Category: Real Estate and Mortgages

One Dozen Observations on Residential Housing

One Dozen Observations on Residential Housing

1) The rating agencies have been running like crazy. They do that when they are behind the curve. Whether it is Moody’s on subprime, or S&P on Alt-A lending, the downgrades are coming in packs. Then there are difficulties with the debts of real estate partnerships, like LandSource Communities Development, which is likely to file for insolvency, together with some residential developers.

2) Now, there have been a few summary pieces on how the rating agencies changed as the housing boom moved on. Here is one from the New York Times, and one from the Wall Street Journal. As I had commented long before in my writings at RealMoney, the rating agencies were co-dependent with those that paid them. That said, it would be hard to construct a system that would not be that way. Buyers don’t have a concentrated interest in ratings. Issuers so.

3) If I were Ambac, I would be doing all that I could to allege fraud on contracts where representations and warranties were not upheld. Ambac is fighting to survive.

4) Mortgage insurers — it is the best of times, if you survive, because you are the almost the only game in town for those wanting to do low down payments, and rates for mortgage insurance are way up. But, it is the worst of times, housing prices are falling, rating agencies are downgrading, and defaults on insured mortgages are rising.

5) Foreclosures:

6) Gotta love OFHEO, which is trying to rein in the GSEs during a lending crisis. Even though they may have traction, I don’t see how they tighten the regulations during a crisis.

7) For that matter, consider the lenders. Countrywide seemed to purposely ignore the creditworthiness of borrowers as they jammed it out the door lent on mortgages. Even with all this, mortgage lenders are complaining that new regulations will make mortgages less affordable. What they mean is that they will issue fewer mortgages, and they will make less profit. Please, let’s stop making it easy for those that can’t afford a home to take the risk of buying one. Higher mortgage rates are bad in the short run, but good in the long run.

8 ) Dr. Jeff reluctantly asks what inning we are in on housing. I understand that it is an overused metric, but it is overused for a reason. Nine is an intuitive number — are we halfway through? Fifth inning. One-quarter? Third. Almost done? Eight or ninth. He also makes a simple request to those of us who opine on the housing slump, to be more definite in what we say, provide more data, and what will be signs that the troubles are turning.

I need to set up some housing recovery googlebots to scan for me, but my guess is that we are in the fifth inning of the troubles. When I get more definitive guesses/answers to the questions, I will post.

9) Delinquencies:

10) Home prices continue to fall, and estimates to the nadir (cycle low) range between 0-50%, with 10-20% being the most common.

11) Falling home prices will lead to many more foreclosures in prime loans, and of course Alt-A and subprime. Foreclosures happen when a sale would result in a loss, and a negative life event hits ? death, divorce, disaster, disability, and unemployment.

12) Second-order effects:

Still Too Early For Banks

Still Too Early For Banks

One thing about Jim Cramer, he is quotable.? Take this short bit from his piece, Graybeards Get It Wrong on Financials.

One of the loudest and most pervasive themes by a lot of the graybeards is that there is still much more pain ahead in the financials.Let me explain why that is wrong. First, the group is down from a year ago. It’s been hammered mercilessly.

More important, every time the stock market rallies is another chance for these companies to refinance.

Remember, as they go up, the companies are in shape to tap the equity market again because those who bought lower are being rewarded, psyching others to take a chance. In fact, other than the monoline insurance faux bailouts, people who pony up are doing pretty well.

Now, he might be right, and me wrong on this point (with my gray beard, though I am younger than he is).? But let me point out what has to go right for his forecast to be correct.

1) The inventory of vacant homes has to start declining.? Still rising for now, another new record.? Beyond that, you have a lot of what I call lurking sellers around, waiting to put more inventory out onto the market, if prices rise a little.? They will have to wait a while, and many will lose patience and sell anyway.? There is still to much debt financing our housing stock, and though most of the subprime shock is gone, much of the shock from other non-subprime ARMs that will reset remains.? Will prices drop from here by 20%?? I think it will be more like 12%, but if it is 20% there will be many more foreclosures, absent some change in foreclosure laws.? Foreclosures happen when a sale would result in a loss, and a negative life event hits — death, divorce, disaster, disability, and unemployment.

2) We still have to reconcile a lot of junk corporate debt issued from 2004-2007, much of which is quite weak.? Credit bear markets don’t end before you take a lot of junk defaults, and we have barely been nicked.? Yes, we have had a sharp rally in credit spreads over the last five weeks, but bear market rallies in credit are typically short, sharp, and common, keeping the shorts/underweighters on their toes.? You typically get several of them before the real turn comes.

3) We have not rationalized a significant amount of the excess synthetic leverage in the derivatives market.? With derivatives for every loser, there is a winner, but the question is how good the confidence in creditworthiness between the major investment banks remains.? Away from that, Wall Street will be less profitable for some time as securitization, and other leveraged businesses will recover slowly.

4) Credit statistics for the US consumer continue to deteriorate — if not the first lien mortgages, look at the stats on home equity loans, auto loans, and credit cards.? All are doing worse.

5) Weakness in the real economy is increasing as a result of consumer stress.? Will real GDP growth remain positive?? I have tended to be more bullish than most here, but the economy is looking weaker.? Let’s watch the next few months of data, and see what wanders in… I don’t see a sharp move down, but measured move into very low growth in 2008.

6) What does the Fed do?? Perhaps they can take a page from Cramer, and look at the progress from private repair of the financial system through equity and debt issuance.? It’s a start, at least.? But the Fed has increasingly encumbered is balance sheet with lower quality paper.? Two issues: a) if there are more lending market crises, the Fed can’t do a lot more — maybe an amount equal to what they have currently done.? b) What happens when they begin to collapse the added leverage?? Okay, so they won’t do it, unless demand goes slack… that still leaves the first issue.? There are limits to the balance sheet of the Fed.

Beyond that, the Fed faces a weak economy, and rising inflation.? Again, what does the Fed do?

7) Much of the inflation pressures are global in nature, and there is increasing unwillingness to buy dollar denominated fixed income assets.? The books have to balance — our current account deficit must be balanced by a capital account surplus; the question is at what level of the dollar do they start buying US goods and services, rather than bonds?

8 ) Oh, almost forgot — more weakness is coming in commercial real estate, and little of that effect has been felt by the investment banks yet.

As a result, I see a need for more capital raising at the investment banks, and more true equity in the capital raised.? Debt can help in the short run, but can leave the bank more vulnerable when losses come.? The investment banks need to delever more, and prepare for more losses arising from junk corporates and loans, housing related securities, and the weak consumer.

One Dozen Notes on Our Manic Capital Markets

One Dozen Notes on Our Manic Capital Markets

1) I think Ambac is dreaming if they think they will maintain their AAA ratings. Aside from the real deterioration in their capital position, they now face stronger competition. Buffett got the AAA without the usual five-year delay because he has one of the few remaining natural AAAs behind him at Berky. (Political pressure doesn’t hurt either… many municipalities want credit enhancement that they believe is worth something.)

2) I read through the documents from the Senate hearings on the rating agencies, and my quick conclusion is that there won’t be a lot of change, particularly on such a technical topic in an election year. And, in my opinion, it would be difficult to change the system from its current configuration, and still have securitization go on. Now, maybe securitization should be banned; after all, it offers an illusion of liquidity liquidity in good times, but not in bad times, for underlying assets that are fungible, but not liquid.

3) I am not a fan of Fair Value Accounting. But if we’re going to do it, let’s do it right, as I suggested to an IASB commissioner several years ago. Have two balance sheets and two income statements. One set would be fair value, and the other amortized cost. It would not be any more work than we are doing now.

4) Now, some bankers are up in arms over fair value, and I’m afraid I can’t sympathize. If you’re going to invest in or borrow using complex instruments that amortized cost accounting can’t deal with, you should expect the accounting regulations to change.

5) Just because you can classify assets or liabilities as level 3 doesn’t mean the market will give full credibility to your model. Accounting uncertainty always receives lower valuations. It as if the market says, :These assets will have to prove themselves through their cash flows, we can’t capitalize earnings here. The same applies to the temporary gains from revaluing corporate liabilities down because of credit stress. If the creditworthiness recovers, though gains will be reversed, and good analysts should lower their future earnings estimates when bond spreads widen, to the degree that present gains are taken.

6) The student loan market is interesting, with so many lenders dropping out. This is one area where the auction-rate securities market initially hurt matters when it blew up, but there was a feature that said that the auction rate bonds could not receive more than the student lenders were receiving. So, after rates blew out for a little while, now some the auction rate bonds are receiving zero (for a while).

7) After yesterday’s post, I mused about how much the high yield market has come back, and with few defaults, aside from those that should have been dead anyway. With liquidiity low at some firms, there will be more to come. Personally, I expect spreads to eclipse their recent wides as things get worse, but enjoy the bear market rally for now.

8) Many munis are still cheap, but the “stupid cheap” money has been made. Lighten up a little if you went to maximum overweight.

9) What’s the Big Money smoking? They certainly are optimistic in this Barron’s piece. One thing that I can find to support them is insider buying, which is high relative to selling at present. And, even ahead of the recent run, hedge funds (and many mutual funds) had been getting more conservative. Guess they had to buy the rally. On the other side, there is a sort of leakage from DB plans, as many of them allocate more to hedge funds and private equity.

10) Does large private equity fund size lead to bad decision making? I would think so. Larger deals are more scarce, and so added urgency comes when they are available. Negotiating for such deals is more intense, and the winner often suffers the winner’s curse of having overbid.

11) I am not a believer in the shorts being able to manipulate the markets as much as some would say. It’s easier to manipulate on the long side. Here is a good post at Ultimi Barbarorum on the topic.

12) Financials are the largest sector in the S&P 500.? Perhaps not for long… they may shrink below the size of the Tech sector at current rates, or, Energy could grow to be the largest.? Nothing would make me more skittish about my energy longs.? The largest sector always seems to get hit the hardest, whether Financials today, or Tech in 2000, or Energy in the mid-90s.

Angry Freeholders?

Angry Freeholders?

After seeing the website Angry Renter, I considered my own position in the matter, because I’m not in favor of bailouts either.? I own my home free and clear, and I paid off my mortgage well in advance of when I had to.? I own a house smaller than I could afford, and with eight kids, sometimes I wish I had chosen otherwise.

But I love our little hovel, and wouldn’t have it any other way.? That said, there would be reason for people like me to be annoyed at any bailout.? I stayed within my means; I sacrificed other goals to own my home free and clear of any encumbrances.

Angry Freeholder Graph
Here is my version of the Angry Renter graph, with one major modification.? Using data from First American (LoanPerformance), I estimated what percentage of homeowners will be vulnerable if home prices fall another 10% or so.? They fall into my “under stress” bucket.? My view of the situation is this — over the next two years, with a fall in housing prices of 10%, roughly 12% of the housing stock of the US will be in a negative equity position, and more so, if one considers closing costs.

Remember, default in housing means negative equity in a sale, plus a negative life event: unemployment, death, disability, disaster, or divorce.

The problem is bigger than Anger Renter represents, which is why the politicians will do something (though it will likely be ineffective).? Politicians care about the banks, also… bank failures are not conducive to a happy economy.? Renters tend to not have much political clout, because they aren’t usually well-off.? My view is that Angry Renter as a movement goes nowhere.? Now, if you could get the relatively well-off freeholders involved, that could be another thing, but, I still think opposing a bailout would fail politically — politicians care about the banks.

Ten Things To Be Concerned About

Ten Things To Be Concerned About

1)? Picking up on some comments from last night’s post, why I am I not concerned about counterparty exposure?? Because Wall Street has always been very good at cutting off overleveraged clients in the past.? LTCM was an exception there, and only because Wall Street gave in to their request for secrecy.? Wall Street grabs collateral first, and then lets the client argue to get it back.? The investment banks require a significant margin, and when there is significant concern about getting paid, the lines get pulled.

The real worry here is that the investment banks don’t have good enough risk controls for each other.? Note that Bear’s crisis started when other banks stopped extending credit to Bear, and the fear fed on itself.

I liken the investment banks to long-tail commercial casualty insurers.? No one knows whether the reserves are right.? No one can.? Confidence is a necessary part of the game, which is made easier at lower levels of leverage.? But high leverage and opaqueness are a recipe for disaster when volatility rises.

2) Should you worry about Fed policy?? Yes.? The Fed is steering away from the Scylla of a compromised financial sector, and into the Charybdis of inflation.? As I will point out later, that is already having impacts on the rest of the world.? As for now, there are a few ill-informed writers who say that a negative TIPS yield on the short end is a reason not to buy TIPS.? That might be correct if inflation mean-reverts.? Given the short-term resource scarcity building in our world, I don’t think that is likely.

3) Should you worry about the US Government budget deficit?? A little — oh, and worry about the real deficit, one that puts the wars and other emergency appropriations on-budget, and takes out the excess cash flow from Social Security.? In a macro sense, for the nation as a whole, the impact isn’t that great… but it sends a message to foreign creditors who wonder what the value of the dollars will be when they get paid back.? When they see the Fed running an aggressive monetary policy in the face of rising inflation and a weak dollar, it makes their heads spin, as they contemplate the hard choices the weak dollar forces on them.

4) Could the falling dollar cause a crisis in China?? Maybe.? China is levered to US growth, which is slowing, and their export competitiveness versus the US declines as the dollar declines.? And what will they do with all of those dollar reserves?? Beats me.? After a certain point, additional reserves are useless — it is akin to lending more to an entity that you know is insolvent.? My guess is that the yuan will get revalued after the Olympics, and then the real slowdown will hit China.

5)? What of foreign food riots; are they a worry?? (More, and more.)? A little.? They are a canary in the coal mine.? They point to the short-term scarcity of total resources in our world, which only becomes obvious as a large part of the world tries to develop.? But, one practical thing that it implies is that energy and food prices will remain high for some time.? We are one global market at present, and energy and food prices are interlinked through the energy and fertilizer costs of farmers, and through stupid ideas like corn-based ethanol.

6) What of flat crude oil? production?? Yes, worry.? As I have said before, the government oil companies of OPEC countries control most of the supply, but they don’t always manage their resources as well as a capitalistic oil company.? Mexico, Venezuela, and Russia have declining production, to name a few.? The Saudis may not want to produce more, because they don’t know what to do with all the US dollar reserves that they have today.? Or maybe they can’t…

7) Worry about falling housing prices?? Yes.? The problems in the housing market stem from overbuilding.? There are too many houses chasing too few solvent borrowers.? This will eventually affect prime mortgages, because declines of 15-20% in housing prices mean that many prime loans would be underwater in a sale.? Remember, an underwater loan becomes a default after a negative life event — unemployment, death, disability, divorce, and uninsured disaster.

Before all of this is done, one of the major mortgage insurers should fail.? We aren’t there yet.

8 ) What of falling residential real estate prices in foreign countries? Yes, worry.? For Europe, it could lead to the end of the Euro, as countries needing looser monetary policies get tempted to abandon the Euro.? If the Euro’s existence becomes questioned, it will be a systemic risk to the world.

9) What of credit card delinquencies?? Yes, worry.? It shows that total financial stress on the consumer is high, particularly when added to the problems in mortgage and home equity loans.

10) Should you worry about bank solvency?? A little.? All of these previously described stresses have some bearing on the ability of the banking system to make good on their obligations.? Be aware that the FDIC was designed to handle sporadic losses, not systemic crises.? The odds of these problems affecting the depositary financials is still low, but the protective measures will not be capable of dealing with the worst case scenario, should it arise.

Perhaps I have more to worry about.? As I close up here, I haven’t mentioned the PBGC, Medicare, and a variety of other problems.? But, I have to call it a night, and symmetry with last night’s piece is worth a little to me.

Five Notes: What Can the Fed Do?

Five Notes: What Can the Fed Do?

1) There have been a number of recent articles questioning/explaining what the Fed can do in this present environment. Here are some examples:

My own view is that the Fed has used up a lot of firepower on the asset side, but still has a lot to work with. That said, the Fed should be careful not to complicate its balance sheet with a lot of off-balance-sheet agreements. Policy flexibility for a central bank is a real plus, so complicated agreements that make formerly liquid assets illiquid are to be avoided, particularly in a crisis.

Regarding Fed funds, it looks like they will cut 25 basis points on 4/30, but make noises that they are getting close to being done. Perhaps 1.75% will be the low for the cycle.

2) I already miss Alea. Before jck went on hiatus, he commented that the TAF was not effective at lowering rates, and that the TSLF was a success, though by success, he means that it’s not in hot demand. Tony Crescenzi speaks similarly. Perhaps the existence of the PDCF reduces the need.

3) Perhaps Lehman is an example of that, moving buyout loans off of their books, and getting financing for the AAA portion from the PDCF. Given the imitative culture of Wall Street, I would expect to see this repeated by other investment banks.

4) Volcker-mania. In one sense, it’s weird to see him speaking out now, given that he was silent for Greenspan, save for a little at the end. I agree with almost all of what he has been saying; it reads like my writings over the past five years. For a sampling of opinion:

Greenspan ate sour grapes, and Bernanke’s teeth have been set on edge. Bernanke inherited Greenspan’s ignored problems. At this point he and the Fed are puzzled — seeing rising inflation, but fearing what higher rates could do to the banking system. With a similar view that the Fed has few good options, consult Tim Duy.

5)? Finally, if we turn off the microphones, and shut down the cameras, will Alan Greenspan cease to exist?? His defensiveness toward his record undermines his record.? Better he should stop talking publicly, particularly if he follish enough to suggest that the housing market will bottom in 2008.

The Global View — Six Themes

The Global View — Six Themes

Though I write mainly about US economic and investment issues, I try to be think globally as I consider macroeconomics. I think that many economists are hobbled because they think about the US economy in a closed framework, neglecting the effects that the rest of the world has on the US. Prior to the end of the cold war, that was a useful shortcut, but now many aspects of the US economy depend on global, and less on local factors. (Some articles cited here will be dated, but are still relevant in my mind.)

This article is meant to take you through six themes affecting the global economy. Here goes:

China

I’ve been writing about neomercantilism and China now for almost five years. The negative effects are now obvious. Inflation has been rising in China, because too much credit is chasing too few goods. That inflation is funneling into US goods prices as well. China exports too much, and imports too little, which forces them to import US credit. This is getting tired, and the Chinese and Middle Eastern savings gluts need a new place to invest, or better, new goods to buy. Absent these adjustments, in order to cool the economy, the PBOC keeps raising reserve requirements again and again. Better they should revalue the yuan up 20%, or they will continue to import inflation from the US.

China has its growing pains amid this. Pollution is rampant, and standards for product safety are low. Beyond that, China now competes with the US and Europe for economic alliances in Africa. Given past bad blood there, the Chinese may at many points be better received, that is, until they abuse their welcome.

Currencies

The main question here is the demise of “Bretton Woods II” where the rest of the world uses the US Dollar as the main reserve currency, while the US continues to debase the dollar through the issuance of more dollar claims. You can read about it in any of the following articles:

Now, Ken Fisher told us not to worry about the declining dollar, but the euro-yen exchange rate. It’s too early to say, but that exchange rate is flat, while the S&P 500 is off 7% or so. Perhaps the overall carry trade is weakening, but not with the euro as a currency to purchase, yet.

Finally, not only is the weak dollar good for exports, but for tourism as well. Now maybe they buy some of our slack houses as well…. please?

Inflation, Especially Food Prices

All the buzz is over rice, which has risen fivefold in six years. You can read about it here:

Now, that inflation is feeding back to the US, but slowly.? You would think that this would be a great time to eliminate US farm subsidies, but no, they are too effective at buying votes insuring economic stability in the Midwest.

Now, in the face of these inflationary pressures, the ECB is not mimicking the Fed.? They see the inflationary pressures, and aren’t loosening, at least not much.? Australia is even tightening.

Recession Fears in the Developed World

Now there are similar stresses in housing in some places of Europe, as compared to the US.? Consider Spain (and here), and the UK.? Low-ish interest rates can lead to overbuilding anywhere, if the regulators look the other way.? Japan may not have housing worries, but their growth is slowing, and they worry about the next recessionary leg of a what is proving to be a long recessionary era (since 1990).

Energy

It doesn’t matter how you slice it, Chavez has mismanaged the Venezuelan economy, and particularly the oil industry.? Now he is trying to do the same thing to cement.? Venezuelans are experiencing shortages and high inflation, as Chavez directs resources that he has stolen nationalized to his cronies and his foreign interests that he funds in order to make life difficult for US foreign policy in Latin America (not that I am a great fan of US policy there — I only recognize the conflict).

The Middle East has lots of new oil fields to tap at the right price, yes?? Well, I’m not so sure.? It is interesting to see the UAE develop a nuclear program.? Perhaps they are looking to a day when oil will not be so plentiful?? Then again, maybe we will have a big energy find in Greenland (an island that may once again be green, now that temperatures are rising to levels last seen in the middle ages).

Emerging Markets

Coming back to the beginning of the article, emerging markets (like China), are going through an adjustment period.? Since these two articles were written, emerging market equities have fallen significantly.? They may fall further; many of those nations are geared to global growth, and when it slows, it slows even more for them.? Many of them are absorbing US inflation as well, and need to raise their exchange rates.? That will hurt exports in the short run, but will aid in bringing economic stability.

Fourteen Notes on Monetary Policy

Fourteen Notes on Monetary Policy

This post is on current monetary policy. The review piece on how monetary policy works is yet to come.

1) Let’s start out with the regulatory issues to get them out of the way, beginning with Bear Stearns. To me, the most significant thing to come out of the “rescue” was the Federalizing of losses from the loans that were guaranteed by the Fed (something which I noted before had to be true, since the Fed turns over its profits to the Treasury), and the waiving of many leverage rules for the combined entity (also here and here). These in turn led to an attitude that if the Fed was going to lend to Bear (however indirectly), then they should be regulated by the Fed.

Now, I don’t blame the Fed for bailing out Bear, because they were “too interlinked to fail.” You could say, “Too big to fail,” but only if you measure big by the size of the derivatives book. The last thing that the investment banks needed was a worry on concentrated counterparty risk affecting the value of their derivative books.

That said, given that Jamie Dimon was very reluctant to help unless the Fed provided guarantees, and the low price paid, it indicates to me that Bear and the Fed were desperate to get a deal done. What was in it for Bear? I’m not sure, but the deal avoided greater ignominy for the board, and might preserve jobs at Bear for a longer period of time.

2) At a time like this, many cry for tighter regulation in the the intermediate-term and more aggressive actions in the short-term to restore liquidity. Forget that the two of these fight each other. Personally, I find the comments from the IMF amusing because they are an institution in search of a mission; the IMF was designed to help developing nations, not developed ones. The comments from the FDIC Chairwoman are good, but really, where were the banking regulators in 2005-2006, when something useful could have been done?

3) Does the Fed want to be a broader financial regulator? My initial guess would be “no,” but I could be wrong here. Part of my reasoning is that they have not used the powers effectively that they already have. Another part is that monetary policy has often been misused, and been pro-cyclical. With their new powers, they will still face significant noise and data lags. Why should they be more successful at a more complex task than they have been with the less complex task of monetary policy? Schiller is way too optimistic here. The central bankers are part of the problem here, not part of the solution. For years they provided too much liquidity in an effort to keep severe recessions from occurring, and in the process they removed fear from the financial system, and too much leverage and bad underwriting built up. Now the piper has to be paid.

4) Eric Rosengren, president of the Federal Reserve Bank of Boston, comments on the difficulties involved in effective regulation of financial institutions as a lender of last resort.? The Fed will have to build new models, and think in new paradigms.

5)? Charles Plosser, President of the Philadelphia Fed, tells us not to overestimate monetary policy.? Sage words, and rarely heard from the Fed (though in my experience, more often heard toward the end of a loosening cycle).? Plosser moves up a couple of notches in my view… monetary policy can deal with price inflation, and that’s about it.? Once we try to do more than that, the odds of making a mistake are significant.

6)? Who loses when the Fed loosens?? Savers.? They earn less; there is a net transfer of wealth from savers to borrowers.? Holders of US-dollar based fixed income assets also bear the brunt, if thy have to convert it back to their harder currency.

7)? Perhaps the TSLF is succeeding.

8 ) But perhaps all of the Fed’s efforts on the asset side are making it more difficult for Fed to keep the fed funds market stable.? I have one more graph that stems from my recent piece on the Fed:

Note that during the past six months, the low transaction on Fed funds was significantly below the effective rate.

9) VIX and More has latched onto this calculation of M3.? Given the changes and the adjustments that they have made, and the 20% or so rate of growth for M3, I would want to see a “spill” of the calculation to see what’s going on.? Perhaps there has been some double-counting.

Now, if we are talking about MZM (all monetary liabilities immediately redeemable at par) , we are facing high rates of growth — around 17% YOY.

My M3 proxy, total bank liabilities, is running ahead at a 13%+ rate.? Only the monetary base stays in the mud with barely 2% growth.? I still think that the Fed is trying to restrain inflation through no monetary base growth, while allowing the healthy banks to grow aggressively.? So much for supervision.

10)? Reading the H.4.1 report the past weeks have had the Fed lending more directly through their new programs, and selling Treasuries to keep the Fed’s balance sheet from growing.

11) I expect the minutes tomorrow to reveal little that is new; if anything, it will highlight the competing pressures that the Fed is trying to deal with.

12) For a view compatible with mine, read Bob Rodriguez of First Pacific Advisors.? One of my favorite equity managers, and he is doing well in the present environment.

13) The yield curve and Fed funds futures indicate another 25-50 basis points of easing in this cycle, at least, until the next institution blows up.

14) Finally, and just for fun — two guys I would nominate for the Federal Reserve Board — Ron Paul and James Grant.? Toss in Steven Hanke, and it starts to get interesting.

Eleven Notes on our Cantankerous Credit Markets

Eleven Notes on our Cantankerous Credit Markets

1) Note to small investors seeking income: when someone friendly from Wall Street shows up with an income vehicle, keep your hand on your wallet.? One of the oldest tricks in the game is to offer a high current yield, where the yield can get curtailed through early prepayment (typically in low interest rate environments), or some negative event that forces the security to change its form, such as when a stock price falls with reverse convertibles.? Wall Street only gives you a high yield when they possess an option that you have sold them that enables them to give you the short end of the stick when the markets get ugly.

2) When times get tough, the tough resort to legal action.? Financial Guarantee Insurance contracts are complicated, and the guarantors will do anything they can to wriggle off the hook, particularly when the losses will be stiff.

3)? The loss of confidence in financial guarantors has not changed the operations of many muni bond funds much.? With less trustworthy AAA paper around, many muni managers have decided that holding AA and single-A rated muni bonds isn’t so bad after all.? Less business for the surviving guarantors, it would seem.

4) Jefferson County, Alabama.? Too smart for their own good.?? So long as auction rate securities continued to reprice at low rates, they maintained low “fixed” funding costs from their swapped auction rate securities.? But when the auctions failed, the whole thing blew up.? There will probably be a restructuring here, and not a bankruptcy, but this is just another argument for simplicity in investment matters.? Complexity can hide significant problems.

5) Spreads were wide one week ago, even among European government bonds, and last week, as these two posts from Accrued Interest point out,? we had a significant rally in spread terms last week.? Now, credit can be whippy during times of stress, and there are often many false V-like bottoms, before the real bottom arrives.? Be selective in where you lend, and if the sharp rally persists for another few weeks, I would lighten up.? That said, an investor buying and holding would see spreads as attractive here.? When spreads are so far above actuarial default rates, it is usually a good time to buy.? I would not commit my full credit allocation here, but half of full at present.

6)? I don’t fear ratings changes, if that is the only thing going on, and there is no incremental credit degradation, or increased capital requirements.? But many investors don’t think that way, and have investment guidelines that can force sales off of downgrades that are severe enough.? Personally, I think Fitch is best served being as accurate as possible here; they don’t have as large of a base to defend, as do S&P and Moody’s.? So, if downgrades are warranted, do them, and then make the other rating agencies justify their views.

7) I have not been a fan of the ABX indices, and I thought it was good that an ABX index for auto ABS did not come into existence.

8) So what is a auction rate security worth if it is failing?? Par?? I guess it depends on how high the coupon can rise, and the debtor’s ability to pay.? It was quite a statement when UBS began reducing the prices on some auction rate securities.? Personally, I think they did the right thing, but I understand why many were angry.? A complex pseudo-cash security is not the same thing as owning short-term high-quality debt.

9) Then again, there are difficulties for the issuers as well, particularly in student loans.? Not only are costs increased, but it is hard to get new deals done.

10)? GM just can’t seem to shake Delphi.? In an environment like this, where liquidity is scarce, marginal deals blow apart with ease, and even good deals have a difficult time getting done.

11)? Regular readers know that I am not a fan of most complex risk control models that rely on market prices as inputs. My view is that risk managers should examine the likely cash flows from an asset, together with the likelihood of the payoff happening.? With respect to bank risk models, they were too credulous about benefits of diversification, as well as what happens when everyone uses the same model.? Good businessmen of all stripes focus on not losing money on any transaction; every transaction should stand on its own, with diversification as an enhancer in the process.

Shelter Fallout

Shelter Fallout

Though sometimes I do posts that are a melange of different items that have caught my attention, I do try when possible to gang them up under a common theme.I try not to do “linkfests” because I want my readers to get a little bit of interpretation from me, which they can then consider whether I know what I’m talking about or not. Anyway, tonight’s topic is housing. I didn’t get to my monetary policy 101 post this week — maybe next week. I do have three posts coming on Fed policy, credit markets, and international politics/economics. (As time permits, and ugh, I have to get my taxes done…. 🙁 )

1) The big question is how much further will housing prices fall, and when will the turn come. My guess is 2010 for the bottom, and a further compression of prices of 15% on average. Now there are views more pessimistic than that, but I can’t imagine that a 50% decline from the peak would not result in a depression-type scenario. (In that article, the UCLA projections are largely consistent with my views.) It is possible that we could overshoot to the downside. Markets do overshoot. At some level though, foreigners will find US housing attractive as vacation/flight homes. After all, with the declining dollar, it is even cheaper to them. Businesses will buy up homes as rentals, only to sell them late, during the next boom.
2) But, the reconciliation process goes on, and with it, losses have to go somewhere. In some cases, the banks in foreclosure refuse to take the title. Wow, I guess the municipality auctions it off in that case, but I could be wrong. Or, they let the non-paying borrowers stay. I guess the banks do triage, and decide what offers the most value to act on first, given constraints in the courts, and constraints in their own resources. Then again, developers can reconcile the prices of the land that they speculated on to acquire. In this case, cash is king, and the servant is the one that needs cash. I just wonder what it implies for the major homebuilders, with their incredible shrinking book values. Forget the minor homebuilders… Can one be worse off? Supposedly my father-in-law’s father lost it all in the great depression because he was doing home equity lending. There are wipeouts happening there today as well. Add in the articles about unused HELOC capacity getting terminated (happened to two friends of mine recently), and you can see how second-lien lending is shrinking at just the point that many would want it.

3) The reconciliation process goes on in other ways also. Consider PennyMac, as they look to acquire mortgage loans cheaply, restructure, and service them. Or, consider Fannie and Freddie, who are likely to raise more capital, and expand their market share (assuming guarantees don’t get the better of them). Or, consider the Fed, which has tilted the playing field against savers, and in favor of borrowers, particularly those with adjustable rate loans. No guarantee that the Fed can control LIBOR, though…

4) The reconciliation process steamrollers on. We’ve seen Bear Stearns get flattened trying to pick up one more nickel, and maybe Countrywide will get bought by Bank of America, but you also have banks with relatively large mortgage-lending platforms up for sale as well, like National City. Keycorp might bite, but I’ve seen Fifth Third rumors as well. Then there is UBS writing down their Alt-A book, along with a lot of other things.

5) A moment of silence for Triad Guaranty. A friend of mine said that they were the worst underwriter of the mortgage insurers. Seems that way now. Another friend of mine suggested that MGIC would survive off of their current capital raise. They stand a better chance than the others, but who can really tell, particularly if housing prices drop another 15%.

6) Beyond that, the financial guarantors have their problems. FGIC goes to junk at S&P. MBIA goes to AA at the operating companies, and single-A at the holding company at Fitch. I personally think that both MBIA and Ambac will get downgraded to AA by S&P and Moody’s. I also think that the market will live with it and not panic over it. That said, BHAC (Berky), Assured Guaranty, and FSA (Dexia) will get to write the new business, while the others are in semi-runoff.

7) Now for the cheap stuff. Amazing to see vacancy rates on office space in San Diego rising. I think it is a harbinger for the rest of the US.

8 ) Buy the home, take the copper, abandon the home, make a profit. Or, just steal the copper.

9) Bill Gross. A great bond manager, but overrated as a policy wonk. Many would like to see home prices rise, but others would like to buy a home at the right price. How do we justify discriminating against those who would like to buy a cheap house?

10) “The prudent will have to pay for the profligate.”? Well, yeah, that is much of life, in the short run.? In the long run, the prudent do better, absent aggressive socialism.? The habits of each lead to their rewards, and the ants eventually triumph over the grasshoppers.

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