Time to party like it's…2007? No thanks.
Just five years ago, the phrase "subprime" started to creep into
the U.S. consumer lexicon. And not long after, the phrase "subprime
mess" became a household name.
In case your memory needs refreshing, the subprime
mortgage
meltdown was veritable tsunami of risky loans that plunged in
value, bringing many
Wall Street
firms to the edge of bankruptcy.
What's shocking is that we're beginning to see a return to these
risky loans.
Why would the same Wall Street firms burned by subprime
mortgages embrace these toxic investments again? Because there are
profits to be made, and memories can be conveniently ignored when
the greed factor kicks in.
Frankly, the resurgence in interest in subprime loans shouldn't
be cause for alarm. Today's subprime
market
is a very different beast.
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Then and now
There's one huge difference between 2007 and 2012. Back then,
investors were led to believe that these subprime loans -- which
were bundled together into opaque financial instruments called
"tranches" -- were quite safe, as the underlying home prices
would increase in perpetuity. We know how that turned out.
These days, investors are sufficiently schooled in the subprime
risks, so they are paying a more suitable price to absorb that
risk.
Here's how it works:
Let's say you are buying a tranche of bundled
bonds
and you believe that 8% of those bonds will run into trouble,
paying off a fraction of what they were supposed to. Let's also say
that you can buy this trance at a 12% discount to the
face value
of those bonds. If you're right about the 8% default rate, then
you've just made a decent 4%
profit
. If the group of loans do even better, with even fewer of them
going into default, then you can make an even fatter profit
spread.
So why is Wall Street now showing a newfound interest? Because
traders are increasingly convinced that the U.S.
economy
is on firmer footing, the excesses of the recent subprime era have
been wrung out and these bonds carry less risk than the current
bond
prices indicate. They say the default rates on loans will be much
lower than anyone expected.
Ways to play
It's very hard for most investors to buy tranches of subprime bonds
directly.
Securities and Exchange Commission (SEC)
regulations restrict sales to financial institutions and high
net worth
individuals (called "accredited investors"). But you can invest in
the companies that aim to profit from subprime and other risky
loans.
Take
Two Harbors Investments (
TWO
)
as an example. The
Real Estate Investment Trust (REIT)
buys and sells residential mortgage-backed securities (
RMBS
) that are bundles of prime and subprime loans. The company layers
on a bit more risk by borrowing additional money to "
leverage
up" results. This helps explain why this REIT offers a juicy 15%
yield
.
Many investors say this combination of RMBS exposure and
leverage is just too much risk to absorb. After all, Two Harbors
wasn't actively involved in the RMBS market during the subprime
crisis, so we don't know how this
business model
would have fared during the crisis. But results are clearly
impressive now. Sales for 2011 exceeded $200 million, much of which
flowed to the
bottom line
. This enabled Two Harbors to pay a $1.60 per share
dividend
.
As long as the economy and RMBS prices don't tank, the company
should keep paying out a solid dividend.
But investors probably shouldn't get too attached to a $1.60
divident. It's abnormally high, reflecting an almost perfect
environment for RMBS buyers. As the economy improves, it will
almost certainly be harder for companies like Two Harbors to find
great bargains. As profit spreads tighten, Two Harbors will simply
make less, and the dividend may fall as low as $1 a share. Still,
this equates to an almost 10% yield at current prices.
Other RMBS buyers include
Annaly Capital Management (
NLY
)
, with a current
dividend yield
of 13%,
American Capital Agency (Nasdaq: AGNC)
(15%),
MFA Financial (
MFA
)
(12%), and
Hatteras Financial (
HTS
)
(12.5%).
Action to Take -- >
As their high yields indicate, these are fairly speculative
investments. The housing market is still on life support, and
there's no assurance that we're near the end of the
foreclosure
mess. But an increasing number of strategists say that any mortgage
that would have gone into default have done so by now, meaning the
current RBMS tranches aren't exposed to further trouble. This means
these investments aren't quite as risky as you might think.
But be prepared for yields to ultimately settle in the high
single-digits instead of the current low to mid-teens. Worried that
these stocks will fall in value if that happens? Most of these
investments trade close to
book value
, so they are unlikely to fall much in value -- assuming the
economy doesn't hit another
air pocket
.
-- David Sterman
David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC does not
hold positions in any securities mentioned in this article.