Markets

The Storm Intensifies

An enormous wave of home defaults, foreclosures and auctions is about to hit financial stocks. How will investors know when to get back in to the sector?

By Whitney Tilson, Contributing Editor

John Heins, Contributing Editor

From Kiplinger's Personal Finance magazine, September 2008

No corner of the market has been more decisively beaten up than financial-services companies. Shares of financial titans with once-unassailable franchises have been cut to pieces right along with those of marginal and niche players.

Citigroup shares are down 67% in the past year. Merrill Lynch shares are off 64%. American International Group has seen its stock dive 63%. Their performances shine, however, compared with high-profile collapses of such companies as bond insurers MBIA and Ambac, investment bank Bear Stearns (since bought out by JPMorgan Chase) and mortgage company Countrywide Financial (bought by Bank of America in a deal likely to go down as one of the most ill-conceived and costly acquisitions of all time).

As uncomfortable as plunging stock prices can be, today's market should also be viewed as fertile ground for opportunity. When pessimism and fear rule, bargains are created that sow the seeds of future investment success. Strange as it may sound, for us, the excitement in hard times -- when stocks of great companies get cheap enough to buy -- often beats the rush in good times when existing holdings hit new highs. We describe the feeling of buying supercheap stocks as "trembling with greed."

Given the carnage to date, the key question now is whether financial stocks are nearing the bottom, presenting historic buying opportunities. Or will they continue to be the value traps they have been for the past year? In general, we'd argue for the latter.

Too soon to pounce

Before describing our rationale, we should point out that we seldom try to forecast macro-economic developments. They're exceedingly difficult to predict. Our time is more productively spent focusing on bottom-up analyses of individual companies' prospects. We also believe that the U.S. economy is resilient and will continue to grow over time, so for the long term we're bulls on America. We simply think it's too early to turn bullish on the financial sector.

To assess the prospects for financial companies, you must carefully analyze the ongoing collapse of the housing and credit bubbles. If the worst is over, then mortgage-related exposure on balance sheets will cease to be the ticking time bomb it has proven to be of late. At the same time, wider availability of credit will spark economic activity that will allow banks and others to start rebuilding their revenues and profits.

Sadly, as bad as things have been, there's a strong argument to be made that we've only seen the tip of the iceberg of housing- and mortgage-related problems, and that an enormous wave of home defaults, foreclosures and auctions is about to hit financial stocks.

Amherst Securities Group, based in Austin, Tex., maintains an extensive database on every mortgage securitized in the U.S. during this decade, and its data tells a frightening story: Mortgage-lending standards became progressively lax starting in 2000 but really fell off a cliff beginning in early 2005, led by the unprecedented writing of subprime loans with two-year "teaser" rates. Sure enough, the holders of the loans made in early 2005 started to default in high numbers two years later, in the first quarter of 2007 -- which, not coincidentally, was the start of the current turmoil in credit markets.

The crisis continued to worsen in 2007, as even lower-quality loans made over the remainder of 2005 reset, triggering more and more defaults. Because it takes an average of 15 months from the date of a homeowner's first missed mortgage payment to get to a liquidation by sale or auction of the home, we're only now seeing the first round of foreclosures and auctions from loans written in early 2005. Given that lending standards got much worse in late 2005, continuing through the first half of 2007, the wave of defaults leading to forced home sales is in its early stages.

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