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Jelly Roll Capital Equity Research |
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Market Analysis, Education, and Wall Street-Quality Stock Reports |
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The Implications of the Sub-Prime Blowup |
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Almost one month ago, I wrote about the concern I have with the negative personal savings rate in America, and how I felt this would have a negative impact on future economic growth. Since then, the sub-prime implosion has seemingly reached a crisis point with the looming bankruptcy threat from New Century Financial (NEW - down 90% since Feb. 18th) and uncertainties surrounding other companies like Accredited Home Lenders (LEND - down 50%) and even industry giant Countrywide Financial (CFC - down 15%). While New Century looks unlikely to continue as a going concern after lenders cut its credit lines, one greater question hanging over the heads of market strategists and economists is what effect the sub-prime blowup will have on the larger whole. Is the problem isolated to sub-prime lenders, or will it move up to segments that traditionally bear slightly less risk, but are by no means immune from widespread defaults? While the extent of the damage remains uncertain, I believe there are a few things that can be drawn from the events we’ve seen of late. Foremost is that easy money, is bad money. Far too many people were given loans who didn’t deserve them; oftentimes these loans were enabled by the creation of mortgage products designed simply to allow for loans to be written for otherwise unworthy borrowers. The adage that the central bank should do the opposite of commercial lenders has held true: the Fed is (correctly) working to tighten credit that the for-profit sector is eagerly looking to give. In regards to the worries that the sub-prime defaults will spillover into the general mortgage market, I think it is fair to assume default rates will be somewhat above average overall, particularly on the lower end of the scale. I find it hard to believe some magic dividing line will separate the sub-prime borrowers from those just above them on the creditworthiness scale. The apparent difficulties these people are having repaying home loans make me wary of stocks like Wal-Mart (WMT) or Costco (COST) that cater to the lower income crowds. Also, big ticket items will likely be deferred by those in the sub-prime market, which should lead to decreasing demand for home furnishings (Bed Bath and Beyond - BBBY, Home Depot - HD), cruises (Carnival - CUK, Royal Caribbean - RCL), and cars (General Motors - GM). Another side effect the sub-prime market could have is worsening the real estate downturn; if many homes become repossessed and are put on the market it could add to an already overwhelming supply surplus. The possibly chain reaction here could lead to the devaluation of properties beyond what we’ve already seen, and this reduction in home equity could squeeze the wallets shut of those who have relied on appreciating home values to live beyond their means for the past several years. While the outcome could be taken to the extreme scenario with Americans finally clamping down on credit-financed lifestyles and revert to diligent savings, such a turn would likely require some sort of dramatic global macro shock, which I cannot realistically pretend to see. While I’d venture so far as to say that the sub-prime mortgage shakeout (among other above-average rates of default I expect to see) will be part of a growing problem and will hinder growth, I see this as being more of a cyclical blip on the radar than the start of a long-term trend change. If the risk-taker in you wants to buy a mortgage company, Countrywide Financial (CFC) is the most solid and stable of the bunch. Although Accredited Home Lenders (LEND) is also a fairly conservative play, its likely liabilities and fate are still up in the air. Because of the prominent role real estate health plays in interest rate decisions, and the effect interest rates have on the stock market, investors would be remiss to overlook the anomalous events taking place right now. Hopefully this has given you some ideas as to what to look for in the near-future on the real estate and consumer spending fronts. |