How analysts missed a meltdown

By Harry Domash

On Tuesday, shares of bankrupt American Home Mortgage Investment closed at 22 cents a share.

That's a far cry from the $34 or so American Home's (AHMIQ, news, msgs) shares were fetching on Jan. 26, when at least five stock analysts were advising buying the real-estate investment trust.

The day before, home-mortgage maker American Home had reported earnings for the quarter that ended in December of 3 cents above the consensus of analyst forecasts. And the company captivated analysts with its forecast of earnings from $5.40 to $5.70 per share in 2007, far above the $4.85 that analysts had expected.

So, on Jan. 26, Deutsche Bank changed its rating to "buy" from "hold" and upped its target price to $34.50 from $32.50. Not to be outdone, RBC Capital reiterated its "outperform" rating and raised its price target to $40 per share.

If you're not familiar with the terminology, "outperform" means "buy," and "market perform" translates to "hold," which many market pros interpret as advising to sell. So Wall Street was telling investors to buy these stocks at precisely the wrong time.

It wasn't the first time. But it was the type of bad advice that was supposed to be a thing of the past. Big investment banks paid billions of dollars to settle lawsuits earlier this decade after their stock-research analysts were alleged to be doing the bidding of their investment-banking arms. After that, their research was supposed to become more independent, less blindly positive and, well, just better.

However, it appears that that doesn't always happen, at least not in the case of American Home. In this instance, Wall Street analysts missed the boat. Below is a blow-by-blow account of how it came down. Did Wall Street analysts miss what should have been obvious sell signals? You be the judge.

Ignoring the facts

This episode unfolded against the backdrop of a collapsing residential-real-estate market. New-home sales were plunging, and, on Jan. 25, the same day that American Home issued its upbeat December quarter report, the news broke that used-home sales fell 8% in 2006 from the year before, the sharpest annual decline since 1989.

Since the company's business was making mortgage loans secured by single-family homes, you'd think that the health of the residential-real-estate market would be very relevant.

American Home specialized in a special type of mortgage called Alt-A loans (otherwise known as "liars' loans"). Unlike subprime loans made to borrowers with bad credit, Alt-A loans were generally made to borrowers with relatively good credit scores, at least as compared with subprime borrowers. The catch was that Alt-A borrowers didn't have to document their income, home values, how they obtained the money to make the down payment -- anything. As an Alt-A borrower, you could say that you took home $50,000 per month, if that's what it took to qualify for the loan, and not show any check stubs or tax returns to prove it.

As was the case with subprime borrowers, all was well as long as homes could be readily sold at ever-increasing prices. Of course, as everybody but the analysts seemed to know, by January 2007, this was no longer the case.

Nevertheless, on Jan. 31, Ryan Beck raised its advice on American Home to "outperform" from "market perform." American Home closed at $35 that day.

To their credit, on Feb. 16, analysts at Bank of America reiterated their negative outlook and advised selling most mortgage lenders, including American Home. However, Bank of America seemed like a voice in the wilderness.

Stubborn optimism

Only five days later, on Feb. 21, Friedman Billings, commenting on subprime lender NovaStar Financial's (NFI, news, msgs) disappointing December quarter report and guidance of little or no taxable income until 2011, reiterated its "outperform" rating on American Home. Friedman said American Home was a different story than NovaStar. Despite Friedman's support, American Home shares dropped $1.80 to $30.80.

AHM shares continued to drift down, and were changing hands in the $25 range by March 5, when AHM declared a $1.12 per share quarterly dividend. Inspired by the payout, RBC Capital reiterated its "outperform" rating the next day.

A few days later, on March 14, Lehman Bros. noted that after examining AHM's balance sheet, AHM was in a better position than other mortgage lenders to manage through this challenging environment.

On April 5, when AHM shares were still changing hands at $25 or so, Bear Stearns, one of the few heroes in this story, cut its rating to "underperform" from "peer perform." Translation: Bear Stearns cut AHM to "sell" from "hold."

Continued: Advice was timely

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