Category: Real Estate and Mortgages

Back in the Game

Back in the Game

Posted on by David Merkel

After a lot of struggle (in my younger days I would have learned the coding, and reprogrammed the whole thing), my links are working again, though I have had to sacrifice the descriptive permalinks for now.? In the bargain, at least I upgraded to WP 2.3.1, which is a lot slicker than the old version.

For this evening, I want to offer you two unrelated thoughts on the markets.? The first is that the plan of the Treasury to freeze reset rates on subprime mortgages is a great big zero.? The real problem is too many homes chased by too few people able to afford them at current prices.? Subprime loans are a very modest portion of residential real estate finance.? Beyond that, the Treasury proposal does triage — separating borrowers into healthy, dead, and savable.? The savable are a small portion of a small component in the total residential financing scheme.? It will keep a few more people in their homes,? but that’s about it.? There will probably be court challenges from hedge funds that lose interest from the changes; they will probably win, because this is an illegal “taking” by the US Government.? That said, there is no way that I can see that they will be able to collect damages.

I said this was a zero, because paying the mortgage payment is not the problem here; it is the overhang of excess houses.? This does nothing to solve that problem.? My more radical solution of offering free US citizenship to anyone who buys a house in the US free and clear (for more than $250,000), is a non-starter for a wide variety of reasons, but it would kill two birds with one stone.? Clear up the excess houses, and solve the current account deficit problem.? A side benefit is giving wealthy foreigners a stake in the prosperity of the US.

Here’s my second thought.? Japan wants China to revalue its currency upward.? Perhaps that’s no big deal, but it reflects US dollar weakness.? China has been running a dirty crawling peg versus the US dollar, while letting other currency relationships languish.? As a result, the Euro and the Yen have gotten expensive versus the Yuan.? In this case, I think the Japanese are correct.? Let the US Dollar fall more, and let other nations buy our goods and services, rather than just swallowing our bonds (promises to pay later).

Notes on Fed Policy and Short-term Credit

Notes on Fed Policy and Short-term Credit

Posted on by David Merkel
  1. I just did my usual review of my FOMC indicators.? The FOMC should cut 25 basis points at the December 11th meeting.? Whatever the formal “bias” is, the verbiage will be a little of this and the a little of that, something like:? “Yes, we are worried about the solvency of some financial institutions.? That’s why we cut.? But this cut very likely should be enough, so don’t expect anymore.? Now leave us alone.”
  2. So Goldman sees a 3% Fed funds rate in mid-2008?? So do I.? Small moves in FOMC policy don’t achieve the desired ends, either when policy is rising or falling.? Large cumulative moves are needed to affect the behavior of market participants.
  3. The TED [Treasury – Eurodollar] spread is at its largest one-year moving average since 1990.? That’s significant short-term credit stress to the large banks, and it is worth watching.? It’s not just a US phenomenon either; in the UK the banks are under stress as well.
  4. Residential housing is driving the decisions of the FOMC.? As prices fall, more houses become non-refinancable, and non-salable (except at a loss).? All it takes then is for a problem to happen… death, disability, divorce, unemployment, or casualty, and another house goes on the market because of insolvency.
  5. So, I agree with Accrued Interest (great blog, doesn’t everyone want to read about bonds?).? Many Fed governors talk between meetings, and they trot out their baseline scenario, but often it is the worry of avoiding a somewhat likely negative scenario that can drive policy.
  6. At some level though, if the dollar falls far enough, the FOMC will have to reverse course, as Caroline Baum has pointed out.? Remember, that’s what drove the FOMC to tighten in 1986-87.
  7. Of course, the credit stress in the short end of the market has led some money market fund sponsors to bail out their funds (Legg Mason, Wachovia and B of A, while GE lets a pseudo-money market fund take a hit.? Remember, with money market funds, it’s not wise to stretch for yield, particularly not in bear markets for credit.
  8. One more weak Commercial Paper [CP] funding structure: using it as part of a “super senior” tranche in CDOs.? Now in this case, the collateral is weak — subprime mortgage loans, but this could be true of any CDO where the collateral comes under stress in the future, including high yield corporate bonds.? I wrote about this three months ago, but this one is still unraveling.
  9. I haven’t talked about it, because I wasn’t sure I had anything to add to the discussion, but the M-LEC, or super-SIV, proposed by the major banks seems like hooey to me.? After all, if this shifting of assets from one pocket to another created value, why wasn’t it done before?? It doesn’t change the underlying asset prices, and for the banks as a whole, it is just a zero sum game, unless new parties enter, at which point, they will have to offer a discount to move the paper, which eliminates one of the reasons for doing the deal.
  10. Putting another nail in the coffin, HSBC takes their SIVs onto their own balance sheet, cleaning up their own financing, and making it more difficult for the other banks who want to do the Super-SIV.

What an interesting time in the short-term debt markets.? For now, prudence dictates staying high quality in what financial institutions you lend to short term.

Seven Observations From Barron’s

Seven Observations From Barron’s

Posted on by David Merkel
  1. Kinda weird, and it makes you wonder, but on the WSJ main page, I could not find a link to Barron’s. I know I’ve seen a link to Barron’s in the past there; I have used it, which is why I noticed its absence today.
  2. I found it amusing that the mutual fund that Barron’s would mention on their Blackrock interview, underperformed the Lehman Aggregate over 1, 3 and 5 years. Don’t get me wrong, Blackrock is a great shop, and I would work there if they offered me employment that didn’t change my location. Why did Barron’s pick that fund?
  3. I’m not worried about the effect of a financial guarantor downgrade on the creditworthiness of the muni market. Munis rarely fail. Most of those that do fail lacked a real economic purpose. What would be lost in a guarantor downgrade is liquidity. Muni bond insurance is a substitute for analysis. “AAA insured, I’ll buy that.” Truth, an index fund of uninsured munis would beat an index of insured munis, because default rates are so low. But the presence of insurance makes the bonds a lot more liquid, which makes portfolio management easier.
  4. I’ve been a US dollar bear for the last five years, and most of the last fifteen years. Though we have had a little bounce recently, the dollar has of late been at record lows against currencies that trade freely against the dollar. I expect the current bounce to persist in the short term and fail in the intermediate term. The path of the dollar is lower, unless the Fed decides to not loosen more. Balance needs to be restored in the global economy, such that the rest of the world purchases more goods and services, and fewer assets from the US.
  5. I don’t talk about it often, but when it comes up, I have to mention that municipal pensions in the US are generally in horrid shape. The Barron’s article focuses on teachers, but other municipal worker groups are equally bad off. The article comments on perverse incentives in teacher retirement, which leads older teachers to retire when it is feasible to do so. For older teachers, I would not begrudge them; they weren’t paid that well at the start, and the pension is their reward. Younger teachers have been paid pretty well. I would not expect them to get the same pension promises.
  6. I like Japan. I own shares in the Japan Smaller Capitalization Fund [JOF]; it’s my second-largest position.

    Japan is cheap, and small cap Japan is even cheaper. I would expect a modest bounce on Monday.

  7. We still need a 15-20% decline in housing prices to bring the system back to normal. There might be an undershoot in price from the sales that forced sellers must do. Hopefully it doesn’t turn into a self-reinforcing decline, but who can be sure about that? At that level of housing prices, man recent conforming loans will be in trouble, much less non-conforming loans.


Full disclosure: long JOF

Brief Note on Homebuilder Valuations

Brief Note on Homebuilder Valuations

Posted on by David Merkel

I have not been tempted to nibble at homebuilders yet. Take one look at the chart of TOUSA, and you can see why:

TOUSA always looked cheap, but the level of leverage was way too high. Falling housing prices would have a larger negative effect on them.? Now they are staring at bankruptcy.

 

As it is, housing prices probably have another 10-15% to fall on average before this cycle ends.? There will be more bankruptcies among homebuilders before all of this is done.? When the cycle is done, there will be a few signs amidst the wreckage:

 

  • Surviving builders trade at 50-75% of written-down book value.
  • Earnings are negative, but no longer getting worse.
  • Early value investors will have given up on the sector.
  • Bond managers will reinstate the “no homebuilder bonds” rule.
  • Leverage will be similar to today, but on smaller companies.
  • Financial magazines will run articles on how smart MDC Holdings was during the “bad old days” of 2004-2006.
  • Old standards will return for loan underwriting.? Financial magazines will talk about prudence in borrowing against residential real estate, and how it is not a “one way ticket” to riches.
  • Inventory levels decline 20% from their peak levels.

 

Anyway, that’s what I expect.? At that time, or slightly before, I would probably buy two of the best capitalized homebuilders.? That’s what I try to do in investing… arrive slightly before the point of maximum pessimism.

Holding My Nose, Still

Holding My Nose, Still

Posted on by David Merkel

Three companies of mine reported after the bell, Flagstone, Deerfield, and National Atlantic. I’ll take them in that order.

Flagstone beat handily, as I would have expected a property-centric reinsurer to do in this environment. Let’s see what optimism tomorrow brings. At 96-97% of book value, it seems cheap, but I can’t imagine property reinsurance rates will be that robust next year.

Deerfield is a little more tricky. They took a loss due to mark-to-market events in their portfolio. REIT taxable income is reasonable at 50 cents/share, and much of the writedown is a GAAP anomaly that shaves $1.20 off of the current book value. Economic book value is $11.84, which provides some support to the stock. The dividend of 42 cents is still intact. There is reasonable excess liquidity, even after the increase in repo margins during the third quarter. Let’s see what the market thinks.

Now for the problem child, National Atlantic, which takes an 83 cent loss. Here’s the main offending paragraph from the press release:

“For the three months and nine months ended September 30, 2007, reserves have increased by $17.6 million and $9.4 million, respectively, principally as a result of the strengthening of the reserves for bodily injury claims. During the third quarter it was determined that the Company’s policy related to claims handling procedures and reserving practices were not applied consistently, primarily within the bodily injury claims unit. As part of the resolution of this matter, the Company retained an independent claims consulting firm.”

For a company the size of National Atlantic, these are huge reserve changes, particularly for a short-tail line like auto. What I am about to write here is only a guess, but this likely was building up since sometime in 2006. One of the reasons I am willing to be a little more bullish on short-tail insurers is that it is a lot harder to get the reserve wrong. Looks like I am getting one of the rare events that teaches greater caution. (That said, my average cost is $8.85, so I’m not that badly hurt.) Given the large reserve change this period, ordinarily, the decks are cleared for future periods, but who can tell for sure? Also, this places the combined ratio since 2002 at 103.7%. It makes me think that the company will do well to eke out any underwriting profit.

I’ll be listening to the call tomorrow. What’s the endgame here? Given the marginal ability to earn underwriting profits, perhaps the company would best be reconciled by merging with another firm. That wasn’t my opinion over the past three years, but it is my opinion now. There are many firms that could have an interest at the right price, which probably approximates the book value of $13.28. That said, many of them may have kicked the tires already and passed, some probably thinking that a bid at book value would not be honored. All I can say is, give it a shot. Rumor is that Commerce wasn’t offering more than book, so if you want a greater presence in NJ personal lines, it may be available at a reasonable price.

Full disclosure: long FSR DFR NAHC

Buying Cheap and Holding My Nose

Buying Cheap and Holding My Nose

Posted on by David Merkel

How comfortable would you be buying National Atlantic Holdings?

Or Deerfield Triarc?


Or YRC Worldwide?

I could go on, after all, recently I bought some Redwood Trust, and a number of smaller cap value names that don’t seem to be getting much respect right now. Value as a strategy is lagging now, and I am feeling that in my performance. Financials that deal with mortgages are out of favor also.
So why mortgage REITs now? Take a look at this chart of the 10-year Treasury yield less that on mortgage REITs:

Mortgage REIT yield spread
Yields are pretty high relative to “safe” Treasuries, comparable with 1990 and mid-2002 spreads. Only the bad old days of 1974 surpass the yield spreads of this era by a significant amount. As I recall, REITs had a really bad name in the late 1970s after the mid-decade shellacking. I remember technical terms like “fraud,” but then, I was an impressionable teenager with an active imagination. 🙂

Now consider this chart of the 10-year Treasury yield less that on equity REITs:

Equity REIT Yield Spread

The result is closer to fair value. I certainly would not call equity REITs as a group cheap; future returns rely on property price appreciation, which doesn’t seem likely to me at present.
Now, I’m not endorsing all mortgage REITs. Review funding structures and excess liquidity; you want excess cash flow and conservatism at this point. Heroics offer more downside than upside here.

As for YRC Worldwide, trucking is needed in our economy, and even with some slowdown, YRC should still make money, just not as much. On National Atlantic, I would only say that it seems that there is a forced seller in the name now, and when he is exhausted, the stock will lift. It is difficult to destroy a personal lines insurer with a conservative balance sheet. At 60% of a conservative book value, I can live with adverse outcomes.

Remember, do you own due diligence here. Just because it looks cheap does not mean it can’t get cheaper.

Full disclosure: long RWT NAHC DFR YRCW

How Powerful or Wise is the Federal Reserve?

How Powerful or Wise is the Federal Reserve?

Posted on by David Merkel

This post will be a little controversial. I believe that most investors over- or under-estimate the Fed. There are two ways to mis-estimate the Fed: power and wisdom. With respect to power, the most common errors are to overestimate the Fed in the short run, and underestimate them in the intermediate run. With respect to wisdom, the errors are to think that they are the wisest player in the market, or that they are less wise than the average market player.

My hypothesis is that the Fed is one of the brighter players in the market, top quartile, but not top decile, and that their power is quite great toward the end of the cycle, but modest until then.

My first contention stems from the lack of scalability of intelligence in a bureaucracy. You can gather large amounts of information, and have bright people interpret it, but the large numbers of Ph.D. economists insures that the result will tend toward consensus, and not be that much different from the consensus of economists outside the Fed, which means that the Fed will miss turning points. Also, in a bureaucracy, political pressures often dominate those near the apex of the organization, which twists the interpretation of the data, as well as what is deemed to be data. (M3 is no longer data worthy of being calculated.? A mistake in my book; the cost savings were minuscule, and the measure told us a lot about credit that M2 does not.)

Also, because of our political culture, there is a bias toward making it look like you are doing something, even when doing nothing is the optimal policy.? (We would likely all be better off by having Congress be a part-time legislature.? Okay, sorry, formally a part-time legislature… they have a lot of vacation already.? The same would apply to the Executive branch, but it would mean reducing the number of regulations enforced.)? So, even if the Federal Reserve is correct about the right long-term strategy, political pressure can force a different policy action, at least in the short run.

The Fed is a political creature, and it prizes its independence.? The funny thing is that it often preserves its independence by giving in to the political pressures that threaten its independence.? E.g. employment is slightly weak, but present policy is adequate to handle it if we wait 12 months?? No problem, we’ll loosen policy further.? (We can always take it back later, right?)

I would argue that no, you can’t take it back.? Yes, the Fed can reverse the cut later, but the effect is not the same as if they had not done the additional cut.? Here’s why, and this speaks to the power of the Federal Reserve: when the Fed lowers rates, more assets become financable at the lower short-term interest rates.? The lower rates go, even if for a time, the more economic players think that they can afford a given asset.? The effect is slow at first, because there’s a threshold to be met for psychology to change.? Changing the financing cost by 5% is dust on the scales; it’s not worth the fixed costs and effort.? Changing it 10, 20, or 30% is another manner, and cheap short-term capital will lead many to speculate and bid up asset prices, whether the assets are housing or businesses.? Economic activity accelerates accordingly.

It also takes a while for policy to bite when rates are rising.? Homeowners and businessmen make adjustments as rates rise, but it takes more of a rise to make their free cash flow go negative, forcing unpopular decisions that may have large fixed costs.? Asset prices normally decline in such an environment, slowing down economic activity.

My contention is that in order for Fed policy to have real impact it has to move the short rate significantly.? Time is not what does it, but the amount of the move.? Because the Fed moves slowly, the two effects become confused.

Back to my original questions.? How powerful is the Fed?? Very powerful when they move rates far enough, but weak before then. How wise is the Fed?? Pretty smart, but hamstrung by politics and bureaucracy, which keeps them from implementing the right strategy even if they have it.? They don’t always have the right strategy; they still miss turning points the same way that external economists do as a group, and often their actions add to economic volatility by being accidentally pro-cyclical.

The question that I have at this point in the cycle is how low the Fed will get before they get scared about inflation, and flatten out policy to see which effect is larger — deflation from overvalued housing assets purchased with debt, or inflation of goods and services prices.? They are separate phenomena, and can occur at the same time.? If they do occur simultaneously, what will the Fed do?? The US has almost always been debtor-friendly, so I would expect inflation, but that is just a weakly held opinion for now.

Eight Notes on Insurance, Economics, and Value Investing

Eight Notes on Insurance, Economics, and Value Investing

Posted on by David Merkel
  1. Doug Kass over at RealMoney made the following comment: “The next shoe to drop will be the failure of a public homebuilder and a private mortgage insurer. The latter concerns me more than the former, as the markets are not aware of the economic implications of my view.”? An interesting comment to be sure.? Unlike other insurers that benefit from state guarantee funds, the mortgage insurers do not so benefit.? That said, in a concentrated sub-industry that has only seven players (MTG, RDN, PMI, TGIC, GNW, ORI, and AIG), one advantage that poses is that failure of one company will not lead to assessments on the rest of the companies, leading to cascading failures.? So who would be affected?? Fannie and Freddie would get a lot of credit risk back, as would any private lender that used the mortgage insurers to reduce risks.? Even some of the mortgage originators with captive mortgage reinsurers would take some degree of a hit (most of the top originators had these).
  2. Some younger friends of mine asked me for advice recently, and the question came up, “Should I invest in the market, or pay down debt?”? Now, we weren’t talking about credit card debt, which they paid off in full every month.? They did have a home equity loan at 8.5% fixed.? My view was this: with 10-year Treasuries yielding 4.4%, and marginal investment grade corporate bonds yielding 6.0% or so, a reasonable return expectation for the equity markets as a whole would be in the 8-9% region.? Add 2-3% to the BBB-bond yield, and that should be a reasonable guess, given that I think the market is somewhere between lightly undervalued and fairly valued.? My advice to them was to pay down the home equity loan, and once it was paid off, invest in an index fund, or a diversified mutual fund.? Until then, better to earn 8.5% with certainty, than 8-9% with uncertainty.
  3. As can be seen from my recent reshaping, yes, I do buy sectors of the market that look ugly.? Shoe retailers and mortgage REITs have not done well of late.? Am I predicting no recession by buying the retailers?? No; so long as the shoe retailers aren’t too trendy, demand for shoes is relatively stable, and these stocks are already discounting a recession.? I chose two that had virtually no debt, so I am on the safer side of the trade, maybe.
  4. Does buying a mortgage REIT mean that I am betting on further FOMC loosening?? No.? The mortgage REITs that I hold embed a pretty nasty set of assumptions for the riskiness of the safest parts of the mortgage bond markets.? While a FOMC loosening would probably help, I’m not counting on that.
  5. My value investing is different than most value investors, because I spend more time on industries, either buying quality companies in beaten-up sectors, or companies with pricing power, where that power is underdiscounted by the market.
  6. If we are trying to estimate the central tendency of inflation and eliminate volatility, it is better to use a trimmed mean, or median, rather than toss out volatile components like food and energy, particularly when those components have led inflation for the last 5-10 years.? The unadjusted CPI is a better predictor of the unadjusted CPI than is the core CPI.
  7. Personally, I think the next ten years will be kinder to “long only” equity managers than hedged managers.? There is only so much room for shorting, which is an artificial overlay on the system.? We aren’t at the limits of shorting yet, but we are getting closer to those limits.? It would not surprise me to see ten years from now to find that balanced fund managers beat hedge fund managers on average (after correcting for survivor bias, which is more severe with hedge funds).? It’s much easier and more effective to do risk management in a long only mode, and I believe that the virtues of long only management, and balanced funds, will become more apparent over the next ten years.
  8. I’m thinking of doing a personal finance post on what insurance to buy.? Is that something that readers would like to read about?
October 2007 Portfolio Reshaping

October 2007 Portfolio Reshaping

Posted on by David Merkel

The reshaping file can be found here. In order to stay in compliance with the Bloomberg data license, I only include numeric fields that I have calculated. My ranking method ranks the companies in my portfolio, and all replacement candidates by several variables:

  1. Relative Strength (lower is better, double weight)
  2. Trailing P/E
  3. This year’s P/E
  4. Next year’s P/E
  5. Price-to-book (double weight)
  6. Price-to-sales (double weight — financials are counted as average)
  7. Dividend Yield
  8. Net Operating Accruals (a measure of accounting integrity — double weight — financials are counted as average)

I rank the companies on all of the criteria, weight the ranks, and calculate a grand rank. I look for the company that I own that has the middle rank for all of my currently owned companies, and I sell a few companies that I own below that, and buy some new companies near the top of the list. Here are my actions:

Sales

  • Sara Lee
  • Dow Chemical
  • DTE Energy

Purchases

  • Redwood Trust [RWT]
  • Gehl Corp [GEHL]
  • Shoe Carnival [SCVL]
  • Charlotte Russe Holding [CHIC]

Future Sale

One reinsurer — could be Flagstone, PartnerRe, or Aspen Holdings.

Rationale

I have enough reinsurance names going into earnings. If you need more of an example of how well they will do this quarter, then look no further than PartnerRe’s solid earnings report this evening. On the other sales, DTE Energy and Dow Chemical were solely for valuation reasons. Sara Lee is another matter; my confidence that they can turn around the company is reduced, and valuation is not compelling.

As for purchases, on the shoe retailers, there were a bevy of cheap names, but Shoe Carnival and Charlotte Russe seemed to have the most consistent operations, and low debt. Gehl seems to be in a good industry, small agricultural machinery is in demand, and valuations are modest. Finally, Redwood Trust seems to be well-run as mortgage REITs go. Asset quality is good and leverage is moderate. Also, the debt is all from securitizations, so it is non-recourse to the company; the most that can happen is that the assets in the securitizations depreciate to the degree that their residual interests are worthless.

One other shift that is unintentional here, is that my portfolio becomes more small cap in nature. I am selling away larger companies, and buying smaller ones. That is an accident of the process, but occurring because there are some genuinely cheap companies to buy. Time will tell as to whether these are good purchases, but most of what I like in investments are lining up here.

Full disclosure: long PRE AHL FSR CHIC SCVL RWT GEHL

Society of Actuaries Presentation

Society of Actuaries Presentation

Posted on by David Merkel

Finishing off the presentation proved to be harder than I estimated, together with all of my other duties.? Well, it’s done now, and available for your review here.? For those looking at one of the non-PDF versions, you might be able to see the notes for my talk as well.

 

I’m writing this before I give the talk.? If I had it to do all over again, I would have made the talk less ambitious.? Then again, of the four topics that I offered them, they picked the most ambitious one.? When you look at the talk, you’ll see that it is a summary of the macroeconomic views that frame my investment decisions.? The presentation will run 40 minutes or so, plus Q&A.? Reading it is faster. 🙂

 

Enjoy it, give me feedback, and I’ll be back to normal blogging Monday evening.

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