It's lit to pop

From the esteemed Economist comes more ghoulish news on subprime mortgages. The article is a summary of the desperate and stupid loans that desperate and stupid lenders made to desperate and stupid borrowers. But what caught my eye was this graph:

The market has realized that subprime loans are so bad, they've lost 20% of their value in a few months.

What does that mean for holders of subprime loans? Big trouble. Especially for the leveraged ones.

Old Zeke was telling me about a wily old investor he met at the poker table. This guy had a hot stock tip. A mortgage lender -- not subprime -- with a huge dividend yield and trading at just 60% of book value. This old bird thought he was pretty clever to have invested in such a gem. As a favor, he told Zeke the name: Impac Mortgage Holdings (IMH). Zeke passed the name on to me.

As it turns out, IMH is really a hedge fund posing as a mortgage lender. First, our old coot was wrong about the subprime thing. Second, take a look at this balance sheet. This turkey is leveraged 20:1. $22 billion in loans, and $1 billion in equity. Leverage is great in the boom years (hence the great earnings and dividends in the boom), but deadly in a bust. What happens when the loans have to be written down to market value or written off as bad debt? Using the 15% - 20% drop from the Economist, IMH's portfolio would be worth about $18 billion... meaning a negative net worth of $3 billion, AKA bankruptcy. Even a much smaller drop in portfolio value (because IMH holds some higher-quality loans), would be plenty to completely wipe out the book value.

IMH's 12% dividend is completely unsustainable. It will be cut drastically, possibly soon. The Q4 earnings announcement is expected soon (next week if not delayed by feverish book-cooking), and I would put the chances of very bad news in the earnings announcement pretty high. We could see portfolio deterioration, origination slowing due to belatedly tighter lending standards, pricing pressure, portfolio disappearing to prepayments, or a combination of these. I am heavily short IMH ahead of the earnings announcement. You could be too.

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