Portfolio Updates July 10, 2007

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July 7, 2007 | SIN Picks | | Author Asif

With the July 20 expiration date approaching soon for our $40 put options on mortgage lender Countrywide Financial (CFC), I am going to sell them based on the price as of market close today. The options are up a little over 60% as I write this post and while I missed the 188% gains I would have achieved by selling them in April, I am satisfied with a 60% gain in six months. You can read more about why I chose put options on Countrywide in my December 2006 blog entry titled The Effect of Housing Weakness on Mortgage Lenders.

They say that when housing inventory hits about 9 months, the sh*t hits the fan (pardon my French but it was hard to put this any other way). As of May 2007, housing inventory is at 8.9 months and is the biggest inventory overhang since 1992 according to this MarketWatch.com story. Even in the highly desirable part of the San Francisco bay area that I live in, I have noticed condo prices drop more than 5% in a couple of months. Home improvement companies like Home Depot (HD) and home builders like D.R. Horton (DHI) are cutting forecasts and some of them are now posting a loss, trapping the value investors who were attracted to the home builders thanks to their low single digit P/E ratios.

In this environment it may be prudent to continue hedging a long portfolio through selective put options. I may roll some of the proceeds from this sale into put options on Countrywide Financial with a longer expiry date. Another alternative would be put options on Wachovia Bank (WB), which has a lot of exposure to adjustable rate mortgages (ARMs) thanks to its acquisition of mortgage lender Golden West Financial for $25.5 billion near the height of the mortgage bubble. Golden West Financial was a pioneer in ARMs. Put options on a diversified bank like Wachovia may not necessarily be advisable and I want to explore its revenue streams some more before I make a decision.

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  1. BSE Gems
    February 23rd, 2018

    Dear Friend,

    After CRYO, HOKU, there was one another stock that has given multibagger returns…BCGI

  2. Anderl
    July 19th, 2007

    I found an interesting chart of the ARM resets  to come based on various type purchased several years earlier.  Some time around November we should see the highest value of ARM mortgages convert over to variable rates and in so doing get adjusted in the process with 10y years trading fairly high I expect it to dampen consumer spending going into the holiday season.

    Is it any wonder that only now we are seeing defaults and foreclosures on these mortgages increasing.  I believe the worst is yet to come and only after we pass by the next 12 months will we get some relief to this real estate crisis.


  3. Asif
    July 19th, 2007

    That is an interesting chart and as you said does not bode well for retail sales. About $1 trillion (for emphasis that is $1,000,000,000,000) of ARM loans are supposed to reset this year and by some estimates the number is even higher.

    One trend that has held up Countrywide has been the refinancing of loans that were originally ARM loans. With Washington Mutual (WM), Countrywide Financial (CFC) and H&R Block (HRB) deciding to curb new subprime loans, some of these resets may not be refinanced by Countrywide. 

    I am inclined to believe that there is additional downside risk to Countrywide and this is also the reason I have been keeping away from financials (except for Barclays and WisdomTree) despite their low valuations.

    Maybe it is time to take a closer look at TJX Companies (TJX) and Ross Stores (ROST) again.

  4. Anderl
    July 19th, 2007

    Anderl, 7/19/2007

    They may not refinance to new subprimes but will probably push their borrowers to refinance under longer termed fixed mortgages. Lenders enjoy a 7-8% rate of return and their borrowers will appreciate the stability.

    It is typical of the average real estate owner to not be able to time the markets very well. In previous market cycles when short term rates (90 day) trend down, property owners refinance to take advantage of those low rates. The problem is that instead of refinancing and locking in the lower fixed rate and saving they instead realize that these low rates allow them to afford more property. So they took on ARMs to upgrade to even larger and more expensive houses. More than they could afford at longer term fixed rates. That was the problem.

    Now the cycle has come full circle the the most speculative and clueless are feeling the effects of the ARMs and are now trying to refinance out of them for fear that rates will continue to go higher. This explosion in refinancing to longer term mortgages means that mortgage brokers see some new business.

    As far as the lenders are concerned the downside going into mid 2008 will be limited. Lenders base their rates against 10y treasury rates which have been fairly high (naturally). The Federal Reserve has made a commitment to keeping rates flat for the time being. That means lenders borrowing costs for not money is higher that it was a few years ago. If they are willing to convert their ARMs to longer termed fixed mortgages then they are expecting that rates are not going to move much higher than they are now. If they do then the lenders would have to expect to be loosing money on every mortgage they accept below those higher rates. If they refinance the majority of mortgages to fixed at 7-8% and inflation runs up to 8-10% then the money already lent is inflating away at the difference between the agreed on fixed rate and the rate of inflation. It is in their best interests to keep inflation capped at these levels and they will pressure their central banks and the Federal Reserve.

    You probably know all this. I guess I’m writing it for my own peace of mind.

    The mortgages I have all are under 5.8% at fixed rates and it has been a little frustrating to have seen them sold and resold to various other lenders because I am hurting their bottom line. Payment schedules have been a nightmare as I am seeing changes at least every 3 months. I think they may be hoping that I will drop the ball in the transitions or on their watch.

  5. Anderl
    July 19th, 2007

    BTW – Congratulations on breaking 100% in you model portfolio. Quite an accomplishment.

  6. Asif
    July 19th, 2007

    Thanks Anderl. It has been a very interesting journey to getting 100% returns and I learnt a lot. Hopefully I will get to post my experience in a second anniversary post on August 2nd.

    You are right about most ARM mortgages being refinanced into fixed rate mortgages. However since both state and federal regulators are cracking down on subprime mortgages (I doubt Countrywide and fellow lenders decided to stop subprime 2 year ARM lending out of higher moral values), many of these subprime borrowers will have to look for other sources for their refinancing and hence loan volume at Countrywide may not rise a whole lot, if at all.

    The key is figuring out where interest rates may head 6 months or a year from now. Inflation is tame right now and the Fed expects it to stay in pretty much the 2% to 3% range through much of 2008. However the spreads have tightened for most lenders over the last couple of years and are likely to stay tight unless the fed lowers interest rates.

    I just finished reading the hilarious and eye opening book Liar’s Poker by Michael Lewis about bond trading at Salomon Brothers in the 80s. There is a whole section about how mortgage bonds were created by Salomon and describes exactly what is happening to your mortgage loan. If you have not already read it, I highly recommend checking it out.

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