Wednesday, August 08, 2007

Could I Have Profited From The Housing and Subprime Collapse?

In early 2005, I could not believe that housing stocks, such as TOL, DHI, PHM, RYL, HOV and NVR were hitting record highs. In addition, the CEOs were making optomistic statements, similar to "It's different now. We're insulated from the cyclical nature of the economy. We're smarter now than last time." I believe one homebuilder CEO made a claim that the buyer of luxury homes wouldn't be impacted by a downturn in the economy. By mid-2005, it seemed that the meteoric rise of home prices was over.

I could have profited from my believe by shorting these stocks or buying puts. Here's why I didn't:

A bubble generally last longer than one expects. The peak in housing stocks occurred in mid to late 2005. However, with the previous technology bubble, it seemed to extend it's life for years. I was became concerned about a tech market bubble in 1995 and therefore, did not invest in tech stocks. However, the market continued to rise rapidly until 2000 and then declining rapidly in 2001 -2002.

Coaching tip - The timing of a bubble burst is hard to predict.

Being wrong on timing can be costly. Shorting can be a very expensive mistake if the stock keeps rising. Theoretically, one's losses are infinite. (In reality, they are not infinite, but "infinite losses" makes a good point :-) If I had shorted housing stocks in late 2004 or early 2005, I would have experience losses of 25% to 100% by mid 2005. Shorting can aslo be gut wrenching when the stock rises steeply. For example, today Beazer Homes (BZH ) gained $2.98 or 24.8%.

Puts offer a less risky method but still can be costly. Most housing stock prices just recently fell back to the late 2004 prices just recently. Thus, an number of put positions may have expired worthless in the meantime.

Coaching tip - Betting against the market requires large reserves or the ability to cut losses quickly.

As a result, I was very risk averse when it came to shorting or buying puts on housing stocks.

However, recent events show that I should have also looked at other sectors. In hindsight, the mortgage lending business was already showing signs of weakness in early 2004. However, I did not expect the financial sector to be affected as much as it was.

I'm kicking myself right now. With the collapse of NovaStar (NFI) and American Home Mortgage (AHMMQ.PK) in the July, 2007, I am thinking I should have known. The option ARM loans were not sustainable. For many people, the upward adjustments would make the loans an expensive mortgage mistake. I knew that the foreclosure rates would rise, leading to a housing market slowdown. I did not see the failure of lenders happening.

Coaching - In a bubble, look for multiple related businesses that may also collapse.

A question now is whether there will be other sectors beyond housing and mortgage lenders.

For more on The Practice of Personal Finance , check back every Wednesday for a new segment.

This is not financial advice. Please consult a professional advisor.

Copyright © 2007 Achievement Catalyst, LLC

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