1. So Moody’s tries to clean up its act, and finds itself shut out of rating most Commercial Mortgage-backed Securities [CMBS] deals? That’s not too surprising, and sheds light on the value of ratings to issuers and buyers. With issuers, it’s easy: Give me good ratings so that I can sell my bonds at low yields. With buyers, it is more complex: We do our own due diligence — we don’t fully trust the ratings, but they play into the risk management and capital frameworks that we use. We like the bonds to be highly rated, and misrated high even better, because we get to hold less capital against the bonds than if they were correctly rated, which raises our return on capital. Moody’s was always in third place behind S&P and Fitch in this market, so it’s not that big of a deal, but I bet Moody’s quietly drops the change.
2. The yields on loans are not only going up for LBOs like Archstone, leading to further deal delays, but yields are also rising on commercial real estate loans generally. Here is an example from one of the big deals. The risk appetite has shifted. Is it any surprise that equity REITs are off so much since early March? The deals just can’t get done at those high cap rates anymore.
3. An old boss of mine used to say, “Liquidity is a ‘fraidy cat.” It’s never there when you really need it, and with residential mortgage finance now, the ability to refinance is being withdrawn at the very time it is needed most. What types of mortgages are now harder to get? No money down, Jumbo loans, Alt-A, more Alt-A, and you don’t have to mention subprime here, the pullback is pretty general, with the exception of conforming loans that are bought by Fannie and Freddie. For (perverse) fun, you can see how detailed the guidance to lenders can become.
4. Should it then surprise us if some buyers of mortgage loans have gotten skittish? No, they forced the change on the originators. A buyers strike. But maybe that’s not the right move now. Let me tell you a story. When I came to Provident Mutual in 1992, the commercial mortgage market was in a panic. The main lines of business of Provident Mutual, hungry for yield, had accepted low-ish spreads from commercial mortgages from 1989-1991, because it improved their yield incrementally. The Pension Division avoided commercial mortgages then, because they felt the risks were not being fairly compensated. In 1992, the head of the commercial mortgage area came to the chief actuary of the pension division, and told him that unless the Pension Division bought their mortgage flow, they would have to shut down, because the main lines couldn’t take any. The chief actuary asked what spreads he would get, and the spreads were high — 3% over Treasuries, much better than before. He asked about loan quality, and was told that they had never had such high quality loans; only the best deals were getting done because of the panic in the market. The chief actuary, the best actuarial businessman I have ever known grabbed the opportunity, and took the entire mortgage flow for the next two years, then stopped. (Saving the Mortgage Division was icing on the cake.) Spreads normalized; credit quality was only average, and the main lines of the company now wanted mortgages. The point of the story is this: the firms that will do best now are not the ones that refuse to lend, but the ones who lend to high quality borrowers at appropriate rates. It’s good to lend selectively in a panic.
5. Eventually the ARM mortgage reset surge will be gone. Really. We just have to slog through the next two years or so. This will lead to additional mortgage delinquencies and defaults. We’re not done yet. There is a lot of mis-financed housing out there, and unless the borrowers can refinance before the fixed rate period ends to a cheap-ish conventional loan, I don’t see how the defaults will be avoided. Remember houses are long-term assets. Long term assets require long-term financing. Floating rates don’t make it. Non-amortizing loans don’t make it.
6. Should it then surprise us that the downturn in housing prices is large? No. With all of the excess supply, from home sellers and homebuilders, current prices are not clearing most of the local real estate markets, and prices need to fall further. (Maybe we should offer citizenship to foreigners who buy US residential real estate worth more than $500,000. A win-win-win. Excess supply goes away. Current account deficit reduced. Wealthy foreigners get a safe place to flee, should they need it. )
7. As a result, the homebuilders are doing badly. They aren’t making money on the hgomes they build and the value of the land (and land options, JVs, etc.) that they bought during the frenzy is worth a lot less. Sunk costs are sunk, and though you lose money on an accounting basis, in the short run, it is optimal to builders to finish developments that they started.
8. Could I get John Hussman to like this Fed Model? It’s from the eminent Paul Kasriel, and it compares the earnings yield of residential real estate and Treasury yields, and he suggested in early June that residential real estate was overvalued. There are limitations here; no consideration of inflation and capital gains, no consideration of the spread of mortgage yields over Treasuries. The result is clear enough, though. Don’t own residential real estate when you can earn more in Treasuries than you can in rents. (I know real estate is local, frictional costs, etc., but it does give guidance at the margins.)

Over the past seven years, my broad market strategy done well against the S&P 500. I reach the seven year anniversary at the end of August, and should business prospects require it, I will get the results audited. But since the start of the quarter, the strategy has not done so well, trailing the S&P by a little less than 4%. Why have the results been so bad?

My portfolio has concentrations in a number of areas. I have a slight overweight in financials (though only one company affected by the current crises), a large overweight in energy, and an overweight in cyclicals, though cyclicals targeted at foreign demand, not US demand. These areas have underperformed, and so have I. Industries are 60% of the performance of the market in my opinion, so when you run a portfolio that concentrates industries, there will be periods of underperformance.

Value is out of favor at present as well. My approach is “all cap” value; I don’t care about the size of companies that I buy. I’m only 2% or so behind the Russell 1000 Value, but I am more than 4% ahead of the Russell 2000 Value. Small cap value has gotten smashed, and I am a partial casualty along with it.
So, maybe I’m not doing that badly. What I do at times like this is to try to identify the factors leading to underperformance and ask whether those factors are likely to persist for a year or more. Let me go through my major exposures, updating what I wrote previously:

1. Energy — Integrated, Refining, E&P, Services, Synfuels. I am still a bull here; we aren’t finding enough energy supplies to meet the needs of our growing world. (15%)
2. Light Cyclicals — Cement, Trucking, Chemicals, Shipping, Auto Parts. These areas are undervalued, given the way our world is growing. (20%)
3. Odd financials — European banks, an odd mortgage REIT [DFR]. Largely insulated from the credit crises, and cheap. (10%)
4. Insurance — AHL, AIZ, SAFT, and LNC. All of them cheap, and with good earnings prospects. (10%)
5. Latin America — SBS, IBA, GMK. All are plays on the growing buying power in Latin America. (8%)
6. Turnarounds — SLE, JNY. Give them time; Rome wasn’t burnt in a day. (5%)
7. Technology — NTE, VSH. Stuff that is not easily obsoleted. (5%)
8. Auto Retail — LAD, GPI. Out of favor. (5%)
9. Cash (15%) — 5.25%/year is not bad.

That’s 93% of my broad market portfolio. Three other miscellaneous companies make up the rest. You can find the complete portfolio here.
After writing this, my tentative conclusion is that my methods still work, but that I am fighting temporary setbacks from value being out of favor, and from financials getting taken out and shot, even if there is no connection to the current credit crises. Therefore I soldier on, trusting the methods that have brought me this far.

Full disclosure: long LAD GPI NTE VSH SLE JNY SBS IBA GMK AHL AIZ SAFT LNC DFR

During the tightening era, a number said that the Federal Reserve Open Market Committee [FOMC] would telegraph their views through Greg Ip of the Wall Street Journal. If so, today’s article should be a concern to those favoring the view that the FOMC must loosen in order to keep the speculative frenzy going preserve the integrity of the markets. Leaving aside the issue of whether it is even desirable to have any intervention in the market, such as Fannie and Freddie buying more mortgage loans, it seems like the debate has shifted to the question of encouraging moral hazard, something foreign to Alan Greenspan, who thought he could micromanage monetary policy.

The consistent throwing of liquidity at crises lulled investors into complacency over financial risk. Economies work best in the long run when risk-taking is moderate, not absent or crazed. It is good to have a bear market every now end then; it keeps investors honest. It is even good to allow failures of financial institutions, particularly risky ones at the fringe of the financial system for the same reason. Financial firms are opaque by nature, and investors should be skeptical of those furthest out on the risk spectrum, particularly when credit spreads are tight.

To those who favor using monetary policy to bail out dud (primarily) non-banks, I say two things: first, are we capitalists only for our profits and not for our losses? Are we the hypocrites who privatize our gains and socialize our losses? Second, it’s not in the FOMC’s charter. Alan Greenspan violated the purposes of the FOMC when he used it for any thing other than low inflation, low unemployment, and preservation of the portion of depositary financial system overseen by the Federal reserve.

Score me in the camp that sees no substantive change in the FOMC’s direction, but sees a nod in the statement toward the current troubles, and a little more in the minutes, but keeps the focus on inflation. I still don’t think the FOMC is moving in 2007.

When I do a review of links, I try not to do a linkfest, as much try to share my ideas, while annotating places where you can get more data.  I keep topical clipping folders.  Today’s review is on the Great Substitution of Equity for Debt, Formerly Led by Private Equity.  Usually I organize by subtopic when I write, but tonight I will do it by time, because it took me seven weeks to get back to this, and a lot has happened over those weeks.

Go back to mid-June.  10-year Treasury rates were challenging 5.25%.  Rates all over the world had risen, and some predicted they would go higher, and choke off the private equity boom.  In hindsight, not a good argument, not because Treasury yields fell, but because junk credit spreads are more critical to private equity than treasury and high-grade yields.  In the short run, junk debt yields don’t react much to Treasury yields.  So most didn’t worry at the time.

Give Andy Kessler credit for timing. He expresses skepticism for private equity before Blackstone comes public, suggesting that all they do is borrow money against the assets of the target companies, and then foist them on the retail public later.  Well, that’s not all of what private equity does, but to a first approximation, that’s 90% of the deal.  He takes both sides of the issue, suggesting that conditions are stretched from a valuation standpoint, but suggesting that the insanity could go on for a while longer.

Failed deals often represent turning points, and by the end of June, both Thomson Learning and US Foodservice pulled their debt deals. The appetite for yield had diminished considerably, versus the need to protect capital.

In the short run though, the market is bouncy, and more deals piled up into early July, even as junk spreads began to widen.  I love the closing quote in this WSJ article: “It’s all worth keeping in mind as the market hits its rough spots. Roger Altman, chairman of Evercore Partners points out, for instance, that by any historical measure, the interest rates for junk bonds remain very cheap.  Barring a very steep climb in rates, Mr. Altman says, private equity ‘is a permanent feature of the capital markets. Nothing foreseeable can change that.’”  Mr. Altman is a bright man, no doubt, but turning points are only clear in hindsight.

Now, 2007 had already surpassed 2006 for private equity deals. Maybe completed deals are another issue.  Going to something more mundane, Mark Hulbert points out some research showing that companies that buyback their stock outperform the market.

By mid-July sentiment was definitely shifting in the debt markets, even as the equity markets rose.  More deals were having trouble getting done.  The willingness of lenders to take risk was declining, particularly on PIK bonds and Toggle notes.  Personally, I find it amazing that high yield investors buy instruments that may not pay interest in cash, given the dismal credit experience of such structures.  What would you expect from a company that doesn’t have enough money to make interest payments in cash?

The next article is a vision of the future. Five or so years from now, who will buy all of the new IPOs generated from today’s flood of private equity?  Then again, with the over-borrowing to make deals work, maybe not so many will come to market in the future, at least, not at the size that they left.

Take a look at the seven bad times to buy equities from John Hussman.  The last five of them came at times when the “Fed Model” would have told you to be in bonds.  The first two were close, but in the long haul, one was better off holding common stock through the declines.

By mid-July, we are a little past the recent peak, and buybacks are taking the place of LBOs in the market for shrinkage of the supply of equity.  With investment grade bond yields falling from mid-June, it seems like a reasonable thing to do.

I would never want to be a dedicated short investor.  Shorts are perpetually short the capital structure option, which the equity holders can exercise to lever up, when it is to their advantage to do so.  In this article, the difficulties of being short are explained, with the risks of private equity buyouts, and getting crowded out by naive shorts running 130/30 funds.  Jim Griffin at RealMoney takes an allied approach, suggesting that with equity getting replaced by debt, that equities are possibly a good deal here.

With rising junk spreads in the credit markets, by late July the buyer of choice for takeovers had become investment grade corporations because they could finance the purchase cheaply.  Private equity had gone quiet.  Things were bad enough, that investment banking bridge lenders wondered whether it wouldn’t be cheaper to drop out and pay the breakup fee on Texas Utilities rather than fund the deal personally.  The potential losses from many deals were mounting at the investment banks.  46 deals had been pulled, versus zero in 2006.

So private equity is dead now, right?  I see it more as a sorting process.  Deals that make economic sense at higher lending rates will get done, and those that don’t make sense will be funded by the investment banks, or shelved for now, depending on the bridge lending deal terms.  It won’t be as big of a force in the market, but buybacks among investment grade corporations will continue to shrink the overall equity supply of the market for now.  I am still a moderate bull on the equity market.