Headwinds Ahead For Mortgage Stocks

Bill Martin, FindProfit, 03.10.05, 9:55 AM ET

NEW YORK - I spent this past Monday in New York City, visiting with a range of our hedge fund industry subscribers and contacts. These meetings always provide us with a new flow of ideas and perspectives and give us a chance to test some of our own ideas against some of the best investment minds around.

One of my more intriguing meetings was with a subscriber of ours who covers the financial services sector for a mid-sized hedge fund. His particular expertise is subprime financing, an area that is right up our alley given our short positions in Accredited Home Lenders (nasdaq: LEND) and Indymac (nyse: NDE).

Like us, this contact is a bear on the real estate and financial services markets. He, too, thinks that things have gotten too hot in the consumer real estate market and that lending standards have degraded terribly. For the year ahead, he thinks we'll see spreads continue to narrow and overall rates continue to rise, while credit quality will begin to show its ugly side. He painted some outright doomsday delinquency scenarios for some of the subprime focused mortgage REITs.

For the mortgage REIT sector as a whole, he sees earnings quality diminishing this year as funds use balance sheet expansion and increased leverage to offset narrowing spreads and a more competitive environment. By next year, most of these funds will find themselves max leveraged right into the teeth of a toughening real estate and credit environment, while interest rates will likely be higher. As a result, he sees earnings falling by 30% at the best-run mortgage REITs next year, while the worst run REITs could struggle to break even. Add in a rising interest rate backdrop, which will lower the value of those earnings, and this group could face a pending double whammy.

For those who do business in the subprime origination market (this is the hottest part of the market right now, as weaker borrowers increasingly "stretch" to afford more expensive real estate), like Accredited Home and Indymac, he doesn't see the recent competitive origination pricing environment abating anytime soon. To support his view, he said that barriers to entry for the origination business are low and industry capacity remains high, while many of the hyper-efficient larger players--such as Countrywide (nyse: CFC)--are increasingly competing in the subprime market.

Our contact was kind enough to provide three short ideas, all of which intrigued us, which he said we could share.

The first was PHH Corp. (nyse: PHH). PHH was just recently spun out of Cendant (nyse: CD), after Cedant failed to find a buyer for its mortgage operations. The combined company includes both mortgage operations, as well as a corporate fleet management (for cars) service. The two businesses are completely unrelated, and our contact argues that Cedant was only able to get the deal done by including the fleet business. He says that the mortgage operation is a very poorly positioned business, and that the total company remains overvalued--even at these values.

The second idea was combination mortgage REIT and investment bank, Friedman Billings Ramsey (nyse: FBR). After posting a red-hot 2004, he said that FBR's underwriting business is going to struggle this year, as investors increasingly lose their interest in mortgage REIT, subprime REIT and related deals. This area is FBR's specialty, and if the poor performance of recent FBR deals like ECC Capital (nyse: ECR) and Saxon (nasdaq: SAXN) are any indication, the company has already seen its high water mark of deal volume for this cycle.

He added that because FBR participates in most of its own offerings (i.e., buying for its own portfolio), the company's book value has and will continue to come under pressure.

Finally, while the mortgage REIT side of FBR should be able to hit its numbers in 2005, due to balance sheet expansion, those earnings should come under pressure next year (for the reasons outlined above). He argues that a more fair valuation for FBR is $13 per share, not the $19.25, or 2 times book value it currently commands.

The other short idea he shared is H&R Block (nyse: HRB). Unknown to many investors, H&R Block owns a significant mortgage business. In fact, this unit has powered a good chunk of the company's earnings gains in recent years. H&R Block shares fell last year due to the rising pressures in this business, but have recently spiked up due to an upbeat earnings report. A lot of the earnings excitement came from a surprisingly strong performance in HRB's mortgage unit. Our contact believes that there are quality of earnings issues in that recent mortgage unit performance, and he says that the company chose to sacrifice quality in favor of quantity--as evidenced by the huge increase in fourth-quarter originations versus more typical levels. He is shorting this recent HRB strength.

We haven't done any recent work on these ideas (we've followed FBR and HRB in the past), but our contact is talking our language on these ideas, given our existing real estate/credit quality headwinds theses. We plan to zero in a bit more on each of them, specifically focusing on the HRB idea, which appeals the most to us.

Excerpted from a March 8, 2005, report in FindProfit.