Recently, the risk/reward relationship became skewed in the market, especially in the subprime mortgage sector. Companies originating loans began to decrease lending standards, which made it easier for people with poor credit histories to borrow.

This is now coming back to haunt the lenders, as rising defaults on these mortgages are severely damaging some businesses, and even causing some to close up shop.

The Casualties
Some of the biggest names to have problems include Countrywide Financial (NYSE:CFC), American Home Mortgage (OTC:AHMIQ), Accredited Home Lenders (Nasdaq:LEND), and Thornburg Mortgage (NYSE:TMA).

Mid-July is when all the news started to hit, crushing these stocks in its path. From July 16 through August 27:
• Countrywide went from $34.84 to $19.68, a 46% drop.
• Accredited went from $13.90 to $5.87, a 58% drop.
• Thornburg went from $26.20 to $12.39, a 54% drop (down 70% at one point).

For perspective, over the same period, the S&P 500 and Dow Jones Industrials Average dropped 5.26% and 4.16% respectively.

Some mortgage companies have even had to shut their doors, the biggest being American Home Mortgage. The company filed for bankruptcy on August 8 citing the recent impact on its liquidity, and problems in the secondary mortgage markets. The share price has dropped 99% over July and August.

The Problems Keep Coming
You would hope that this is the worst it would get, but it will be awhile before we can fully tell where all the problems are. Accredited seems to be on thin ice. After Lone Star Funds backed out of buying Accredited, the company had to stop issuing home loans, and said it will shut down many of its retail and wholesale operations. Soon after, an announcement came that its CFO John Buchanan was also resigning. The company is in turmoil, and will have a hard time achieving any stability in its business.

The bigger boys are getting hit as well. Lehman Brothers (NYSE:LEH), Capital One (NYSE:COF) and HSBC Holdings (NYSE:HBC) have discontinued mortgage operations. It is still uncertain whether this will have much broader effects on the economy, but the subprime problems are clearly not as contained as once hoped.

The Positives
When there are bad problems, opportunities can also arise. Warren Buffett said the frenzy in the markets is exciting because "dislocations" can occur in pricing. I have mentioned some big financial names in previous articles that I think have been discounted by the mess including Citigroup (NYSE:C), American International Group (NYSE:AIG) and Goldman Sachs (NYSE:GS). I would add Morgan Stanley (NYSE:MS) and Merrill Lynch (NYSE:MER) to the list of strong undervalued financials.

Another that I would take a second look at is Countrywide. While this company has been at the center of the storm, it is one that I cannot see going under in the turmoil, and I think most, if not all, of the bad news is priced in to the share price, since it has been aggressively writing down losses.

On August 22, Bank of America (NYSE:BAC) invested $2 billion into Contrywide's preferred stock, and Countrywide is borrowing $11.5 billion from banks to battle the liquidity problems. There have also been rumors that Warren Buffet was interested in the stock. And while those are just rumors, it wouldn't be surprising as Buffet took similar action with a distressed Salomon Brothers in the past. I definitely would not be betting against Countrywide anymore. I would also be timid to recommend the stock, since there is still considerable risk, but I think it deserves a look at this point.

The Bottom Line
There is turmoil in the subprime sector of the market, and we may continue to see aftermath for a while. I would stay away from companies such as Accredited, which are struggling to deal with the subprime issue. Instead, look to strong financial companies that have been pulled down by all this news but have diversified businesses that can more than absorb these problems.

For a one-stop shop on subprime mortgages and the subprime meltdown, check out the Subprime Mortgages Feature.

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