Real estate woes bring both worry and opportunity to the financial sector.

It didn't take long for financial stocks to recover from that nasty bout of subprime lending problems back in the first quarter. Heading into Memorial Day, the sector was actually up a little on the year, albeit less than the broader indexes. Even so, Steven Delaney, a managing director and senior research analyst at JMP Securities in Atlanta, was pretty sure the housing story was far from over.
"I don't think we've seen the bottom yet in either home prices or the subprime fallout. We've got a couple of quarters of excess to burn. But I also believe that 2008 can be a very nice year for the mortgage industry, and real estate in general, because of the underlying demographic trends, especially considering that the Fed appears more willing to lower rates than raise them," Delaney says.
How the housing market's troubles are likely to affect investments in financial stocks, which at the end of April accounted for a hearty 21.6% of the S&P 500 and 26.1% of the MSCI World Index, is one question advisors should be prepared to field from clients. Other, larger-scale queries that clients may have (and which are addressed first) are whether many home loans might sour en masse, and if so, could the financial system handle it. The answers, respectively, are possibly and probably.
Certainly, macroeconomic variables such as sustained high gas prices or rising unemployment could exacerbate foreclosures. Then there's the issue of adjustable-rate mortgages, including teaser loans that start with a super-low introductory rate but reset at higher, unaffordable interest rates.
That alone will cost consumers $42 billion per year and will cause 1.1 million foreclosures over the next half-decade, according to a new study. But that's not enough to bring the economy to cataclysm, concludes the report's author, Christopher Cagan, director of research and analytics at First American CoreLogic, a real estate information company in Santa Ana, Calif.
Housing prices could contribute to defaults, too. Rising values effectively enable overextended borrowers to bail out; they can either sell for a profit or refinance. But falling prices confound homeowners in trouble and, in the short run at least, many observers anticipate declining home values. The Mortgage Bankers Association, for instance, predicts a median drop of 2% across the country this year.
The real wild card, though, is the bad credit that's been injected into the mortgage marketplace. Defaults are a normal part of the lending business, of course. What's different this cycle is that loans were written that shouldn't have been, something Charlie Smith, chief investment officer at Fort Pitt Capital Group in Pittsburgh, traces to the mortgage market's recent evolution.

The Rise (And Fall) Of Subprime And Alt-A
Today, roughly 80% of outstanding mortgages are prime paper, or loans to top-quality borrowers. The rest is split roughly evenly between subprime, which is the lowest tier and includes a lot of ARMs and teaser loans, and Alt-A, a middle zone in which loan applicants can skip providing a traditional financial dossier. However, subprime and Alt-A held much smaller shares of the market not long ago.
In 2001, 8% of all mortgage originations were subprime loans, compared with 20% last year, according to Inside Mortgage Finance, a Bethesda, Md.-based mortgage industry publication. Alt-A grew from 2.2% to 13.4% of the market in that time. Combined, in 2006 $1 trillion of subprime and Alt-A loans were made-one-third of the total.
The lower tiers' growth was spawned by the rise in the last several years of collateralized debt obligations, a genre of mortgage-backed security that Smith believes dramatically changed the mortgage market's business model. Once upon a time, would-be home buyers went to the local banker, who assessed their creditworthiness and, in approving their loan, tied his own fortunes to their ability to repay.
But the securitization process separates underwriter from investor. Loan originators sell the mortgages they make to investment banks, with perhaps a loan wholesaler involved in between. The banks then package the loans into large portfolios and sell interests in these CDOs -at a profitable spread-to eager investors. "So the final owner of the mortgage could be several transactions removed from loan origination," Smith says.   
With the originators' prosperity linked largely to factors other than repayment (even if bad loans can be returned to the originator under certain conditions), this new paradigm has rewarded volume at the expense of sound underwriting practice. Once some players figured that out-such as New Century Financial, which filed for bankruptcy in April when its fund sources dried up-they started gaming the system.

Potential For Contagion
"There was some very nonchalant and dubious lending," says Quincy Krosby, chief investment strategist at The Hartford. Unfortunately, the rush to give away loans may not have been restricted to subprime, she says. "The Alt-A market is starting to see problems arise, although not as severe as in subprime."
In early 2007, according to one account, payments were delinquent on 2.6% of Alt-A loans, double the figure from 12 months earlier. Meanwhile in prime, Krosby hears that payments on home equity loans may be slowing. "We are watching this group very closely because it is the majority of the market," she says.
Lenders tightened standards after New Century's blowup, but how much bad credit the markets ingested before that is unclear and likely to remain so for some time. "Mortgages typically season in years two through four, so we won't know if there's an inherent credit problem with the '06 book, which is the one people are really worried about, until the '08-'09 time frame," says Geoffrey Dunn, managing director of research at Keefe, Bruyette & Woods, an investment bank that specializes in the financial services sector.
For investors the $64,000 question is, who owns the loans and what will they do in the event of significant borrower defaults? The general consensus is that the securitization process, for all the trouble it may have engendered, has done a pretty fair job of spreading the loans throughout the international capital markets. The risk is fragmented sufficiently, goes the thinking, to insulate the financial industry from a major shock to any single one of its pillars.
Morningstar believes that the weakest credit tranches are held by hedge funds. Indeed, in May Swiss bank UBS shuttered its hedge fund, Dillon Read Capital Management, reportedly over subprime-related losses.
To Dunn, though, the real worry isn't credit risk, especially considering today's modest interest rates and relatively healthy economy. More bothersome is that the fixed-income markets have displayed an unprecedented appetite for yield in recent times that has shrunk risk premiums to paltry levels.
"What happens when people realize they have been underpricing risk the last few years? If investors rush for the door at the same time, then you have massive market disruptions and credit spreads gap way out. That's what I'm most worried about," Dunn says. "The Q1 market disruptions [in the financial sector] that quieted down in Q2 had to do with some subprime players getting their funding pulled by Wall Street. The issue was liquidity, not credit."

Finding Opportunities
All these concerns have inappropriately and temporarily hurt some subsectors and names, leaving them undervalued, professional investors say. Dunn believes one of the biggest eventual beneficiaries of the current goings-on could be the mortgage insurers. They write PMI, or private mortgage insurance, a once highly profitable line that lost market share with the advent of certain alternative mortgage products earlier in the decade.
But in the intial subprime scare, the market for these hot alternative mortgage products quickly disappeared, which was a boon to mortgage insurers and helped their top lines, Dunn says. "Investors haven't really focused on that. The MIs certainly do have exposure to some problem areas, and we expect some short-term pressure. But relative to the overall market, they have a disproportionately low share of the potential issues," he says. These insurers include MGIC Investment, Radian Group and PMI Group, each of which Dunn rates "outperform."
Similarly, and as noted at the outset, Delaney thinks the mortgage lenders-Countrywide Financial, IndyMac and American Home Mortgage-have issues to work through but good longer-term prospects. The average life of a mortgage is only about four years. "People move, people refinance," Delaney says. "About $2.6 trillion in new mortgages will be made this year, and while that's down from previous highs, it's higher than any year prior to 2002." In the meantime, though, there will be pain. "American Home does very little subprime lending but has been hurt by a spill-over effect," says Delaney.
Morningstar likes Countrywide for its strong balance sheet and nonmortgage interests.

Don't Go There
Other pros see housing's blues as a reason to avoid certain areas. "I'm naked in the regional banks," says Les Satlow, a portfolio manager at Cabot Money Management in Salem, Mass. Regional banks tend to hold sizable proportions of the mortgages they originate, rather than securitize them, so they could have significant exposure to defaults.
"There's so much uncertainty about the subprime pothole possibly turning into an earthquake-why not sidestep it?" Satlow says. Plus, the yield curve is inverted and loan-loss provisions on banks' books are low. "We're concentrating our financial-sector exposure in insurance, mostly property and casualty, which we think will have better near-term earnings," Satlow says, citing positions in Berkshire Hathaway ("A closet P&C," he calls it) and Ace Ltd.
Charles Lahr, manager of the Mutual Financial Services Fund, also is quite dour about the whole housing scenario. Derelict underwriting. Declining home prices. A drag on GDP. "All in all, it makes the U.S., on a global basis, a very weak market to be in," he says, noting that presently about 70% of his portfolio is invested abroad.