A Wild Ride with Subprime Lenders


When credit-card issuer Metris announced on Apr. 17 that earnings for the year would be lower than expected, its stock fell 30% in one day, to $11.65. Big deal? Not for this Minnetonka (Minn.) lender. It's used to being pummeled, even when its numbers are good: Two weeks after it reported better-than-expected fourth-quarter earnings on Jan. 16, the stock had fallen 30%, hitting a 52-week low of $12.35 during a period of jitters over the economy and mounting credit delinquencies. After that, it had surged by 50% -- until the new quarter's release.

What's with the roller-coaster ride? Metris is among a handful of lenders -- AmeriCredit and Household International are two of the bigger names -- whose fortunes hinge on consumers with spotty credit histories or no credit histories at all. Some of these so-called subprime lenders are strong enterprises with rising revenues that do a good job of managing risks.

However, many analysts and investors get nervous about holding shares in this sector when the economy is wobbly, fearing that these outfits are overreliant on stressed-out consumers. Hence the ups and downs.

"POLARIZED" OPINIONS. Short-sellers, who sell borrowed shares as a way of wagering that they'll fall, have been all over these stocks during the economic downturn. Yet the volatility may just be starting. "I don't recall a sector where opinions were more polarized," says Sean J. Ryan, an analyst with Fulcrum Global Partners, an institutional brokerage firm in New York. "The only point of agreement is that these stocks will have a 100% move."

With the economy improving, who will be proven correct? Until recently, the bears, a.k.a. short-sellers, have carried the day. They maintain that Americans are buckling under mounting debt: Personal-bankruptcy filings hit a record high of 1.49 million in 2001, up 19% from a year earlier. A handful of subprime lenders -- Conte Financial, Mego Mortgage, and The Money Store -- have already gone out of business, and Providian Financial is in the midst of a restructuring.

Yet the bears face a growing contingent of optimistic money managers who say the shorts have it all wrong: With the economy improving, albeit modestly, loan volumes at these companies are up. Moreover, personal bankruptcies are expected to be flat this year, a "markedly more positive outlook," as Morgan Stanley's financial-services analyst Kenneth A. Posner wrote in a recent report.

SQUEEZED SHORTS. As a result, stocks of some subprime lenders have begun to rally -- causing big headaches for short-sellers. Shares of AmeriCredit, which makes car loans to consumers with past credit trouble, have leaped 16% over the past month, to $44.95.

Market-watchers believe much of that was probably caused by a "short squeeze" -- a 23 million-share short position was reported by the New York Stock Exchange on Mar. 15, 28% of the outstanding float for AmeriCredit. As stock prices rise, short-sellers have been scrambling to cover their positions by buying back shares they sold short. The result is a squeeze, in which short-selling results, ironically, in share price gains. And the shorting of these subprime lender stocks has been considerable.

There could be more upward pressure on the shares, as long as the short position remains so high. Nearly 12% of mortgage lender Irwin Financial's outstanding shares are lent out short, while the figure for Metris is 33%.

"GOOD LENDERS." The bulls think nobody gives the well-run companies in this subprime lending group enough credit. "The bears will say the economy saved these companies, but what they got wrong is how good lenders these companies are," says Thomas K. Brown, chief executive officer of Second Curve Capital, a hedge fund specializing in financial stocks.

Subprime lending can be a very lucrative business. The companies charge their riskiest borrowers steep annual percentage rates, often 20% or higher. Even if interest rates rise, card companies' net interest margins -- or the difference between interest charged and the cost of funding the loans -- has continued to expand.

What's more, many subprime lenders have a healthy cushion of loan reserves to cover future blowups. "There's a misconception that the subprime consumer would deteriorate to such a great extent during a downturn that subprime lending wouldn't be profitable anymore," says AmeriCredit CEO Daniel E. Berce. "But I can tell you that subprime lenders get paid for the risk that they take."

UNDERVALUED? Profits are ticking up, too, and Wall Street is low-balling earnings estimates for many subprime lenders, argues Michael P. Durante, a fund manager at John McStay Investment Counsel in Dallas. He forecasts that Metris will beat analysts' consensus estimates this year. The stock trades at a current price-to-earnings ratio of five, but Durante thinks it can support a valuation of 30 times earnings, which means it could trade as high as $90.

Make no mistake. If the economy continues to slip and slide, so will shares of these highly volatile stocks. The shorts sure are wagering that way. But with every new tidbit of favorable economic news, some of the subprime lenders could start to look prettier than ever. By Mara Der Hovanesian in New York


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