Money manager sees 2 ways to make money in subprime 'mess'

Posted: May 27, 2007
To some, investing in stocks associated with the deepest housing decline in 16 years might sound like a bad idea.

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John C. Thompson

Fannie Mae


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Buy a link hereKen Rosen, a high-profile University of California-Berkeley economist, has predicted as many as 1.5 million homeowners out of a total of 80 million will lose their homes through foreclosure by the time the dust has settled.

Subprime mortgage companies that lend money to people with bad or limited credit have laid-off thousands of employees. Irvine, Calif.-based New Century Financial Corp., once the biggest independent subprime lender and now in the process of shutting down, said earlier this month that it had laid off another 2,000 workers, pushing the total number of people it has sent packing in the last year above 5,000.

Amid the debris, though, a Madison money manager sees investment opportunities.

"There are two ways to make money out of this mess," said John C. Thompson, co-manager of the Thompson Plumb Growth Fund and vice president at Thompson Investment Management LLC in Madison.

Investors can buy shares of companies that provide mortgage insurance or buy shares of the government-sponsored corporations that underwrite home loans, he said.

Ten years ago, financial institutions generally required a 20% down payment when they originated fixed-rate mortgages. More often than not, Fannie Mae or Freddie Mac would buy the loan. If the customer didn't have the 20% to put down, the bank would arrange mortgage insurance.
How to make money
That began to change in the last decade as a rash of products hit the market to help people avoid buying mortgage insurance. Lenders would take 10% down payments and make second mortgages for the other 10% to help customers avoid having to make the full down payment. Credit standards loosened to the point where lenders were making loans with no down payments, or with no requirement to show documentation of income.

"The market's appetite for risk just went to an insane level in the last five to seven years. But this is obviously reversing now, as banks are finding their loan losses are going up a lot on the 10% down payments," Thompson said.

The subprime market and many of the lenders who sprung up around it are essentially shut down, he said.

Fannie Mae, Freddie Mac and the mortgage insurance companies will roll out new loan products to replace the subprime loans, but these new products will be better for consumers, with fixed interest rates and maturities of 40 to 50 years, Thompson said.

Fannie's and Freddie's share of the residential mortgage market has dropped below 40% from more than 60% several years ago, Thompson said. The number of insured mortgages has dropped to about 8%, from 16%, he said.

But he says those figures should rise again, paving the way for investment opportunities.

Here are some of the stocks in Thompson's portfolios that he says should benefit:

MGIC Investment Corp. (MTG, $65.71), Milwaukee, will be the biggest mortgage insurer after completing its acquisition of Radian Group Inc. (RDN, $62.50), with about 30% of the industry, Thompson said.
Earning money from home.
"I think mortgage insurance is coming back in a big way. Even though mortgage insurers will have higher losses in the next year or two, they sidestepped the worst loans by just not participating, and their market share should go back up to roughly 15% in the next three to five years," Thompson said.

These companies' stocks are trading at about 1.1 times book value, much lower than the 5.7 times book they traded at in late 1998, and below their average of about 2.6 times since 1991, he said.

The merger between the two companies is a low risk deal, with huge synergies that should contribute hundreds of millions of savings to the combined firms, he said.

An even safer way to find opportunity in the housing bust is through the shares of the government-sponsored organizations, Thompson said.

Fannie Mae (FNM, $64.56) and Freddie Mac (FRE, $66.65) had a 39.9% share of all residential mortgages issued at the end of 2006. They had increased that to 46.9% by the end of first quarter 2007.

"We think the market will continue to go their way because they can still fund loans and the subprime market has disappeared," Thompson said. He says the subprime market will likely never come back with the vigor it had over the last few years.

Fannie and Freddie were targeted by regulators several years ago for having multibillion-dollar accounting problems and faced the possibility of stiffer federal oversight and new restrictions from Congress. Top executives of both organizations were ousted or resigned, and Fannie Mae restated earnings for several years.

"Those issues are going away and, within the next 12 months, it should be business as usual for both of them. They should be able to grow their portfolios substantially, given the market dynamics we see," Thompson said.

He says he'd buy Fannie Mae, the larger of the two, up to $70 and that its shares could go as high as $120 in the next three years.