SECOND QUARTER 2007                                                                                                       ...
Meet the parents                                                         Breakdown of Mortgage Universe
Players within the...
revenues across all segments amounted to 40 percent        Gaining from a subprime shakeout
of Lehman’s total. Lehman, lik...
400 Robert Street North, St. Paul, MN 55101-2098
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Transcript of "Subprime lending: Investment opportunities in the wake of bad ..."

  1. 1. SECOND QUARTER 2007 Discover Value. Subprime lending: Investment opportunities in the wake of bad news Joseph Scanlan, CFA Sean Timonen Investment Analyst Investment Analyst Subprime lending, once a small 25 largest subprime lenders and market share percentage of the overall mortgage Highlighted companies have filed for bankruptcy (As of 4/6/2007) market, has taken center stage. Alarming Lender Market Share stories about defaults, foreclosures and HSBC Finance, IL 8.3% bankruptcies are all over the airwaves, New Century Financial, CA 8.1% in the papers and on the street. In the Countrywide Financial, CA 8.1% blizzard of bad news, investors have CitiMortgage, NY 5.9% come to view all things subprime as WMC Mortgage, CA 5.2% radioactive, punishing companies even Fremont Investment & Loan, CA 5.0% marginally involved. But when investors Ameriquest Mortgage, CA 4.6% overreact, opportunities emerge. Option One Mortgage, CA 4.5% A more careful assessment shows that while some Wells Fargo Home Mortgage, IA 4.4 % companies in the subprime market face serious First Franklin Financial Corp., CA 4.3% difficulties, mitigating factors will protect others. Washington Mutual, WA 4.2% Financial institutions that boast diversification across Residential Funding, MN 3.3% product type, geographic region and sources of capital, in addition to those players that benefit from strong Aegis Mortgage Corp., TX 2.7% parental support, are likely to not only weather the American General Finance, IN 2.4% subprime storm but end up stronger in the aftermath. Accredited Home Lenders, CA 2.5% BNC Mortgage, CA 2.3% Bad subprime loans do pose a serious threat for some companies, as the table to the right shows. Companies Chase Home Finance, NJ 1.8% that relied on subprime loans as their sole line of Equifirst, NC 1.7% business are in real trouble. For them, funding sources NovaStar Financial, KS 1.6% are drying up and the situation has become life threatening. Ownit Mortgage Solutions, CA 1.5% ResMae Mortgage Corp, CA 1.2% But for every company that fits that profile, others Mortgage Lenders Network USA, CT 0.9% are being found guilty just by association. A number ECC Capital Corp., CA 0.9% of traditional banks, for example, have seen their credit spreads widen in 2007 even though, in some Fieldstone Mortgage Company, MD 0.8% instances, subprime mortgages make up less than Nationstar Mortgage (Centex), TX 0.7% 5 percent of overall loans. continued Source: UBS All of the views expressed in this report accurately reflect the personal views of the authors about any and all of the subject securities or issuers, and no part of the authors' compensation was, is or will be directly or indirectly related to the specific views expressed in this report. ® C A P I TA L MANAGEMENT Page 1
  2. 2. Meet the parents Breakdown of Mortgage Universe Players within the subprime arena that have the Subprime Prime benefit of strong parental support are better $1.51 trillion, $6.37 trillion, positioned to withstand the current market pressures 14% 59% than their independent competitors. HSBC Finance, formerly Household Finance, the North American arm of the international banking organization HSBC Plc, shows why. HSBC Finance was one of the first financial institutions to reveal cracks in the subprime market. HSBC commented throughout its 2006 filings that deterioration in the 2005 and 2006 vintages of the second lien, correspondent loan portfolio exceeded loss expectations. Alt-A $2.92 trillion, Bad news mounted, and HSBC Finance was forced to 27% Source: Bank of America Securities LLC estimates almost double its fourth quarter provision for bad loans, which translated into a loss. In a display of just how diverse its parent truly is, HSBC Plc saw The model of rapid securitization its profits increase for the year as strength in Europe The major Wall Street banks originating mortgage and Asia more than offset weakness in North products follow a rapid securitization model. Their goal America. Notably, HSBC Plc has since taken steps is to capture origination and securitization spreads and to stem losses at its North American subsidiary and quickly sell the assets. They do not keep subprime loans continues to view this business as a valuable piece on as balance sheet assets. For example, Bear Stearns of the overall company. sells the residual interest piece (the primary credit exposure for the brokers) within approximately 100 Residential Capital (ResCap) has a similar story. days after the settlement of securitization. ResCap, which focuses on residential lending, also reported a fourth quarter loss primarily because of Investment banks are not mortgage portfolio its subprime business. However, ResCap’s parent, companies, and investor concerns have been more GMAC, has publicly affirmed its commitment to the top-line revenue related than focused on the balance mortgage business and intends to allocate capital sheet. With multiple lines of business, an intermediary (resulting from the sale of a majority stake in position and geographic diversification, brokerage GMAC to Cerberus by GM) to maintain ResCap’s companies are well positioned to weather lost revenues investment-grade ratings. that would be created by a dramatic drop in subprime- related originations. Four of Wall Street’s titans with HSBC and ResCap aren’t the only financial institutions November fiscal year-ends recently released first with a strong parent. American General, a subsidiary quarter results that ranged from solid to outstanding. of AIG and an active participant in subprime lending, Negative revenue drag from any slowdown in is also a part of a large multinational company able to subprime-related revenues was not evident. bring huge resources to bear in a pinch. Lehman Brothers, for example, reported record For all of these companies, parental support provides revenues and net income despite weaker residential a backstop (through funding) against potential mortgage securitization revenues. Within the firm’s downward ratings actions. fixed income business, a number of units produced record results that more than offset the impact of softer U.S. MBS business. The firm gained strength from its continued push overseas. Overall foreign net continued Page 2
  3. 3. revenues across all segments amounted to 40 percent Gaining from a subprime shakeout of Lehman’s total. Lehman, like its peers, is benefiting The market dislocation, however volatile, has also from strong secular growth in capital markets around provided the potential for opportunity. For those the world, which helps mitigate volatility from such financial institutions looking to enter the subprime flare-ups as the subprime dislocation. arena or expand their current mortgage capabilities, the current environment has given astute buyers access to Liquidity also gives financial behemoths such as JP these businesses at severely reduced prices. Even those Morgan and Citigroup a sizable advantage over players looking to maintain or reduce capacity (without monoline subprime lenders. Thanks to their large exiting altogether) will benefit as the competitive banking operations, both companies have access to landscape becomes more rational. various capital resources including large retail deposit bases (an excellent source of low-cost or no cost The bottom line is that in many instances the market funds). As a result, neither company relies exclusively has overreacted, viewing all financial institutions on any one funding vehicle, giving each the ability to through a very narrow perspective. We find that withstand stress in any one market. looking carefully at individual companies and thoroughly examining their strengths and weaknesses is a more promising approach. We think that investors who are able to take a step back and look beyond the headlines will be able to fish excellent opportunities out of the sea of subprime bad news. Page 3
  4. 4. 400 Robert Street North, St. Paul, MN 55101-2098 www.advantuscapital.com | 1.800.665.6005 F66257 4-2007 0704027-IM 4 ©2007 Advantus Capital Management, Inc. All rights reserved.

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