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Archive for August, 2009

Avoid Risk; Make Money.

Saturday, August 29th, 2009

Sometimes a single article can change my direction for publishing for an evening.  So it was for this article, Hedge Fund Keeps Reins on Risk.  I had not heard of Graham Capital Management until today, but given what I read, I like what they do — they focus on risk.

I am currently reading Eric Falkenstein’s book, Finding Alpha, and I am a little less than half through it, but he makes the point quite ably that the way to make money is to avoid risk, and that those that do avoid risk tend to do better than those that take a lot of risk.  I know that this is tough to understand for those that have bee indoctrinated by Modern Portfolio Theory, but I will phrase it my own way.  Take risk when you are paid to take it; avoid undercompensated risks.

Here’s the money quote from the WSJ story:

The firm’s risk manager Bill Pertusi leads a meeting at 9:30 a.m. each day in a large room in Graham’s 93-year-old Irish Tudor mansion. There, a group of seven or so people — always including Messrs. Tropin and Pertusi — discusses all aspects of risk: market risks, risks in individual traders’ portfolios and how they have changed since the day before, risks to the way the firm is investing its cash, counterparty risk — or risk that the firm on another side of a trade will fail, even evaluations of whether traders’ are in positions that are “crowded” with other hedge funds.

“I’m not aware of anyone who has a daily meeting just to talk about risk in the absence of talking about opportunity,” according to Leslie Rahl, managing partner of risk-management firm Capital Market Risk Advisors.

Graham requires managers of some of its funds to fill in a survey every Friday, answering the question: “How much money would we lose if you had to completely liquidate your portfolio in one, three or five days, in both normal and stressed environments?”

Risks are multi-dimensional, and a wise manager thinks through all aspects of his risks.

  • How creditworthy are my counterparties?
  • How readily can I convert my portfolio to cash if I had to?
  • What are my competitors doing?  Are my positions in strong hands or weak hands?  How many are making the same bet that I am?
  • Have the fundamentals of my positions changed?  Have the views of other major players in the market changed?
  • Has the time horizon of other investors alongside of me changed?
  • What cash flow yield am I likely to get, and how might that vary?
  • What should we do about major moves in the markets that we trade — go with the trend, or resist it, or ignore the move?
  • Am I implicitly taking the same bet through seemingly different  areas of my portfolio?

Limit the downside, and the upside will provide for you.  I am not saying to avoid risk, but to take prudent risks.

Now, I try to avoid making a lot of market calls, because those who do make a lot of calls are incautious at best.  I do believe that this is a time for caution with respect to the equity markets and the corporate bond markets.  I agree with Jason Zweig here, it is a time to trim risk positions.

On another front, consider illiquidity.  Taking on illiquid investments is a bet the the future will be very good; there will be no reason to liquidate funds.  This is why there should be a substantial yield or likely return premium for investing where there is no liquid public market.  The university endowments have stumbled here; they needed more liquidity than they thought.   So have pension plans, who aimed for high returns at the worst possible moment.

That said, some pension plans are taking money off the table in stocks in the present environment.  Good move, I think.  Even the venerable Value Line is recommending lower commitments to common stocks.

Human nature does not change, and that is what makes behavioral finance and value investing stronger.  As the market moves up, shorts cover, but greed and envy drive people to invest more in the hot sectors.

This is not limited to retail investors, though.  Even investment banks are getting into the act.  Add to the leverage and let’s take some sweet bets!  Devil take the hindmost!

I get it, and I don’t get it.  This is a time to decrease risk, even though I might be early.  The troubles of our financial sector are not solved.  Our consumers are still overleveraged.  I don’t see how we get sustainable decent returns on capital in the present environment, aside from stable sectors of the global economy.  Avoid risk; make money.

AIG is Dead; Long Live AIG!

Friday, August 28th, 2009

When Robert Benmosche was named CEO of AIG, I thought it was a good thing.  Ed Liddy, possibly tired of the abuse, wanted to move on.  Liddy was primarily skilled with personal lines P&C insurance, which was a small part of AIG, and has been sold off.  Benmosche’s skills extend to that — MetLife has a small personal lines subsidiary, but he has run the largest life insurer in the US.  AIG has grown to be as much a life insurer as a P&C insurer, having grown through the acquisitions of Sun America and American General.

Benmosche has his work cut out for him, and it may be an impossible task.  Quoting from today’s WSJ article:

As shares of American International Group Inc. continued to ascend Thursday, newly minted Chief Executive Robert Benmosche said he is taking a far more patient approach than his predecessor toward selling assets to repay the government.

He is willing to wait as long as three years, he said, to offer stakes in two multibillion-dollar foreign units that the insurer had been racing to spin off.

“It’s not a question of if, but when,” Mr. Benmosche said in an interview with The Wall Street Journal at his home here. “Once the market gives us a price that I think is fair, we can go forward. … If we sell too soon, everyone loses.”

And the money quote:

After analyzing all of AIG’s businesses, Mr. Benmosche said, he determined the company wouldn’t be able to repay the government even if it sold everything. But he suggested that if he can bolster the businesses before selling off units, the situation might improve.

“The sum of the parts are a little below the whole. The whole has to be big enough to pay back the government, and with a little hard work there will be something left called AIG,” he said.

Okay, so the value of the equity is zero, but maybe AIG can grow out of the situation with government aid, waiting for higher valuations to appear? The article continues:

In May, AIG said it planned to “accelerate” that process for one of the units, American International Assurance Co., which sells life insurance in Asia. AIG hired lead underwriters in June, and the IPO was scheduled for the first quarter of 2010; it was expected to raise more than $5 billion.

Similarly, in July, AIG said it planned to accelerate the IPO for the other unit, American Life Insurance Co., known as Alico, which also sells life insurance overseas.

It isn’t clear how much the businesses are worth, but their value has been eroded by the financial crisis and AIG’s problems. In February, AIG was said to be valuing AIA at $20 billion to $40 billion.

In the interview, Mr. Benmosche said current estimates for what the businesses would fetch were too low.

“That kind of price talk is ridiculous,” he said, without specifying what he considers a fair price. “I’ve told the government that if we have to sell them right now, we may not be able to pay back what we owe.”

Then come the following contradictory statements:


Mr. Benmosche said his primary goal is to repay as soon as possible the government support that is still allowing the company to operate.

“If the U.S. government doesn’t continue to support AIG, we will fail,” he said. “We have no right to use the government funding to make a profit; that is inappropriate.”

Yes, AIG would fail without US Government support. US Government support allows AIG to profit off of its relatively cheap funding base. Benmosche is delaying the sale of units previously slated for quick sale by the prior management, because if valuations recover significantly, there will possibly be some value to share among shareholders.

That’s a big if, though.  It is rumored, or rather, alleged by some insurance CEOs that AIG has been aggressively cutting prices in order to gain business for short-term liquidity reasons.  After all, if you were an employee of AIG, your largest incentive might be having your salary paid for a few more years, before the reserving catches up.  In the short-run, insurance reserving can be gamed.  The majority owner, the US Government, has little expertise with such matters.  Insurance is a black box to them.

What of AIG’s recent impressive rise in the stock price?  Impressive, huh?  Maybe.

What, that’s up over 400% from the nadir?  Wow.  What’s it down from the peak?

AIG five years

I’ll bet you don’t remember when AIG was trading over 1500.  Well, I do.  At my last firm, I sold our shares of AIG the day it entered the DJIA.  We got prices of over $75, which post the last reverse split, is over $1500 today.

This current rally is fueled by bullish comments from the new CEO, day traders who follow momentum (look at the recent rise in volume in the first graph, and short sellers buying in their positions.

Looking at the middle graph, short-covering isn’t that common yet through 8/14, but the rapid price move since then has likely had some shorts with weak balance sheets covering their trades.

This brings me to my last point regarding AIG for the evening.  Benmosche wants advice from Maurice Raymond “Hank” Greenberg.  I don’t know for sure, but I suspect that the two knew each other from their days as CEOs of NYC’s two largest insurers.  It wouldn’t surprise me if AIG offered to demutualize and buy MetLife; back in the early ’90s, we tried to do the same thing with The Equitable when it was in trouble.  AXA won because it was willing to bet on a real estate recovery, and AIG was not willing to take that chance.

Though Greenberg blames the woes of AIG on incompetent successors, I lay the blame at his feet.  If AIG was such a great company, how could it be undone in three years?  From the mid-1980s until 2005, leverage at AIG quadrupled.  ROE achieved the hallowed 15%/year target, but ROA sagged, which is a better measure for financial services firms.

My last issue here is the accounting.  It is rare for companies under financial stress to not have accounting that is liberal.  Firms with conservative accounting typically have management cultures that retreat when times are not conducive to low-risk profits.

AIG was an aggressive company during its glory days.  They have had their share of reserve restatements, and my own experience with AIG left me skeptical about their balance sheet.

The upshot here is simple.  AIG is a leveraged play on the financial sector.  If insurance company valuations rise far enough, AIG might have value.  AIG common is behaving like a warrant on the underlying assets.  But even at present levels, AIG common is worthless.  Sell it to the speculators, but watch your own balance sheet; even when a stock is likely to go to zero, it is difficult to manage a short position all of the way to extinction.

With that, be wary.  I still believe AIG common is still an eventual zero, but it will be very noisy between now and the end.  Complicating the matter is the asset inflation the Fed is trying to engender.  They want to bail out financial company balance sheets without creating inflation that the average person can notice.

AIG five years $75

Book Review: The Flaw of Averages

Thursday, August 27th, 2009

“Just give me the number, willya?”  Ugh.  I’ve had the question asked many times in my life working in or alongside financial reporting in a company.  They need a number for the budget, even though that number will certainly be wrong, leading to numerous explanations for why we are mistracking the budget.

The truth is though there will be one result for the question you ask prospectively, hypothetical answers will often systematically mis-estimate the result when average inputs are fed into models.

As I have experienced in the insurance industry many times, good companies accept feedback from claim experience  into new product pricing, and consider the potential downside risks.  Bad companies rely on industry tables (averages), and assume that downside deviations are just random.

Would we manage companies better if we shared data on how uncertain our estimates are?  Certainly, but the whole company would have to be geared toward understanding how to deal with risk and uncertainty.

Often there is option-like behavior in companies, where if sales are low, expenses will be cut back to a baseline level, but if they are high, expenses will run.  Average expense numbers rarely express the likely result.

Most people/companies assume that things will be stable.  If we look at projections of investment results, stability is the norm.  But our world is unstable.  There are booms and busts; there are wars.  Plans lose their validity when the real world appears.

“The Flaw of Averages” is a popular book on statistics.  It points out many ways in which statistics are abused.  This book will make you a skeptical and reasoned consumer of statistics.

Quibble:  My main difficultly with the book, is that much as the author tries to simplify the concept of complex simulations, is that in the ninth part of the book, he seems to overly encourage use of his own software.

Aside from that, the average reader will learn many ways that statistics such as averages can deceive.  As Benjamin Disraeli, once said, “There are three kinds of lies: lies, damned lies, and statistics.”  This book will help you avoid the last sort of lie.  I recommend this book.

If you want to buy it, you can buy it here: The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty

Full disclosure: All purchases from Amazon entering through my site give me a small commission.  Your price at Amazon does not change as a result of the commission.

Questions and Answers

Tuesday, August 25th, 2009

This may become a series, but I’m going to post some questions I have been asked, and the answers that I gave.  Anyway, here goes:

Has anyone prepared a summary of US Treasury bonds, say five years ago and now and looked at average maturity, etc.

GE was taken to task by the investment community in 2002-03 for using very short term money to fund long term lending/capital needs.  Was the investment community right?

Where is the US government right now – Are they playing the short end of the maturity ladder, if so what could be the reasons why and what are the implications for the investment community?

Thanks for all of your insight.

Average Maturity

This is a graph of the average maturity in months of the marketable portion of US Government debt.  Reagan really lengthened the debt, and Bush, Jr. shortened it.  (Just another bad legacy for that economic liberal, Bush, Jr.)  The most notable aspect of that was the elimination of the 30-year bond in 2001, and its subsequent reappearance in 2006.  The Obama Administration is not a known quantity in these matters yet.

The sharp drop from June 2008 to September 2008 I believe is due to the creation of a lot of short-dated debt that was given to the Fed to allow it to grow its balance sheet.

With respect to GE, yes, the lending community was right.  Prudent borrowers match assets and liabilities.  I recently criticized GE for borrowing with too much short-term debt for their finance arm.  As it is, GE has had a wild ride in its stock price, dipping below six this year.  Without the TLGP, who knows?  GE might have had to send GE Capital into insolvency.

In general, I have been an advocate of lengthening the maturity structure of the US government’s debts.  Governments are supposed to try to be permanent; thus they should finance long.  Governments like the generally lower cost of short debt, and so they sometimes finance shorter than they ought to in an effort to save money.  Governments that don’t finance long enough can be subject to runs, such as Mexico in 1994.

I hope the US government takes the opportunity to finance long while it is still cheap to do so.  My guess is that the opportunity gets wasted; not that the average maturity shrinks a lot, but that it doesn’t grow much.

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What does your husband say about this? Small investors don’t bother?

> http://money.cnn.com/2009/07/29/pf/steve_lehman_federated_investors.fortune/index.htm

This one came to my wife for me.  Quoting from the article, my response was:

>>So what’s a retail investor to do? Lehman’s answer: Leave it to the pros. “It’s never been more difficult [to invest],” he says, “and it will remain more challenging than ever. Unless someone really has a flare for investing and enjoys doing it, I would say don’t waste your time.”<<

Small investors should probably use low cost index funds and vanilla Exchange Traded Funds.  That will lower their costs, which will raise their returns.  It is rare for outperformance to persist in funds management, particularly as the funds under management for any manager grows.  There are some value managers that are worthy of being invested in over the long haul for equities, and if you want a list, I will provide one.

David

PS — to the editors at Money — “flare” s/b “flair”

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We have a certificate of deposit that we are cashing out and are wondering if buying some gold would be a better way to protect our savings? Considering the way the government is spending money, it seems the only way to be safe from the inflation that is coming.

This is a tough one. A lot depends on whether the government inflates their way out of this or not. I almost think they have to, but they could have done it in the Great Depression/WWII, and did not. They raised taxes, and the best investment was government bonds for a long while.

This situation is probably different. Gold will preserve purchasing power over the long haul, but it rarely does more than that. Sometimes, that’s the best you can do.

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I don’t have a good place to post this last bit, so here it goes: here is a recent audio interview of me. I only wish we had focused more on investing topics. For those interested, I had my notes in front of me, which cited a number of my articles.

Full disclosure: I don’t own any gold, aside from my wedding band.

Three Notes on the Federal Reserve and Financial Services Reform

Tuesday, August 25th, 2009

As I have said before, it doesn’t matter who the next Fed Chairman is, because all of the candidates are basically the same when it comes to monetary policy.  There are no hard money candidates.  So, with the announcement that the reappointment of Ben Bernanke is likely, we can all breathe a sigh of relief because Larry Summers won’t be there (ego kills), and, Ben Bernanke is a known quantity.

On another front, a Federal judge ruled that the Fed would have to turn over data requested by Bloomberg, LP, regarding the emergency lending programs that the Fed has entered into.  Good thing, as I have said before, there is no reason why banks can’t disclose their asset books as insurers do.

Finally, Paul Volcker wants to regulate money market funds like single purpose banks.  Interesting idea, but money market funds have suffered far fewer losses than regulated banks.  I would pass on this idea, and look for more substantive ways to modify the financial system — as an example, make banks as transparent and complete in their regulatory filings as insurance companies.  Now, that would be real reform.

Book Review: Making Sense of the Dollar

Tuesday, August 25th, 2009

Many people think in non-systematic terms.  They consider the US current account deficit to be an unmitigated disaster.  They look at one side of the issue and conclude that the US has become less competitive.

Understanding accounting, the books must balance.  Not everyone can run a current account surplus.  Some countries must run deficits in order to purchase goods from those that run surpluses.  Capital account surpluses balance out current account deficits; net foreign investment fills the gap.

Marc Chandler, with whom I became acquainted while writing for RealMoney, has written a book for the average reader to explain the basics of international economics and foreign exchange.  The book deals with common myths that arise in the discussion of trade and currencies.

Why do we lose industrial jobs in the US?  It’s not foreign competition, though that may occasionally play a role when countries subsidize their industries.  We lose industrial jobs because of technological improvements that require less labor in the manufacturing processes.  As I have said, Nucor was a bigger risk to the rest of the steel industry than foreign competitors.

Chandler is a proponent of the turn-of-the-century Open Door Policy, which led the US to be more free market capitalist than the rest of the world, gaining influence through trade.  Together with military victories, this led the US to be the world’s dominant economic power post-WWII.  Given the change in currency regimes, this made the US Dollar the leading reserve currency in the world.

Aside from military superiority, and political calm,  labor market flexibility and a culture of innovation have made the US dominant in global economic affairs.  As I have sometimes said, if the world did not have America, it would have to invest one.  Where else would all of the spare labor, capital and goods go?

There are advantages to being the world’s reserve currency.  The US runs current account deficits, and other nations buy our debts.  Such a deal; every nation should want this (but, as we learn, it is likely only one nation can have this at a time).

Capital flows are much larger than trade flows; it should be no surprise that the US Dollar does not react to the current account deficit.

(An aside: when I was in Grad School, the idea that interest rates drove currencies through arbitrage was new, and gaining favor.  Since then, a blend of the interest rate markets and goods markets driving currencies is the dominant paradigm, with momentum thrown in.)

Chandler deals with these issues, and other myths that plague the discussions around international economics and the currency markets.  In general, I agree with his views, but with a few quibbles/additions:

  • It is not costless for countries to run current account deficits.  Countries that run current account deficits have to offer attractive opportunities for foreigners to invest in their country, or suffer declines in the value of the currency.
  • The country taking the non-economic action will eventually pay the price.  Whether hoarding gold in mercantilism, or neo-mercantilism, hoarding US debt assets, whether Japan in the late ’80s or China today, the nation forcing the issue gets hurt more.  China will suffer for over-promoting growth of exports.
  • It would be reasonable to have a gold standard once more — the trick is setting the initial price level, so that it would not be inflationary or deflationary.
  • It would have been nice to offer retail investors some theory to explain how currencies move, rather than just dispel myths.  That said, there probably is no such theory, and if it exists, ordinary people probably could not understand it.

Absent my quibbles, on foreign currency Marc Chandler knows far more than me.  If foreign exchange and trade is of interest to you, you will benefit from this book. One more note: this is not a technical book with lots of math, and there is no technical analysis on its pages.

If you want to buy the book, you can buy it here: Making Sense of the Dollar: Exposing Dangerous Myths about Trade and Foreign Exchange

Full disclosure 1: I actually read the books that I review.  Many reviewers don’t.  They read the stuff the PR flack sends along, and read a chapter or two, and write the review.  I throw away what the PR flack sends before I read the book.  I give you my own opinion on the matter, nothing more, nothing less.  Finally, if you enter Amazon through my site and buy anything, I get a small commission.

Full disclosure 2: long NUE

Fusion Solution: The Stable Value Fund Guide to Commodity ETF Management

Friday, August 21st, 2009

This piece is one of my experiments where I try to straddle two different investment worlds in an effort to bring more understanding.  The two world are stable value funds and commodity ETFs.

Commodity ETFs have a hard job, in that they are supposed to replicate the returns on spot commodities.  Given the difficulty of storage, only a few commodities — gold and silver, can be physically stored — they don’t deteriorate.  Unlike government promises, they are uniquely suitable for being money.  (Sorry, had to say that.)

Other commodities require futures markets or off-exchange markets where swaps get traded.  The swaps introduce counterparty risk, which is a common risk in many currency and commodity-linked funds.  I’ve written about that before, along with criticisms of exchange-traded notes.

One of the problems that some commodity open-end funds and ETFs run into is that their investment strategy is too simple.  “Buy the front month futures contract, and roll to the second month contract before the front month expires.”  Nice, it should replicate holding the commodity itself, until a large amount of money starts to do it, and other investors recognize what a slave the funds are to their strategy.

So, what do the other investors do?  They take the opposite side of the trade early, in order to make it more expensive to do the roll.  Buy the second month contract, and short the first.  As the first gets close to maturity, cover the first, sell and then short the second, and go long the third month contract.  What a recipe to extract value out of the poor shlubs who buy into a commodity fund in order to get performance equivalent to the spot market.

Compounding Money Slowly

If you want to keep your money safe, and earn a little bit, what should you do?  Invest in a money market fund.  “Wait a minute,” some intrepid investor would say, “I can do better than that.  I don’t need all of my money for immediate liquidity.  I can ladder my funds out over a longer period.  I can invest surplus funds out to the end of my period, and earn a better yield, and over time, my funds will mature bit by bit.  I will have liquidity in a regular basis, and I will get a higher yield because yield curves slope up on average.”

Leaving aside the wrap agreements that a stable value fund buys, stable value funds build a bond ladder with and average maturity of 1.0 to 4.5 years.  Commonly, it averages around 2.0 years.

The funds could invest everything short and give up yield.  That would give them certainty, but lose yield.  That is what the commodity funds are doing.

What could go wrong?  There could be a large demand to withdraw funds when longer-dated contracts are priced below amortized cost, and the fund might not be able to meet all withdrawal requests.  So far that has not happened with stable value funds.

The Fusion Solution

Whether in war or in business, it is not wise to be too predictable; opponents will take advantage of you.  In this particular example, I would urge commodity funds to look at their liquidity needs over the next month, and leave an amount maturing in the next three months equal to 4-6x that amount.  Then spread the remainder of funds according to advantage, looking at the tradeoff of time into the future versus yield of the futures contracts versus spot.  Longer dated futures do not move as tightly with the spot markets, but they often offer more yield.

Ideally, a commodity fund ends up looking like a bond ladder, and as excess funds mature, they don’t get invested in the new front month contract, instead, they get invested in the longer dated contracts, near the end of the ladder, as a stable value fund would do.

This maximizes returns for the bond/stable value funds, and I believe it would work for commodity funds as well.  Please pass this on to those who might benefit from it.

A Closing Aside:

Back in the late 90s, I ran one of my interest rate models to try to determine what the best investment strategy would be.  I found that the humble bond ladder was almost always the second best strategy, regardless of the scenario, because it was always throwing off cash that could be reinvested out to the end of the ladder.

Again, please pass this along, and commodity fund managers that don’t get this, please e-mail me.  I will help you.

Return of the “Carry Trade”

Thursday, August 20th, 2009

The idea of a carry trade is simple.  Borrow inexpensively, and invest at a higher yield.  Make money.

Too easy you say?  Right.  Usually something has to be compromised for a carry trade to work, usually betting on lower rated credits performing, or currencies not moving against those borrowing in a low interest rate currency, and investing in a high interest rate currency.  Or, borrow short and lend long when the yield curve is steep, hoping the situation will correct with the long yield coming down, rather than a 1994 scenario, where short rates outrace long rates higher.

Carry trades blow up during times of high volatility, which typically have high yield bonds or countries seeming to be more risky than usual. Carry trades return when times are quiet, allowing placidity to clip yield.  As the WSJ has commented, that time is now, and the carry trade has returned.

I’m going to use the Japanese Yen as my example here.  Because of the chronically low interest rates there, it is a favorite currency for borrowing, and using the money to invest in higher yielding currencies.

That’s the yen over the last five years.  Wish I could have gotten option implied volatility over the same period, but I got nearly the last two years here, by using the CurrencyShares Yen ETF:

You can see how option implied volatility peaked in late October of 2008.  At that time, with the strength of the yen, which would not crest until mid-December, there was a rush to buy protection against the rising yen, because those with carry trades on were losing money, and wanted to get out.  Momentum carried the yen for another six weeks.

After significant fury, the implied volatility settled out at a baseline level, and the carry trade returns because conditions are more placid.  Implied volatility and the currency have stabilized for now.

As another example. consider this:

The Powershares DB G10 Currency Harvest Fund [DBV] borrows in the three lowest yielding currencies of the ten countries that it tracks, and invests in the three highest yielding.  This is the perpetual carry trade fund.

Note the plunge into October/November 2008.  High yield currencies were getting killed, and low yield currencies were rallying.  Since then, the performance of DBV has improved.  Why?  The currencies are more placid, so clipping excess yield makes sense to some in the short-run.

And so it will be until the next big implied volatility explosion occurs.  Carry trades don’t offer significant profits across a full cycle, but can profit those who time it right, few as those people are, and matched by those who lose.

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PS — Sorry for not writing about commercial mortgages, as I said I would.  I will get to it soon, but I have been hindered by personal issues.

Nine Notes on Residential Real Estate

Saturday, August 15th, 2009

I don’t really have one unified article type when I write here.  Sometimes I have a really strong conviction about something, and then it flows.  At other times, I gather data, do an analysis, and come up with a way of motivating it.  Then there are the Seven, Eight, Ten, Twelve, Fifteen, Twenty Points/Notes/Comments articles.  Tonight’s piece is one of those.

(An aside — the numbers stem from a comment from an editor of a Canadian business publication — he told me that certain numbers grab people’s attention more.  True?  Not sure.  I do know that one of my editors at RealMoney felt that some of my quirky titles lost readership.  Even today, my editor at SA freely revises my titles, sometimes making something an emphasis that I had not intended.  Whatever; she titles better than me.  What intrigues me is that other sites sometimes pick up her title, not mine, even when they link directly to my blog.)

I don’t do linkfests.  I don’t do them not because they are not valuable, but because others do them better then me, like Abnormal Returns.  So, I do something different.  As I troll the web each day, I tag articles for future comment.  I then wait until I have a critical mass of articles on a given topic, and then I publish one of the “XX Points” articles.  This enables a greater range of facets on a given issue.  I also allows me to give more of an integrated explanation of how I think it all fits together.  Now, the price is that some of the articles are dated.  I think they are fresh enough to highlight trends.

Enough explaining.  On to tonight’s topic, real estate and its effect on the real and financial economies.

1)  Principal forgiveness — it is what underwater homeowners want, and what they are unlikely to get.  Principal forgiveness means that a loss has to be taken by someone now.  Adjust the rate, adjust the term, adjust the amortization — it is all tinkering, even if it lowers the payment slightly, because the owner is still inverted on his mortgage.

Ideas like lowering the principal, but giving the bank a large chunk of the price appreciation at sale, or say 30 years out, would be cute, but still, the bank (or juniormost MBS certificate holder, who usually directs the servicer) would take a loss now.

So, I’m not surprised when I read articles like these:

Governments have power, but it is very difficult to fight the economics of the situation.  One further note, as is mentioned by a few of the above articles, is that the most profitable situation for the lenders/servicers, is that the property teeters on the edge of solvency, not only paying the mortgage slowly, but pays additional fees in the process.

2)  Will there be a second foreclosure wave?  Maybe.  First American CoreLogic argues that it will be the existing wave continuing.  I tend to agree with CoreLogic for the following reason: when you have enough of the mortgaged homes of the country underwater, it is difficult to slow the rate of foreclosure, because foreclosures happen to properties that underwater where one of the following occurs:

  • Death
  • Divorce
  • Unemployment
  • Disability
  • Disaster
  • Strategic default (buy a nicer home cheaper, and stop paying off this overpriced garbage)
  • Debt reset/recast

3)  The GSEs, despite the rally, are still in lousy shape.   Fannie lost $14.8 Billion, and tapped the Treasury for liquidityFreddie earned less than $1 billion, but only because they revalued assets $5 billion higher.  Their regulator believes that they won’t be able to repay all aid that the US has granted them.  My verdict: the common of each company is an eventual zero.  Stay away.  Thrillseekers that like zero shorts, don’t do it; the odds are good for a zero, but the payoff is asymmetric.

4)  What percentage of homeowners are or will be upside-down or underwater?

I favor the estimates of First American CoreLogic.  First, they have great data.  Second, my view is that properties with greater than 90% LTVs are likely upside-down in a sale due to closing costs.  The inflection point in mortgagee behavior occurs between 90-100% LTVs, not at 100%+.

That’s why we are in such deep trouble.  With 32% of all mortgages inverted, there will be many more foreclosures, and prices should still head downward, even on the low end.

5)  But maybe things aren’t so bad, at least on the low end.

6)  All that said, the high end isn’t seeing much action, and prices continue to sag.  There aren’t many move-up buyers.

7)  What characterizes the underwater borrower?  Cash-out refinancing, and home equity loans.  The home as an ATM always relied on the “greater fool” theory implicitly — that there would always be a greater fool willing to buy out the home at a greater price than the new amount of leverage.  On the home equity loans — banks are doing all that they can to avoid recognizing losses.  With home equity loans, losses are usually total.  The only thing that surprises me here is that it has taken this long to get to realizing the losses.

8 ) So you want appraisers to be honest, but not yet?  Appraisers, auditors, etc. — third party evaluators are conflicted — he who pays the piper calls the tune, and no one is willing to have the buyer pay for the appraisal.  So now the appraisers try to be honest and business can’t get done?!  Those who hire appraisers, make up your minds; do you want a few short term deals, or do you want reliable long term business?

9)  On the dark side, many option ARMs will default before the payments recast.  That means the recast wave will be more gradual, but it won’t be any less troublesom in aggregate.

That’s all for this evening.  Absent something else pressing, I will write about commercial real estate on Monday night.

Ten Unsolved Problems in the Global Economy

Saturday, August 15th, 2009

There are many celebrating the recovery as if it were already here.  This is a brief post to outline my main remaining concerns for recovery of the global economy.

1)  China is overstimulating its economy, and forcing its banks to make bad loans.  This pushes up commodity prices, and makes it look like China is growing, but little of the investments made are truly needed by the rest of the global economy.

2)  Western European banks have lent too much to Eastern European nations in Euros.  The Eastern Europeans can’t afford it, and widespread defaults are a possibility.

3)  The average maturity of bonds held by foreign investors in US Treasuries is falling.  Runs on currencies happen when countries can no longer roll over their debts easily, which is facilitated by having a lot of debt to refinance at once.

4)  On a mark-to-market basis, market values for commercial real estate have fallen dramatically.  Neither REIT stocks nor carrying values for loans on the books of banks reflect this yet.  Many banks are insolvent at market-clearing prices for commercial real estate.

5)  We still have yet to feel the effects from pay-option ARMs resetting and recasting.  Most of the pain in residential housing is done, but on the high end, there is still more pain to come, and the pay-option ARMs will reinforce that.

6)  The rally in corporate debt and loans was too early and fast.  Conditions are not back to normal for creditworthiness.  There should be a pullback in corporate credit.

7)  We had global overbuilding is cyclical sectors 2002-2007.  We overshot the demand for large boats as an example.  We overdeveloped energy supplies (that will be short-lived), metals, and other commodities.  It will take a while to grow into the extra capacity.

8 )  The US consumer is still over-levered.  It will be a while before he can resume his profligate ways, assuming a new frugality does not overcome the US.  (Not likely by historical standards.)

9)  The Federal Reserve will have a hard time removing their nonstandard policy accommodation.

10)  We still have the pensions/retiree healthcare crisis in front of us globally.

That’s all.  To my readers, if you can think of large unsolved problems in the global economy, forward them on to me here in the comments.  If I agree, I will incorporate them in future articles.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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