Let me start off with two Columnist Conversation posts that talk about crowded trades:

		David Merkel
		When Is a Trade Crowded?
		8/9/2006 9:35 AM EDT

At the end of every day, every asset is owned by somebody. If you want to count in the shenanigans that occur as a result of shorting (naked or legal), those are a series of side bets that do not change the total number of shares/bonds outstanding. (I.e., if legally, shares get borrowed. Naked shorting creates a liability at the brokerage for the shares that should have been borrowed.)

So how can a trade be crowded? It comes down to the character of investors in the given stock or bond. A trade will be crowded if those owning the asset have a short time horizon that they are looking to make money over.

My example of the day is the run-up in financial stocks while waiting for the Federal Open Market Committee to pause. Financial stocks ordinarily don’t do well when the FOMC tightens, but from the time of the first tightening until now, they have returned 10%-11% annualized. There still are a lot of people betting that things will get a lot bettr for depositary institutions now that the FOMC is (in the eyes of some) done tightening.

Even if the FOMC is done tightening, as Bill Gross thinks (Who cares that he has been wrong since tightening number 5?), the yield curve needs to steepen by about 75 basis points from twos to tens before the lending margins of banks are no longer under pressure from the shape of the yield curve.

Maybe once we get our first loosening, I’ll be more constructive on lending institutions, but as for now, I am steering clear. There are too many parties that believe that the FOMC is done and too many trying to profit from the rebound that “has to happen” in lending-based financials when the FOMC is “done.”

Position: None.

		David Merkel
		Make the Money Sweat, Man! We Got Retirements to Fund, and Little Time to do it!
		3/28/2006 10:23 AM EST

What prompts this post was a bit of research from the estimable Richard Bernstein of Merrill Lynch, where he showed how correlations of returns in risky asset classes have risen over the past six years. (Get your hands on this one if you can.) Commodities, International Stocks, Hedge Funds, and Small Cap Stocks have become more correlated with US Large Cap Stocks over the past five years. With the exception of commodities, the 5-year correlations are over 90%. I would add in other asset classes as well: credit default, emerging markets, junk bonds, low-quality stocks, the toxic waste of Asset- and Mortgage-backed securities, and private equity. Also, all sectors inside the S&P 500 have become more correlated to the S&P 500, with the exception of consumer staples.

In my opinion, this is due to the flood of liquidity seeking high stable returns, which is in turn driven partially by the need to fund the retirements of the baby boomers, and by modern portfolio theory with its mistaken view of risk as variability, rather than probability of loss, and the likely severity thereof. Also, the asset allocators use “brain dead” models that for the most part view the past as prologue, and for the most part project future returns as “the present, but not so much.” Works fine in the middle of a liquidity wave, but lousy at the turning points.

Taking risk to get stable returns is a crowded trade. Asset-specific risk may be lower today in a Modern Portfolio Theory sense. Return variability is low; implied volatilities are for the most part low. But in my opinion, the lack of volatility is hiding an increase in systemic risk. When risky assets have a bad time, they may behave badly as a group.

The only uncorrelated classes at present are cash and bonds (the higher quality the better). If you want diversification in this market, remember fixed income and cash. Oh, and as an aside, think of Municipal bonds, because they are the only fixed income asset class that the flood of foreign liquidity hasn’t touched.

Don’t make aggressive moves rapidly, but my advice is to position your portfolios more conservatively within your risk tolerance.

Position: none

The concept of a crowded trade is simple.  Trades are crowded when those that hold the assets in question have short time horizons.  This can happen for a variety of reasons:

• The trade could have negative carry, i.e. you have to pay to keep the trade going (e.g., shorting a high-dividend stock).
• The investors holding the assets are predominantly momentum-driven.
• The investors bought the assets using borrowed money. (or, sold short…)
• There is an event expected to take place that will provide liquidity (e.g., a buyout); woe betide if it doesn’t happen.

Now, some will look at crude oil and other hydrocarbons and say that the trade is crowded.  Though I am now finally underweight the energy sector for the first time in seven years, I’m not sure it is a crowded trade.  The financing of the sector is pretty strong, and valuations are reasonable, discounting an oil price of around $80 or so.

What I do think is a crowded trade is residential housing, and commercial property as well.  A little over three years ago I wrote a piece called, Real Estate’s Top Looms. It had all the marks of a crowded trade:

• Lots of leverage, with much of it short-dated (Option ARMs, 2/28, etc.)
• Momentum buyers (and the get rich quick books)
• Negative carry for investors (capital gains must happen in order for the purchase to work)
• Much reliance on the “greater fool” that would buy the property from the new owner.
• A high proportion of investors to owner-occupiers

It is still a crowded trade today.  There are excess homes.  Investors still face negative carry.  Buying power of prospective buyers is reduced because of higher lending standards.  Then, there’s dark supply.

Dark supply are the homes that will come onto the market if it looks like prices have stabilized.  There are owners who want to sell, but they don’t want to take a large loss, or, they can’t afford to, because they would go bankrupt.  So, they feed the mortgage for now, and wait for the day when the market will have life again.

I experienced things like this in the corporate bond market in 2001-2003.  Whenever a bond would fall sharply and not die, the recovery would be fitful, because there would be market players who were burned, wanted out, but could only justify a certain level of loss.  Dealers would tell me when I expressed interest in some of the damaged names that there would be supply a short bit above the price where I could buy today, so, I should be careful.  I had a longer time horizon, so I would often buy, and watch the struggle as fundamentals improved, but prices went up more slowly due to selling pressure.

Oh, here’s another area of dark supply:  Real estate owned by the GSEs.  They can probably be a bit more patient than commercial banks, but as prices begin to firm, they will start to unload properties.

I have been reading estimates of the size and duration of further declines in residential housing prices.  My view is that we have another 10% down, and that in two years, we should be at the bottom.  How long it takes to burn through the dark supply is another matter, and one that I don’t have a good guess for.

When investors can make a good return off of buying and renting (but there aren’t many of them), and many people have reconciled themselves to the losses they have incurred, then the trade will no longer be crowded, and we will have a normal residential real estate market once again.

For those that want to read some of my older articles on market structure, have a look at these five articles at RealMoney:

The Fundamentals of Market Tops
Managing Liability Affects Stocks, Pt. 1
Separating Weak Holders From the Strong
Get to Know the Holders’ Hands, Part 1
Get to Know the Holders’ Hands, Part 2

The latter four were a series, but not labelled as such.

1) How to control your emotions when the market is nuts?  Develop a checklist, or at least a strategy that makes you re-evaluate the fundamentals, rather than buying/selling indiscriminately.

2) What, one standard for revenue recognition?  Impossible! Great!  Revenue recognition is probably the most important issue in accounting, and whatever comes out of this will be important to investors.  (If the standard is bad, value investors that watch the quality of earnings will gain additional advantages.)

3) America is too big to fail?  You bet, at least to our larger creditors.  As it stands now, our economy is partly propped up by foreign creditors.  Remember, the mercantilists lost more than they gained.  The same will happen here.

4) Tom Graff is a bright guy, and I respect him.  He disagrees with my view on buying agency mortgage backed securities.  He is worth a read.

5) Dark supply.  There are many people who want to sell homes who have them off the market now waiting for better prices.  There are investors buying properties hoping to flip them.  These are reasons I don’t expect housing prices to come back quickly.

6) When I read this piece on Countrywide, I was not surprised by the existence of special deals, but only by their extent.

7) HEL and HELOC experience will continue to decline.  Face it, on most home equity loans in trouble, the losses will be 100%.  This will only burn out one year after the bottom in housing prices.

Fannie and Freddie have their concerns:

• Their books are being reviewed again.
• They are too big to fail, but they are in trouble.
• The Government is pressing them to lend more, but their capital bases say the opposite.

9)  Loser rallies rarely persist, but that is what we have had recently.

10) Along with Barry, I do not believe that banks have bottomed yet.  There are more credit losses to be taken, particularly as housing prices fall another 10%.

The above graph shows the difference in yields between a current coupon 30-year FNMA pass-through security, and a 10-year on-the-run FNMA senior note.  It is a good proxy for how much value is available in agency mortgages versus the debt that they issue.  Now, in mid-March, spreads were particularly high, because mortgage REITs and other leveraged holders of agency mortgages were forced to sell because of rising haircuts on repo financing.  Today, the furor is over the solvency of the agencies themselves.

I would not be worried about the creditworthiness of agency mortgages.  The US Government is not going to let the senior liabilities of the agencies be questioned as to creditworthiness.  To do so would incite panic among investors in many financial institutions that own agency debt and agency guaranteed mortgages.

Here is a graph of the Lehman Brothers Swaption Volatility index:

Now, in March, there was panic in the mortgage market, leading to high implied volatilities.  Today, it is more quiet.

I don’t agree with everything El-Erian of PIMCO says, but I think he is right when he believes that the senior portions of capital structures at the agencies will not be harmed.  It sounds high to me, but according to the article, 61% of PIMCO’s Total Return Fund is in mortgage bonds.  I can support an overweight position in agency mortgage bonds, the yields seem attractive at current levels of volatility.

1) Going back to one of my themes, be wary of companies that sell their best assets to bail out their worst assets.  Tonight’s poster child is GM.  How to get cash?  Borrow against the remainder of GMAC, foreign subsidiaries (most promising part of the corporation), etc.  Not a promising strategy.  As I have said many times before GM common is an eventual zero.  Same for Ford.  All the errors in labor relations over the years, compounded with interest, are coming back to bite, hard.

2) So where does GM cut expense?  White collar retiree medical care.  This is rarely guaranteed, except to unions, so it is legal to cancel it.  A word to those whose corporations or state/municipal employers presently have retiree medical care.  It is worth your while to find out whether there are guarantees of coverage or not.  If there aren’t, I can assure you that it will be terminated in the next ten years.  If there are guarantees, then you need to see whether there are standards of care guaranteed, and whether the plan sponsor has the wherewithal to make good on his promises.

One more prediction: many states and municipalities will devise clever ways to escape guarantees over the next 20 years.  That will include Chapter 9 of the bankruptcy code.

3) Note to the SEC, not that the powers-that-be read me: if you’re going to require a contract to borrow shares in order to short for a bunch of financial companies, then require it for every company, now.  Shorts are not the problem.  Failure to properly locate and borrow shares is a problem.  Let there be a level playing field in shorting, and let the investment banks that are lending out more than they have suffer.  (Ironic, huh, ‘cuz they are the ones complaining…)

4) Note to the new management of AIG: please do the following: a) locate lines of business with low ROAs and significant borrowing for funding in order to achieve high ROEs.  b) Close down those lines.  Possible areas include GIC-MTN programs, and life insurance generally.  c) Take a page out of Greenberg’s early playbook, and exit lines, or sell off divisions where it is impossible to achieve superior ROEs.  (I can see American General re-emerging, with SunAmerica in tow!)

5) File this under Sick Sigma, or Six Stigma — GE is finally getting closer to breaking up the enterprise.  It has always been my opinion that conglomerates don’t work because of diseconomies of scale.  As I wrote at RealMoney:

		David Merkel
		GE — Geriatric Elephant
		4/27/2007 1:16 PM EDT

First, my personal bias. Almost every firm with a market cap greater than $100 billion should be broken up. I don’t care how clever the management team is, the diseconomies of scale become crushing in the megacaps.

Regarding GE in specific, it is likely a better buy here than it was in early 1999, when the stock first breached this price level. That said, it doesn’t own Genworth, the insurance company that it had to jettison in order to keep its undeserved AAA rating. Which company did better since the IPO of Genworth? Genworth did so much better that it is not funny. 87% total return (w/divs reinvested) for GNW vs. 28% for GE. A pity that GE IPO’ed it rather than spinning it off to shareholders…

But here’s a problem with breaking GE up. GE Capital, which still provides a lot of the profits could not be AAA as a standalone entity and have an acceptable ROE. It would be single-A rated, which would push up funding costs enough to cut into profit margins. (Note: GE capital could not be A-/A3 rated, or their commercial paper would no longer be A1/P1 which is a necessary condition for investment grade finance companies to be profitable.)

Would GE do as well without a captive finance arm (GE Capital)? It would take some adjustment, but I would think so. So, would I break up GE by selling off GE Capital? Yes, and I would give GE Capital enough excess capital to allow it to stay AAA, even if it means losing the AAA at the industrial company, and then let the new GE Capital management figure out what to do with all of the excess capital, and at what rating to operate.

Splitting up that way would force the industrial arm to become more efficient with its proportionately larger debt load, and would highlight the next round of breakups, which would have the industrial divisions go their own separate ways.

Position: none, and I have never understood the attraction to GE as a stock

6) One to think about: if US Bancorp is having a bad time of it, shouldn’t most large banks be having a worse time of it?  I spent a little time this evening reviewing the prices of junior debt securities of marginally investment grade banks (and a few mutual insurers, also).  The pressure on marginal financial institutions bearing credit risk is huge.

7) Speaking of junior debt securities, Moody’s gave the GSEs, and the US Government a shot across the bow when it downgraded the preferred stock ratings of Fannie and Freddie.  With the fall in the common and preferred stock prices, any possiblity of private capital raising fades.  The Administration and Congress should realize that whatever flexibility/help they grant the GSEs will be taken, and quickly.  Budget for the worst case scenario.

Then again, Ackman’s plan to restructure the GSEs, which is similar to mine (given in the last week), is reasonable.  Leverage is reduced and a market panic is avoided.

9) But even if neither plan is implemented, the dividends may be cut for the GSEs common stocks.  Shades of GM.  What is more significant, is if the GSEs feel they can’t issue preferred stock at acceptable yields, maybe they will omit those dividends as well.

10) Now, in the midst of expensive bailout talk, is there a cost imposed on the US?  Yes.  The dollar is weak, and default swaps on US government debt are rising in yield.  (Thought: how do swaps on US government debt pay off?  Hopefully not in dollars…  Also, what qualifies as an event of default?  Inflation doesn’t count, most likely, and yet that is one of the main ways for a government to try to escape debt.

11) Socialism!  Is the bailout socialism? Even for a libertarian like me, I can justify a bailout like Ackman’s, because it hurts those that tried to profit from the public/private oligopoly.  But no, I can’t justify what Paulson is trying to do, and maybe, just maybe, the market is sending him a message that half-measures won’t work.

12) More on preferred stocks.  They have been crushed.  This reinfirces why I rarely recommend preferred stocks, or junior debt securities: the payoff is low in success, and losses are high when things go wrong.

13) Let me get this straight.  You trusted Wall Street on an implicit guarantee?  You didn’t get a formal guarantee in writing?  Oh, my, it happens every decade… implied promises fail, and the cold, hard, printed text governs.  “Yes, that could technically be called, but don’t worry, they never do that.” “AAA insurance obligations never fail.”  “Portfolio insurance will protect you; you don’t have to buy puts.”  Never trust implicit promises of Wall Street, because in a real crisis, they go away.

14) Looking over some of my indicators, it looks like we are close to a bounce.  It feels a lot like January of 2008.  So, is it time to buy?   I’m not sure, but I am adding little by little to my stockholdings.  I’m probably going to up the equity percentage in some of my accounts where I have few options (old job Rabbi Trusts).

15) Not that I am likely to liquidate 401(k) assets, or anything like it.  That some are doing so is a sign of the stress that we are under.  Don’t do it, if you can avoid it.  Better, perhaps, to take in a boarder.  It increases cash flow on an underused asset, and optimally, increases community relations.

Four notes for the evening: first, on Lehman Brothers: Deal Journal wrote a piece earlier this week on Lehman potentially selling their subsidiary Neuberger & Berman.  I generally agreed with the piece, and wrote the following response:

Be wary when managements sell their best/safest assets to stay alive. It means that the remaining firm is more risky, and that should the downturn persist, the firm will be in greater jeopardy.

Firms that sell their troubled assets (really sell them, not park the assets in affiliated companies) can survive the harder times. Trouble is, that requires taking losses, and sometimes the balance sheet is so impaired that that cannot be done.

So, selling the good assets may be a necessity, but it does not imply a good future for Lehman.

The same applies to Merrill regarding their stakes in Blackrock and Bloomberg.  Also, I am skeptical that Lehman was truly able to reduce its risk assets as rapidly as they claimed in the midst of a bad market.  I believe that if the tough credit markets persist into 2009, Lehman will face a forced merger of some sort.  Merrill Lynch has more running room, but even they could face the same fate.

Second, Alt-A lending worked when it was truly using alternative means to screen borrowers to find “A” credits.  It failed when loan underwriting ceased to be done in any prudent way.  Alt-A lending will return, but it is less likely that Indymac will see the light of day again.  Whether in insurance or lending, underwriting is the key to long-term profits.  Foolish lenders/insurers economize on expenses at the cost of losses.

Third, we have a possible deal that the US government may buy a convertible preferred equity stake in Fannie and Freddie.  This comes on the heels of news that no access would be granted to the discount window, but this deal would include discount window access.  (Ugh.  Is it going to take a Dollar crisis to make the Fed realize that only the highest quality assets should be on the balance sheet of the Fed?)

Now, this is not my favored way of doing a bailout, but it probably ruffles fewer political feathers, and many get to keep their cushy jobs for a while longer.  My question is whether $15 billion is enough.  It will certainly dilute the equity of Fannie and Freddie, but is it large enough to handle the losses that will come?

Now, reasonable followers of the US debt markets have shown some worry here, but in the short run, this will calm things down.

As a final note, I would simply like to say to all value investors out there that the key discipline of value investing is not cheapness, but margin of safety.  I write this not to sneer at those who have messed this up, because I have done it as well.  Pity Bill Miller if you will, but neglecting margin of safety and industry selection issues have been his downfall, in my opinion.  (And don’t get me wrong, I want to see Legg Mason prosper — I have too many friends in money management in Baltimore.)

I’m coming up on my next reshaping, and one thing I have focused on is balance sheet quality, and earnings stability.  Many value managers have been hurt from an overallocation to credit-sensitive financials.  They own them because the value indexes have a lot credit-sensitive financials in the indexes, and who wants to make a large bet against them?

Well, I have made that bet.  Maybe I should not have owned as many insurers, but they should be fine in the long run.  There is still more leverage to come out of the system, and owning companies that have made too many risky loans, or companies that need a lot of lending in order to survive are not good bets here.  Look at companies that can survive moderate-to-severe downturns.  If the markets turn, you won’t make as much, but if the markets continue their slump, you won’t get badly hurt.

want to tread a fine line this evening.  I am going to argue that a government takeover of Fannie and Freddie would not be as costly as some imagine — it would likely be more expensive than the S&L bailout, but not in inflation-adjusted terms.  My post is driven by the New York Times article, as cited by Barry Ritholtz, and Yves Smith (as I was drafting this).

The first thing to say is that conservatorship may not happen.  The GSEs have many powerful political friends, and they won’t give up without a fight.  I rate the odds of conservatorship as less than 50/50 in 2008, and the next President/Congress may have a different opinion.

I want to rule out the idea that the Federal Reserve could save the GSEs.  Unlike Bear Stearns, the Fed is too small to materially affect the situation.  Sure, it can buy the senior paper of the GSEs, but that would not be enough to absorb more than 10% of the total senior financing base for the GSEs at maximum.

But suppose conservation of Fannie and Freddie takes place.  What then?

Most mortgages insured by Fannie and Freddie are good quality already.  They financed smaller loans, reasonable down payments, tilted away from the high cost areas that are under the most pressure.  For loans prior to 2006, losses should be small.  Also, Fannie and Freddie have been careful, even with pressure from politicians.

But some loans were done with mortgage insurance because of low down payments, and the mortgage insurers are in bad shape now.  True, and though Fannie and Freddie may not get full payment, they should get 80% payment on the 20% or so of the loan that was insured.  Mortgage insurers are worth something, even if not full value.  My scenario implies 4% losses on a small portion of their mortgage book.

Now the GSEs will continue to receive guarantee fees, and they still have embedded margins from the loans on their balance sheets.  Now, WIlliam Poole says that Freddie is insolvent on a fair value basis, and Fannie might be.  Still, the losses are small compared to the S&L bailout at present.

Thus, I argue that a guarantee of senior obligations of the GSEs would not be horrendously costly.  Let the preferred and common equity be wiped out.  Let the subordinated bondholders sweat.  The losses at the senior level should be small.

The benefits of such a guarantee would be big, though.  Who invests in Fannie and Freddie direct and guaranteed paper? Banks, insurers, stable value funds, foreign investors, and more.  Do we want a “domino effect” that might lead to further financial failures?  I think not.  Arresting the losses at the senior level, and eventually folding Fannie and Freddie into GNMA preserves many other financial institutions.

Two notes on the politics here: the Bush Administration wins, and loses.  Wins, because they end the dominance of the GSEs in a bigger way than they ever could have imagined.  Loses, because they can’t use them to support the mortgage market any more.  Can the FHLB pick up the slack without them?  I doubt it, at least not fully.  The FHA isn’t big enough either.

So, be careful here.  There are too many variables and political angles to make decisions easy.  I think I understand what is most likely here, but I would assume a conservative posture, unless the cost of achieving that posture was too high.  We are close to that “too high” level now.

PS — As a bond manager, aside from mortgage bonds, I rarely bought agency bonds because the spreads were too small to bother with.  I have a rule for avoiding small bond yield spreads; they are too narrow to waste time over, and the present distress illustrates why.  At present a barbell of Treasuries and high yield bonds is more attractive than agencies.

(These are my opinions, and not those of my employer.)

Ugh.  I’m still not home yet, but after my recent 48-hour news blackout, the news on Fannie and Freddie is pretty amazing.  Now, I would not be so certain that an interpretation of SFAS 140 would force Fannie or Freddie to raise capital — GAAP accounting often has little to do with regulatory capital rules.  Only if OFHEO decides to mimic the treatment in GAAP would it force capital-raising, absent any net worth covenants on their debt that might be poorly written.

All that said, the problems with Fannie and Freddie are not primarily accounting-driven, but are being driven by diminishing housing prices, which erodes their margin of safety on their lending and loan guarantees, and diminishes the value of the mortgage insurance that they rely on for some of their business.  Writedowns from these items are what hurt.  It is likely that Fannie and Freddie need to raise capital, but the great questions are how much is needed, and how much can the market stomach?

At times like this, I run through my pecking order of the “financing methods of last resort.”

• Have you maxed out trust preferred obligations? Other subordinated debt?
• Have you maxed out preferred stock?
• Have you issued convertible debt to monetize volatility?
• Have you diluted your equity through secondary IPOs, rights offerings, PIPEs, and/or deals with strategic investors?
• Have you sounded out investors in your corporate bonds about debt-for equity swaps?
• And, unique to Fannie and Freddie, have you asked the US government for a capital infusion or a debt guarantee?

All of these financing methods carry a cost.  (And, as with most situations like this — if it were done, best it should be done quickly.  Delay usually means that cost of financing rises.)  Most of the cost is dilution to existing shareholders, whether common or preferred.  The debt guarantee, or investment by the government has costs for the US taxpayer, which I would rather not see.

Clearly, Fannie and Freddie have room to raise more capital, but the room is not unlimited.  As the Financial Guarantors found, when your stock price gets too low, the jig is up.  You can only raise so much capital relative to the size of your current market capitalization before the market chokes.  After all, most capital raising requires a discount to current price levels, and somehow the diluted value of the equity needs to represent a premium price where new capital gets put in.

In short: it’s tough to get new investors to pay for past losses.  Capitalize a new company?  Could be done, and has already happened with the Financial Guarantors, which has largely sealed the fate of the tarnished incumbents.  That said, why would the US government want a competitor to Fannie or Freddie, aside from GNMA?

As for the US Government, perhaps this all waits for a new President and Congress to act.  Personally, I think that any help extended to Fannie or Freddie should have strings attached.  Investments, or debt guarantees should allow the US government to profit if things turn around.  Other things to explore: only guaranteeing new liabilities, or, expanding the role of GNMA, which is a full-faith-and-credit of the US Government lender.

The one thing I don’t want to see is a bailout that benefits the shareholders of Fannie or Freddie.  They have long had private profits with many public subsidies for years.  Now it is time for the shareholders to bear the losses; let public money only step in to keep senior obligations whole, if it steps in at all.

(Note: these are my private opinions, and not those of my employer.)

I’m waiting for the day when I can write upbeat stuff about housing…  when I can buy homebuilder and mortgage stocks and crow about my gains.  I hope I live two more years. ;)  (Many thanks to Calculated Risk for their excellent coverage of residential housing.)

1) The first thing to note is that residential real estate values are still falling nationwide.  That affects Mortgage Equity Withdrawal [MEW] and derivatively, consumption.

2) Now, housing prices are likely to fall another 10-15%, which is what I have been saying for a while.  That will lead to more situations where there is negative equity, and more defaults, as they happen with negative equity and negative life events.

3) Foreclosures are making up a larger percentage of all sales, which is not a positive in the short run for prices.  In Sacramento, and some other places in California, foreclosures are the majority of sales.  As a result, it is no surprise that housing sales are at a low.  Foreclosures have risen rapidly across the country, not boding well for future sale prices.  Even in Florida, foreclosures are gumming up the market, and are getting reconciled slowly.

4) The GSEs are in a tough spot.  The government pushes them to make suboptimal loans that their shareholders don’t like.  I guess that’s a part of their deal.  As it is, the GSEs are playing a large role in many loans today.  Private capital doesn’t step up in an environment like this.

5) Labor mobility is limited when housing prices fall.  Pretty normal, if infrequent, in my opinion.  I faced this back in 1989; employers offered limited housing perks to new hires.  In three years, this will be gone.

6) Now, it should be no surprise for lending standards to tighten now.  We always shut the barn doors after the cows are in the fields.

7) Mortgage rates are rising, largely due to the reaction of the bond market to Fed chatter.

8 ) Prime ARMs will fuel the next wave of delinquencies.  If home values fall enough, any class of lending is vulnerable.

9) It should not surprise us that housing starts are low in an environment like this.  The bigger the boom, the bigger the bust.

10) I am not generally a Tom Brown fan.  He is too perma-bullish for my tastes.  He may have a correct technical point on subprime losses, but it may misrepresent losses for the financial sector as a whole.  Subprime is small.  Alt-A and Prime are much bigger, and losses are growing there.

There are many people calling for a bottom to banking stocks, and I must admit, it is a tempting place to play. I never thought Fifth Third would trade so low. Or Keycorp. Royal Bank of Scotland, sorry, I sold you early in 2008; yes, I thought you would fall. When does the excessive leverage finally eliminate the CEO?

Here’s the challenge for investors: on the one hand, you have declining earnings per share in the near term, from losses and capital raises. But when have equity prices fallen enough to discount the future losses?

I am being cautious here. I own no banks.

Here’s another way to think about it — after all of the bad debts are written off, and bad banks eliminated, what kind of earnings stream will be attractive?

I’ll use the homebuilders as an example here — at troughs, they sometimes trade for half of written-down book value, The question becomes the final side of the book value after the writedowns.

I would still be cautious here, but markets are discounting mechanisms — we are getting closer to a bottom in the banks; we are not there yet.

My, but haven’t we had interesting times in the short end of the yield curve lately. Have a look at this graph:

This covers the period from the final aggressive 75 basis point move by the FOMC, where there were expectations of a 1% fed funds rate by year end 2008, to now, where the rate at year end is between 2.5-3.0%.  Now look at this chart, which summarizes the yield curve moves:

The graphs and numbers tell a story.  My four datapoints represent:

• 3/17 - The sharpest point in the loosening cycle, prior to going to 2.25%.
• 4/25 - Anticipation of the end of the loosening cycle.
• 6/6 - FOMC jawboning that we must support the dollar and fight inflation.
• 6/12 - Now.

Let’s describe the moves, period by period.  In Period 1, the transition was from maximum FOMC accomodation to the end of the loosening cycle.  What happened?  Investors required more yield to invest for two years versus cash instruments, because they concluded that short rates would not go near record low levels.  The long end of the curve flattened, because inflation expectations were under control.

In period 2, things were quiet.  Three month rates rose to reflect the new consensus that the FOMC was on hold after the 4/30 meeting for the foreseeable future.  The rest of the curve did nothing.

In period 3, members of the FOMC began beating the inflation drum, particularly the hawks, including Plosser, Lacker, Fisher, and Bernanke.  The belly of the curve (twos to fives) rises the most, anticipating tightening moves by the FOMC, leading the long end to flatten, and the short end to steepen.  This implies that inflation will remain under control in the long run, an idea borne out by the TIPS market, where you can buy 20+ year inflation protection at a real yield of 2.3% — a pretty good bargain for investors that must own Treasuries and other high quality debt.

I’ll give the FOMC this.  In the last four trading days, they helped create the biggest move in the 2-year note yield that we have seen in a long time.  They managed to push up 30-year mortgage yields around 35 basis points, close to the move in the 10-year note.

Now, (to the FOMC) is that what you wanted?  Go ahead.  Start tightening monetary policy in August or September.  See what that does to the investment and commercial banks.  See how that affects weakening employment.  Do it during an election year, when politicians in 2009 might say, “Central bank independence hasn’t helped the nation.  Let’s clip the wings of the Fed.”

I see the FOMC tightening, and then abandoning the tightening early, and reverting to a weak policy, accepting more inflation for the sake of growth in the real economy, and leniency to banks that are facing tough market conditions.