A Subprime Lender's Ascent

Accredited Home Lenders' stock has zoomed since its IPO. Now, the challenge is to continue growing even if interest rates spike

By Amey Stone

This would hardly seem the time to invest in a mortgage banker -- let alone one that deals in the "subprime" segment of the market, providing higher-rate loans to people who don't qualify for mortgages at the lowest rates. The amount of mortgage debt issued this year is expected to fall by about two-thirds as interest rates rise and refinancing activity dries up.

Plus, higher rates mean heavily indebted subprime borrowers could start having trouble making their payments as the cost of servicing variable-rate debt rises. The housing market could also weaken. Sales of existing homes dropped 5% in January, according to seasonally adjusted figures released Feb. 25 by the National Association of Realtors. The drop could be a sign the housing market is finally cooling off.

So why is the stock of Accredited Home Lenders (LEND ), a San Diego-based mortgage banker that serves the subprime market -- the company prefers the term "nonprime" -- up 350% in the past year? The simple answer: Because Accredited is growing so fast.


  Recently, the stock's torrid momentum since its February, 2003, initial public offering has started to slow as investors take note of the new pressures weighing on the mortgage market. Although the share price climbed above $40 briefly in January, it fell later that month after the Federal Reserve hinted that it might eventually boost rates. It has has since bounced around the $33 range.

Analysts surveyed by First Call predict that Accredited's 2004 earnings per share will climb less than 2%, to $5.07. But Accredited's 2004 guidance is for EPS to come in at $5 to $5.25.

Accredited's management readily admits that its growth rate is unsustainable, and it anticipates declines in mortgage volume, more price competition, and higher costs -- just not to the extent that some investors fear. Not only is the subprime market less volatile than the market for conforming loans, but of subprime lenders, Accredited has a better mix of customers, argues Chief Executive James Konrath.


  Even if Konrath is overly optimistic, the stock still seems inexpensive based on analysts' conservative estimates. At $33 a share, its forward price-earnings ratio is just 6.5. That contrasts with 13.3 for the financial-services sector, and 18 for the Standard & Poor's 500-stock index.

Konrath says among its peers, Accredited has one of the highest percentages of customers using loans to purchase homes (39%) and one of the lowest using its loans as refinancing vehicles to get lower monthly payments (9%). Even if the pure refinancing business dries up in a rising-rate environment, he thinks the housing market will stay strong and just as many people will still need mortgages to purchase homes.

Even better, he thinks demand could actually increase for cash-out refinancings -- when customers tap into their home equity, mainly as a way to consolidate their debt. Such customers already account for 52% of Accredited's base. The average credit card now charges 13% interest, according to Greg McBride, a financial analyst at loan-market data site Bankrate.com. Accredited's average rate is 7% to 8%, says Konrath. As rates rise, more people will be looking for a way to reduce their variable-rate credit-card debt, he believes. The potential to get a lower rate, plus gain the ability to deduct the interest payments on a mortgage, "could amount to a strong opportunity for people in our business," he says.

Maybe. But Accredited will still have to make sure its current customers can handle the debt they've taken on, says Jackie Reeves, a banking analyst with Ryan Beck Securities. "If interest rates go up because the economy improves and we see job growth, then consumers could potentially be able to fund debt at higher rates," she says. But if the jobs picture doesn't improve, she wonders where consumers will get the additional cash that would allow them to pay higher rates on their debt. "It is just such a delicate balance," she warns.


  Accredited now boasts a 1.8% delinquency rate on its loans, down from 5.5% at the end of 2001. Konrath argues that he and his team have a wealth of industry experience, plus the lender has established incentives for its underwriters that will lead to continued strong results. Accredited also has an opportunity to gain market share: Of the $332 billion in subprime loans that originated in 2003, Accredited provided just $8 billion, or 2.4%.

Its 2003 sales more than doubled to $435 million, up from $201 million in 2002. Earnings in 2003 climbed even faster. Net income last year totaled $100 million, or $4.98 a share. That's nearly 250% higher than its net income of $29 million in 2002.

Even at the end of 2003, when mortgage applications were down more than 50% from the year earlier, Accredited's growth was accelerating. For the quarter ended Dec. 31, the company reported that net income grew more than 400% from the prior year, to $30 million, and sales doubled, to $132 million.


  Accredited has wild cards, for sure. A major risk is the current regulatory environment. Already, some states have passed predatory-lending laws that were so strict that subprime mortgage bankers have threatened to stop doing business in those areas. That could mean slower growth for originators of those loans.

Accredited has had the wind at its back for the past year, thanks to low interest rates, a strong housing market, and an improving economy. Investors could still fare well in the stock if it can grow faster than expected while confronting the headwinds of rising interest rates.

Stone is a senior writer at BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column

Edited by Beth Belton

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