This Wall Street Disaster is Making a Comeback

Time to party like it’s…2007? No thanks. 

Just five years ago, the phrase “subprime” started to creep into the U.S. consumer lexicon. And not long after, the phrase “subprime mess” became a household name.  

#-ad_banner-#In case your memory needs refreshing, the subprime mortgage meltdown was veritable tsunami of risky loans that plunged in value, bringing many Wall Street firms to the edge of bankruptcy.

What’s shocking is that we’re beginning to see a return to these risky loans.   

Why would the same Wall Street firms burned by subprime mortgages embrace these toxic investments again? Because there are profits to be made, and memories can be conveniently ignored when the greed factor kicks in.

Frankly, the resurgence in interest in subprime loans shouldn’t be cause for alarm. Today’s subprime market is a very different beast.

Then and now
There’s one huge difference between 2007 and 2012. Back then, investors were led to believe that these subprime loans — which were bundled together into opaque financial instruments called “tranches” —  were quite safe, as the underlying home prices would increase in perpetuity. We know how that turned out.

These days, investors are sufficiently schooled in the subprime risks, so they are paying a more suitable price to absorb that risk. 

Here’s how it works:

Let’s say you are buying a tranche of bundled bonds and you believe that 8% of those bonds will run into trouble, paying off a fraction of what they were supposed to. Let’s also say that you can buy this trance at a 12% discount to the face value of those bonds. If you’re right about the 8% default rate, then you’ve just made a decent 4% profit. If the group of loans do even better, with even fewer of them going into default, then you can make an even fatter profit spread. 

So why is Wall Street now showing a newfound interest? Because traders are increasingly convinced that the U.S. economy is on firmer footing, the excesses of the recent subprime era have been wrung out and these bonds carry less risk than the current bond prices indicate. They say the default rates on loans will be much lower than anyone expected. 

Ways to play
It’s very hard for most investors to buy tranches of subprime bonds directly. Securities and Exchange Commission (SEC) regulations restrict sales to financial institutions and high net worth individuals (called “accredited investors”). But you can invest in the companies that aim to profit from subprime and other risky loans.

Take Two Harbors Investments (NYSE: TWO) as an example. The Real Estate Investment Trust (REIT) buys and sells residential mortgage-backed securities (RMBS) that are bundles of prime and subprime loans. The company layers on a bit more risk by borrowing additional money to “leverage up” results. This helps explain why this REIT offers a juicy 15% yield

Many investors say this combination of RMBS exposure and leverage is just too much risk to absorb. After all, Two Harbors wasn’t actively involved in the RMBS market during the subprime crisis, so we don’t know how this business model would have fared during the crisis. But results are clearly impressive now. Sales for 2011 exceeded $200 million, much of which flowed to the bottom line. This enabled Two Harbors to pay a $1.60 per share dividend.

As long as the economy and RMBS prices don’t tank, the company should keep paying out a solid dividend.

But investors probably shouldn’t get too attached to a $1.60 divident. It’s abnormally high, reflecting an almost perfect environment for RMBS buyers. As the economy improves, it will almost certainly be harder for companies like Two Harbors to find great bargains. As profit spreads tighten, Two Harbors will simply make less, and the dividend may fall as low as $1 a share. Still, this equates to an almost 10% yield at current prices. 

Other RMBS buyers include Annaly Capital Management (NYSE: NLY), with a current dividend yield of 13%, American Capital Agency (Nasdaq: AGNC) (15%), MFA Financial (NYSE: MFA) (12%), and Hatteras Financial (NYSE: HTS) (12.5%).

Action to Take — > As their high yields indicate, these are fairly speculative investments. The housing market is still on life support, and there’s no assurance that we’re near the end of the foreclosure mess. But an increasing number of strategists say that any mortgage that would have gone into default have done so by now, meaning the current RBMS tranches aren’t exposed to further trouble. This means these investments aren’t quite as risky as you might think.

But be prepared for yields to ultimately settle in the high single-digits instead of the current low to mid-teens. Worried that these stocks will fall in value if that happens? Most of these investments trade close to book value, so they are unlikely to fall much in value — assuming the economy doesn’t hit another air pocket.