Subprime Sentiment

Amid the rubble, S&P sees opportunities in higher-quality banks

Only two weeks after a 3.5% one-day drop in the S&P 500, the market suffered another 2% decline, triggered by a Mortgage Bankers Association (MBA) report of an increase in subprime and prime delinquencies and by a weaker-than-expected retail sales report. All 10 sectors in the S&P 500 took a hit on Mar. 13, with the S&P 500 financials sector down the most on the day (-3%), while energy held up best (-1.2%).

S&P's Equity Strategy believes the sell-off was the result of investors' unfounded concerns that these reports were symptoms of bigger underlying problems, such as a drying up of global liquidity, the spreading of the subprime problem into other areas of the lending market, and the potential drag-down effect on consumer spending. The decline, in our opinion, is not likely over.

Mark Arbeter, S&P's chief technical strategist, believes the successful price test on Mar. 14 was impressive and may have broken the back of the bears, at least in the short term. While the S&P 500 did break below Mar. 5's closing low of 1374.12 on an intraday basis, the index reversed sharply back to the upside and traced out a candlestick known as a hammer. When these patterns occur near important support, their implications are very positive for the market. To complete a potential reversal formation or double bottom, the S&P 500 would have to take out its recent closing high of 1407. If the index can do that, the intermediate-term trend would once again be bullish.

From a technical perspective, Arbeter believes the S&P 500 financials index has broken down on an intermediate-term basis on very heavy volume, and appears headed for a test of long-term support just 1% below current prices. The index is quickly closing in on the support drawn off the lows in October 2005 and mid-2006, in the 461 area. The sector index recently broke below nearer-term trendline support that had held up prices since mid-2006.

In addition, the index sliced through its 17-week and 43-week exponential moving averages. Because the drop was so swift, the 17-week has not yet crossed below the 43-week, which would be an additional negative signal. If that moving average crossover were to occur, we would get a long-term sell signal. A break below long-term trendline support in the 461 level would set the index up for a test of chart support in the 420 to 450 range. Since the index is not yet oversold on a weekly basis, we would avoid this area.

Cathy Seifert, head of U.S. financial services equity analysis for S&P, reiterated her neutral fundamental opinion of the financials sector, while S&P Equity Strategy maintained its marketweight recommendation. Seifert acknowledged that near-term investor sentiment in this sector has been hurt by concerns that the meltdown in the subprime mortgage market may spill over into the broader mortgage and mortgage-backed securities markets, but said that longer-term opportunities may be emerging.

Frank Braden, S&P's U.S. large-cap bank equity analyst, put the MBA report into perspective by noting that even though residential mortgage delinquencies were at 4.95% at the end of 2006, delinquencies averaged 5.3% during the 1980s. He also said that many large diversified banks have already tightened their lending standards and have sought to reduce their exposure to a deteriorating mortgage market. In addition, he says, these large banks have deep pockets and a diversified revenue base that should minimize the impact of a significant downturn.

Wachovia (WB; S&P investment rank 5 STARS, strong buy; recent price, $55), through its acquisition of Golden West Financial, has greatly increased its exposure to nontraditional products, such as option adjustable-rate mortgages, but does not originate any subprime mortgage loans, Braden says. Conversely, Wells Fargo (WFC; 3 STARS; $33), where about 20% of mortgage originations are in the subprime space, does not offer option ARMs. Nor does it offer negative amortizing, non-prime interest-only, or non-prime low-doc or no-doc mortgages. Bank of America (BAC; 5 STARS; $50) exited the subprime real estate lending business in 2001 and now has what we consider a high-quality home equity and residential real estate portfolio.

Citigroup (C; 5 STARS; $49), another large player in the subprime market through fixed-rate products, felt the effects of the subprime downturn through its ClearBridge Asset Management subsidiary, which held a 3.5% stake in New Century as of December 31, 2006. Citigroup reported non-prime first mortgage 30-day delinquencies of 3.6% vs. 6.5% for its peers. The company's consumer real estate lending business, both prime and subprime, accounted for about 4% of total revenues in 2006.

The financials sector offers a relatively high dividend yield and carries the second-highest overall S&P Quality Ranking by market cap within the S&P 500. As a result, Seifert recommends investors acquire four- and five-STARS stocks, many of which offer dividend yields that are twice that of the S&P 500 and rival the yield on the 10-year Treasury note. Some four- and five-STARS stocks that are large-cap with Quality Rankings of A- or better include Bank of America (Quality Ranking: A; yield: 4.4%), Citigroup (A+; 4.3%), BB&T (BBT; 4 STARS; $40; A-; 4%), Regions Financial (RF; 5 STARS; $34; A-; 4%), and Wachovia (A-; 4%).

Seifert adds that several subindustries, such as the insurers, are defensive by nature, since their fortunes are not dependent on economic growth and their portfolios predominantly hold short-term debt.

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