New Century Financial's 19% Yield from its Option ARMs Mortgage Business

At first look, New Century Financial (NEW) may look TGTBT (that's "Too Good To Be True" as we like to say at Theyieldhoe.com, in case you haven't heard yet). And if you read the cover story in Businessweek (Sept. 11, 2006 issue), you may find plenty of reason to just walk away from the temptation NEW's massive, juicey and otherwise wopping 19% yield.

NEW sells something not so new in exotic mortgages. What is new is that massive roll out of these exotic mortgages to subprime market of folks who don't have the best credit rating. These Option Adjustable Rate Mortgages, or "Option ARMs", as they are called are often sold with contract clauses that you might see in a Contracts law book as an example of an one sided deal, where courts see a deal written by a big bank with a lot of smart lawyers as something that can be modified when the consumer is in a poor position to negotiate anything (such as refinancing fees). Businessweek's Mara Der Hovenesian rightly point this out with examples of several cases, including a hardworking Police officer in California who can not afford to refinance but for the fees that his Option ARM mortgage contained.

There are several companys making hay packaging, selling and laying off these notes to hedge funds and other institutional investors. A lot of NEW's earnings come from these Option ARM sales, which are expected to blow up if interest rates climb as the result of inflation. Realtors looking for indicators may also do well to watch how the companies in this little nook of the mortgage world fare.

Yet recently (September 20), financial journalists, such as CNBC's Ron Insana have reported that bankers are taking step to review these exotic mortgages with folks who are stuck between the Fed and a hard place and facing big increase in their payment, with nowhere to turn for refinancing without massive fees. Adjusting the terms of these loans may impact the bottom line of companies like NEW (and Indymac, whose CEO Michael Perry went on CNBC to address the potential trouble with Option ARMs head on.)

So as a stock, it looks like the fear is all in NEW's yield. Buyers face a wall of worry, which is often the stuff, of which capital gains are made. Some financial journalists think it a good idea to buy NEW and hedge the position with options. Stop limit orders are yet another way to plan your exit before a drop in NEW that could knock that 19% yield down to earth.

For example, Kopin Tan's in "The Striking Price" section of Barrons takes a bullish slant on NEW. Tan looks at the pros and cons of NEW as an investment, weighing the outsized yield against the fears, the treat of bad news, and rough ride subprime lenders have faced as the Fed has raised rates almost 20 times over the last two years. Tan asked around, and a few options bookies (not Option ARMs, but the other kind-- the right, but not the obligation to buy or sell an underlying security at a given price) even think writing calls on NEW is a good way to collect more rent for parking your money here and give you downside protection, as they say.

Maybe even a few Puts to offset your downside risk on NEW, in the event maybe Congress goes democratic this fall, and they start cleaning up this profitable little mortgage lending nook releasing, the hardworking people Businessweek found from loans so they can not refinance without paying way too much. However, many think the risk to NEW's dividend is factored into its price, which makes sense. A careful investor may even want to buy NEW, write the calls and collect the premium, and use it to buy puts, for further downside protection against the risk of rising rates, and what could come of democratic majority in Congress this November.

These issues appear to have been on investor's mind. Since it's October 1, 2004 NEW's price moved up from the NASDAQ to the NYSE, it's price has faced a drop. On the charts, it's trading below its 50 and 200 day moving averages, which is generally considered a good place to buy if the company's is not in deep stuff.

As a REIT, NEW stands out among it's comps in a few ways, including a outsized total debt to total capitalization ratio, which tops 75%, verses it's very respectable Return on Equity, which tops 20% .. These include. Profit margins seem steady for NEW over the last five years, verses it's last 12 months, which is so so. On the plus side, NEW has both high revenue growth (almost 50%) and high earnings yield when looked at next to its peer group. It's peers include other real estate investment trust, such as H, SLG , AIV, SFI and more.

What's the bottom line on NEW? As always, that is up to you, but if you are looking to load the boat on NEW, in spite of its big debt ratio versus its peers, we'd keep those stop limit orders tight like Goldmember, to protect that downside from taking back what NEW offers via it's great big return from its offbeat dividend yield. Others may not have the taste for the kind of risk NEW offers, and may just want to watch its fate bounce with the vagaries of interest rates.