March 13, 2007: Sub-prime tidbits and Swire Pacific

I will do a mini-mea culpa regarding sub-prime financing. As I looked into the situation from the angle of total financial immersion out of curiosity, some facts head slapped me.

First off, it is not just a sub-prime issue. A good portion of the mortgage market is at risk of a significant adjustment from tightening credit and increased regulatory scrutiny. The areas of most concern are stated income affectionately called Liar's loans, high CLTV/piggyback and interest only/negative amortization loans. The proliferation of these mortgages has been been highest in former real estate hotbeds such as (surprise), California, Nevada, Arizona and Florida. These states have also accounted for the lion's share of builder profits and many retailer's profits as well.

Countrywide, Option One and Wells Fargo have announced plans to discontinue many risky products - especially the stated income program (Liar's mortgage). Freddie Mac will cease buying sub-prime ARMs that qualify buyers at a teaser rate.

Thus, approximately 21% of the loan business is drying up. The drop in new home construction may thus be 35-45% nationwide. This is a LOT higher than I thought. However, there is a sense that tighter criteria will bring a more logical and orderly mortgage business model henceforth. It is possible that the Fed may even lower interest rates to help ease the situation in mid-summer of this year.

Headwinds from deteriorating credit will impact supply and pricing conditions. Thus, if you are a first-time home buyer with good credit, you have a Goldilocks scenario, low interest and large builder discounts.

Foreclosures are expected to maintain a heavy hand throughout much of the nation with many short sales from banks anxious to rid real estate from their books.

Finally, the tightening liquidity and more stringent appraisals put current builder backlogs at considerable risk for fallout, which should lead to another surge in cancellations and additional spec inventory on the market. This situation will be felt throughout the entire market and lead to a possible 20% DECLINE in home prices over the next twelve months.

$300B (36%) of sub-prime loans are set to adjust upward in 2007. Many dramatically so, from teaser rates. Wal-Mart's reliable monthly customer survey results indicate that overall financial well-being has become the number one concern of its customers. Wal-Mart thinks that housing obligations are likely contributors to this concern.

Analysts at Credit Suisse First Boston state that Costco, Target, Nordstrom and Saks are most exposed.to this downdraft of credit.Don't ask me why...ask CSFB.

In total, IMO, resets of sub-prime and alternate mortgages represent a challenge to sustaining consumer spending at all levels.

Thus, except for Wal-Mart, you may want to forget about the retail sector for the near and intermediate term.

One bright spot are non-US banks stepping in with sub-prime money, albeit with more stips as I mentioned in an earlier blog post. Another is that the fallout may confined in large part to the aforementioned states. California, Arizona, Nevada and Florida will be painful for home builders and retailers if the statistics presented are correct.

CSFB is the source of critical and timely data for this post.

On brighter side (unless you are Airbus), China announced it will be building its own aircraft with a target date of 2010 for the first model to 2020 for full production. Investors may want to take a look at Swire Pacific, a Chinese conglomerate with hands in everything from soda pop distribution to aircraft repair and retrofit. It trades very thin at SWRAF. When E-Trade opens up their trading desk overseas to individual investors, Swire Pacific will be one of the first stocks I will consider for purchase. www.swirepacific.com