Novice Investing - Hunting For Investment In a Panic

Date: Sunday 20th 2008f July 2008 12:50:12 PM

Hunting For Investment In a Panic - 03/14/2007

By: Hari Wibowo

This past several weeks has wreaked havoc to many subprime lenders. These are defined as institution that gives out loan to individuals with less than perfect credit. As house prices soared in the early part of the decade, lenders are becoming confident and approve their loans freely. Now, as house prices cool from its 2005 high, riskier borrowers are unable to meet their mortgage payment.

Victims over the past several weeks include: HSBC, New Century Financial Corp. (NEW), Novastar Financial Inc. (NFI) and Accredited Home Lenders Holding Co. (LEND). Aside from HSBC, shares of these companies have plunged more than 80% over the last month alone! Now, that is quite a drop for these financial stocks. In the case of New Century Financial, it is in the verge of bankruptcy since it cannot pay margin call from its warehouse lenders.

That sounds scary. Should you get out of financial stocks completely? Well, not quite. In theory, the best time in investing in financial stocks is when interest rates is high, like...... now ! The reason is that during period of high interest rate, financial's net interest margin gets squeezed and more people are defaulting on their debt. As a result, stock price remains depressed. If you expect the interest rate cycle is about to turn, then buying the stock at a depressed level will net you a decent investment return.

The federal reserve had been steadily raising interest rates since 2004 from the low of 1.00% to 5.25% in June 2006. Since then, the fed has held interest rate steady. It takes 9 to 12 months to feel the effect of an interest rate hike/cut in the economy. Therefore, the economy has felt the 5.25% interest rate effect (hence, the result is many of the subprime lenders defaulting on their loan last month). Things may turn worse but since the fed had stopped raising rates eight months ago, the chance of it happening is less.

So, can interest rate go any higher? It might go higher if 1) commodity price keep rising, 2) inflation is rampaging, 3) economic growth is ramping up, the fed would have to raise rates higher. Commodity price, especially oil, has stabilized at around $ 60 and I do expect oil to drift lower ahead. Inflation had been higher but not high enough to warrant interest rate hike while economic growth has been less than stellar lately, cooling down to 2% in the past two quarters from 3.0 to 3.5% growth back in 2004-2005 period. Thus, while interest rate may go yet even higher but at least, the odd is for interest rate to remains steady or lower.

Now, in the past cycle, when interest rate is at its peak, financials are getting pummeled. This time around, financial stocks hold steady until recently. While the drop is not significant yet, if you have extra cash, you should be prepared in buying some of the solid financial companies when they are dropping. For example, the past interest rate hike campaign begins on June 30 1999 until May 16 2000, Washington Mutual (WM) dropped from $ 25 to $ 17 per share (32% drop), Bank of America (BAC) from $ 32 to $ 24 per share (25% drop) etc. Not all banks drop that much but in one or two years afterwards, most banks register significant appreciation in stock price. This happens as interest rate drops and margin improved. By August 2001, Washington Mutual has risen to $ 40 per share (135%) while Bank of America has risen to $ 32 per share (33.3% appreciation)

For this past interest rate hike, Washington Mutual shares had actually risen to $ 46 from $ 41 per share at the beginning of interest rate hike campaign. Meanwhile Bank of America shares has risen to $ 46 from $ 42 per share. Now, due to overblown subprime market which I believe will affect other mortgage delinquency as home price continue its descent, several of these financial stocks will lose value in the future. As of now, shares of Washington Mutual had dropped from $ 46 to $ 40 (13% drop) in 30 days. Shares of Bank of America similarly has fallen from $ 54 to $ 50 (7.4% drop) in 30 days. I feel that the drop has just begun and we might experience 20-25% drop in 2007 should things got worse in the subprime land. Please remember to invest in a solid companies instead of subprime lenders mentioned above ( New Century, Novastar Financial etc.)

END

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Disclaimer: The sole purpose of this article is educational. This article is merely the opinion of the writer and is not in any way a buy/sell recommendation regarding Washington Mutual Inc. (WM) or any other securities.

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