Profiting from the Housing Bubble

In the past 6 months, Wall Street has been hit hard by the sub-prime crisis. Even though there has been a barrage of news flashes and headlines, many investors don’t understand exactly what the sub-prime crisis is all about. This article serves to flesh out the issues and recommend an investing strategy that can allow you to profit if further pain on Wall Street is felt.

It all began with the real-estate boom that started in the early 2000s. For the next several years, real-estate prices climbed so high that nearly everyone became a real-estate speculator. This, in turn, drove real-estate prices higher and everybody was happy. It was a win-win situation.

During these golden years of real-estate, prospective homeowners purchased homes outside of their price range, current homeowners refinanced to further improve the value of their property, and real-estate investors speculated like it was… well, it was their job. All of these individuals were eternally optimistic that the price of real-estate would continue its climb and they would reap the benefits.

To fund this fantastic idea of buying high and selling higher, these individuals would need mortgages. Luckily for them, the mortgage industry was booming right along with the real-estate prices, so finding an originator was hardly a challenge.

Fuel for the fire:

These loan originators had legions of investors, homeowners, and prospective homeowners requesting loans. Many of those requesting loans had very poor credit scores, and thus qualified for only sub-prime mortgages. Loan originators, in a never-ending search for increased profits, came up with some pretty sophisticated ways to package these mortgages. Adjustable rate mortgages (ARMs) were (and still are) one of the most lucrative mortgages for originators. These ARMs, as opposed to fixed rate mortgages, have low, or “teaser,” starting rates. These rates would increase in a pre-specified period of time, usually 3-5 years. The rate to which these loans reset is staggeringly high. So high, in fact, that most of the individuals for whom these loans reset cannot afford the new payments.

In some cases, the individual was not financially savvy enough to realize that the loan payments, at the higher rate, would be too high to afford. Most of these individuals, however, understood the rate hikes but thought they could refinance or sell the house before the hikes took hold. The loan originator, due to the structure of the loan industry, couldn’t care less if the individual can’t afford the new monthly payments. This might sound counter-intuitive, but it makes perfect sense when you understand the lifecycle of these loans.

The lifecycle of a loan:

After the individual signs the loan agreement, the loan originator turns around and sells the loan to a bank or investing firm. Once the loan originator sells the loan, he or she is no longer involved in receiving the payments and doesn’t really care if the loan goes into default or not. The new owner of the loan, the bank or investing firm, now takes on the risks associated with default even though they weren’t a part of the risk identification process for determining an appropriate rate for these ARMs.

Now that the banks or investment firms own these loans, they package them up into funds and specialized investments and then sell them to - you guessed it - regular investors like us!

So what’s the problem?

Fast forward to 2007 and we find that many of these ARMs have reset to higher rates. Normally this wouldn’t be a problem, as homeowners would simply refinance for a lower rate now that the housing market has continued to skyrocket. Unfortunately for them, and all of us, the housing market did not continue its impressive run and, instead, took a sharp drop. Without the ability to effectively refinance or sell the real-estate, and now facing the increased monthly fees, many homeowners were forced to foreclose. Enter the current market. Banks, who owned the mortgages backed by the real-estate, are now getting hit hard by foreclosures. Additionally, the houses that they repossess worth less than the amount owed, due to the falling market prices. Banks put them up for sale anyways, hoping to recoup at least some of their losses. This creates a waterfall effect and further drives down the prices, as the number of houses on the market skyrockets. Also around this time, lenders cut the number of sub-prime mortgages they wrote by nearly 100%. As you can imagine, this only further drives down prices as the demand for houses is reduced by a large amount. All of these things combined drove (and continue to drive) housing prices down, which are now owned by banking institutions as more are foreclosed on.

Isn’t it over, though?

Many banks and analysts would like you to think the worst is over. It might be, but there is evidence that suggests the end is not as close as they would like you to think.

To begin with, the median value of homes is expected to continue falling well into 2008, with some predicting a fall of 20% or more in the more speculative regions such as California, Florida, Massachusetts, and Nevada. This will create an even larger reduction in bank holdings of all the properties that have been foreclosed on. Not only that, but many homeowners have yet to feel a rate increase on their ARMs, so many are still outstanding and not yet foreclosed on. As these rates reset - most lined up to reset in early 2008 - the owners of these homes will find themselves unable to afford the new monthly rates, causing another spike in foreclosures. This will, in turn, amplify the number of write-downs that banks who own these loans will face.

The lack of sufficient demand to purchase these loans from the banks, coupled with the inability of those with poor credit to even get a loan, and banks will find themselves unable to unload foreclosed inventory, forcing them to further reduce prices.

Many of the banking institutions have issued warnings that earnings will take a massive hit in the coming quarters as ARMs reset and foreclosures rise. These warnings have been sugar-coated, though, and are just enough to satisfy SEC requirements of not misleading shareholders. The actual losses will more than likely be larger than the banks are telling us.

Profiting from all this:

Fortunately for the investors of the world, there is a way to hedge the economy and profit from the impending doom that we are facing. There are several stocks out there that allow investors to profit from the banking industries demise.

One particular stock is the Ultra Short Financials Proshares (AMEX: SKF) exchange traded fund (ETF). This ETF trades like a stock, and simulates the shorting of all financial stocks. For every 1% the financial industry goes down, this ETF goes up 2%. In the past year, this stock has boasted more than a 40% return, doubling the loss of 20% for the financial industry.

52-week target:

If everything plays out as it seems it will, it is likely that this stock will see prices upwards of $150 per share, representing nearly a 50% gain from today’s levels of $103.

Freund Investing Managing Member Ryan Freund holds no position in any of the companies mentioned in this article. Freund Investing has a solid Disclosure Policy.