For Strong Stomachs,
Some Mortgage REITs

Has the subprime mortgage shakeout peaked?

Now that New Century Financial has filed for bankruptcy, it's tempting to go shopping in the mortgage REIT sector.

If this were an efficient market, there wouldn't be any doubts. But investors in real-estate investment trusts continue to be blindsided by events so obvious they should be reflected in prices. Even New Century's bankruptcy dragged down the sector on Monday. How could New Century shares have been trading at $30 a few months ago, when tales of reckless lending standards and fraud in the subprime market were rife?

Let's consider some other equally obvious likelihoods that should be -- but probably aren't -- reflected in stock prices of mortgage REITs:

There will be more defaults among subprime borrowers.

Banks seem to be building up reserves and anticipating defaults in the neighborhood of 20%, but we aren't at that rate yet. It stands to reason that the shakiest borrowers are defaulting now, as the effect of low "teaser" rates vanishes and they get their first mortgage bills reflecting higher long-term rates. But there are plenty more people barely able to make payments. Still, the percentage of defaulting borrowers should begin to ease off. With the Federal Reserve's short-term lending rate at 5.25%, almost as high as 10-year borrowing costs, lenders don't have much leeway to "tease" new borrowers with low adjustable-rate loans.

Defaults will work their way up the food chain to prime borrowers.

If you think those teaser rates, no-down-payment deals and other come-ons were limited to poor-credit borrowers, think again. Many of the stories about alleged subprime borrowers have described what seem to be solid middle-class people buying $500,000-and-up properties.

The real-estate slump may well worsen before it improves.

The low-end market is already being hit by foreclosures and fire sales. But that, too, will spread up the ladder as the ripple effect passes through the system. And as more affluent people default, their properties will come on the market, finally depressing the high end.

Any or all of these factors may further depress REIT prices. That said, I decided it's time to nibble, and last week I bought three mortgage REITs for my retirement account: American Home Mortgage, Thornburg Mortgage and Newcastle Investment. None has significant exposure to the subprime market. American has a broad portfolio of residential mortgages, but a very low percentage of subprime; Thornburg focuses on high-end, "super jumbo" residential mortgages; and Newcastle has a diversified, mostly commercial portfolio, with relatively limited exposure to residential loans. (Newcastle is run by Fortress Investment Group, the big hedge fund that has an equity stake in Newcastle.)

The triggers to buy were news reports that insiders at American and Thornburg were buying shares. If anyone knows the risks lurking in their portfolios, they should. The other was a report that Newcastle (along with some of the big Wall Street investment banks) was snapping up a package of subprime loans from a faltering subprime lender. When there's panic in a market, I want to be a buyer, not a seller. From a more technical standpoint, all of these REITs are off their recent lows and are no longer in free fall. Finally, there are the eye-popping yields: 9.95% (Newcastle), 10.45% (Thornburg), and 16.6% (American). Compare that with fixed-income alternatives.

James B. Stewart, a columnist for SmartMoney magazine and SmartMoney.com, writes weekly about his personal investing strategy. Unlike Dow Jones reporters, he may have positions in the stocks he writes about. For his past columns, see: www.smartmoney.com/wsj_common.

Email your comments to rjeditor@dowjones.com.