Getting The Subprime Shakes

Forbes.com: John Dobosz, 02.23.07

Choose whatever adjective you want: Awful, brutal, crippling--any of these will do and are quite appropriate to describe the action in the subprime mortgage lenders over the past week or so. The swift and severe descent in the sector has a lot of investors swearing off these stocks the way recovering alcoholics would the bottle.

"It's amazing how many people were so addicted to this stock," says Minneapolis patent attorney John Berns, referring to NovaStar Financial, the Kansas City, Mo.-based mortgage REIT whose shares are down 68% year-to-date. NovaStar has lost more than half of its value since Feb. 20, when the company dropped a bombshell, announcing that it expects to show no taxable income from 2007 through 2011, and that it's considering dropping its status as a real estate investment trust.

Berns, who sold his NFI shares several months ago but got caught with some preferred stock, is a member of ValueForum.com, an online community of fairly savvy stock enthusiasts who share ideas and analysis with each other and pay $220 a year for the privilege of doing so.

Many ValueForum members are big fans of stocks that pay dividends, and in mortgage REITs like NovaStar and fellow fallen soldier New Century Financial, they found fertile grounds for fat yields. Going by trailing dividend yields--which are essentially meaningless now--you can see that NFI yields 59% and NEW yields 44%. New Century has lost about half of its value in the month of February, saying it needs to go back and restate three quarters of earnings for 2006.

"I sold out of NEW long ago, because their reports were more accurate and they were not recording increased originations like NFI was," says ValueForum member and long-time mortgage REIT investor Robert Nuckols from Punta Gorda, Fla., who concedes that NFI was his largest single holding until he sold it last Wednesday. "The NFI originations, which were running over 10% higher than previous years, gave everybody a false sense of security that NFI was managing the meltdown better."

Nuckols also unloaded American Home Mortgage Investment, which is not subprime, but he fears that it could get painted with the same brush.

"A lot of people felt that NovaStar was merely a victim of manipulation by the shorts, kind of a conspiracy theory," says Berns. "They also thought that the big divided would protect them."

It turns out the shorts were right and that there is some validity to credit scores after all: People who have a history of not paying their bills on time donít pay their bills on time. Shocking.

But the allure of the big dividend was very tempting--too tempting even for some of the most successful investors.

Semiretired private investor Mark Tennenbaum from Santa Monica, Calif., bought NovaStar two trading days before the implosion. But don't worry about Tennenbaum having to feed his family cat food. He says that 70% of his "liquid portfolio" is in cash right now. Plus this month he was wrapping up the sale of a golf course he owned in Arizona.

Says Tennenbaum: "These stocks really aren't for the faint of heart."

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