regardless of the events taking place in the subprime market. New home starts were running at twice the historical average during 2003-2006. Granted, some of this was fueled by a relaxation (or abandoning) of underwriting standards in the subprime market but it also was the culmination of aging baby boomers buying second homes, low interest rates, and a strong economy. Speculators in areas such as southern Florida and easy credit just pushed it over the edge. We would be in a housing slowdown regardless of the subprime problem, although this will exacerbate it, and a weak housing market will continue at least through 2008. Investors: avoid homebuilders.

Mortgage lenders and financial companies in related businesses generally are leveraged and, in many cases, rely on short term debt to finance their operation. The concerns over the creditworthiness of their businesses, not the level of defaults in the subprime market, have caused much of their funding to disappear. This is the biggest risk for many finance companies.

All finance companies are paying the piper for problems in the subprime market-lax underwriting standards and mortgage obligations that borrowers can't meet. This problem was not caused by rising interest rates. Interest rates have gone up very little over the past year. The problem was artificially low teaser rates, the ability to skip payments, interest-only payments for a period of time and other contractual mechanisms which induced (or seduced) buyers to take on a bigger mortgage than they could afford. Do your homework in this sector to determine which companies have funding problems, subprime and related mortgage exposure, and which don't.

It's not obvious. These problems will take a good year to sort out and companies will be destroyed or seriously damaged in the process. Investors: Avoid originators, servicers, buyers/holders of paper, fixed income funds, and mortgage REITs which are highly leveraged or focus on the subprime mortgage market.

Banks generally hold some, but not a significant amount of, subprime mortgages relative to their total portfolio. The bigger risk for certain money center banks is their exposure to bridge loans and take-out financing guarantees for the many billions of dollars of private equity deals that are pending. The hit the banks took on the Chrysler deal is a good example.

This problem will work itself out by the end of the year. Banks with private equity financing exposure could have one or two bad quarters. Banks without this exposure will do fine. Investors: Buy banks without big private equity exposure now. Wait one or two quarters to buy banks with exposure to private equity.

Brokerage houses generally have subprime and private equity exposure, as discussed above. Investors: Give them one or two quarters to sort out their problems before you buy.

Mutual fund managers, investment advisors, and REITs that own income producing have little or no subprime exposure (again, do your homework on the specific investment to make sure). These stocks have taken a hit. Investors: Buy now.
About the Author
Bill Byrnes is co-founder of MUTUALdecision, a website providing mutual fund data , and the author of the MUTUALdecision Blog. He's been an investment banker with Alex. Brown & Sons and a Finance Professor at Georgetown University. He's been CEO, chairman and served on the board of directors of several public and private companies. He holds MBA and JD degrees and is a Chartered Financial Analyst with over 30 years experience in the investment industry.
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