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|Charting Your Course |
Hope Springs Eternal but the Worst is Not Over.
By Mitch Siegler, Managing Director
The CEOs of the world's largest financial institutions might have been a wee bit too sanguine these past few months by declaring that the end of the global credit crisis is at hand. Goldman Sachs' Lloyd Blankfein compared it to "the third or fourth quarter in a football game. Morgan Stanley's John Mack said, in a baseball analogy, the crisis had reached "its eighth inning or maybe top of the ninth." Lehman Brothers' Richard Fuld and Merrill Lynch's John Thain have also been upbeat about the future.
One recent edition of the Wall Street Journal contained the following headlines:
"Big Loss at Lehman Intensified Crisis Jitters"
"More Pain Ahead for UBS"
"WaMu Shares Hit 16-Year Low"
"Greenberg's Take: AIG 'Is Falling Apart'"
The recent anxiety about the financial industry, combined with rising inflation and unemployment and an economy that continues to weaken, make it appear that Morgan Stanley's John "Top of the Ninth" Mack may have, in fact, been referring to the first game of a double-header.
Meanwhile, this story, dateline Washington, D.C.: "Bernanke: Risk to Economy Fading." While we're as happy as the next guy that the Fed Chairman says the sky isn't falling, we're not quite ready to break out the champagne just yet. (Neither is Warren Buffett, who, when asked during a recent CNBC interview what he would do if he were Fed Chairman replied, "I'd resign.")
And, it seems that the uptick in May retail sales, which had the CNBC talking heads dancing a jig, may be a wee bit artificial, thanks in no small part to the $50 billion in tax refund checks Uncle Sam recently mailed to households near you. (Presumably, Helicopter Ben's whirlybirds weren't available.)
But for this little stimulus, even the ever ebullient American consumer - inexplicably continuing to use her credit cards with abandon despite falling home values - might have ratcheted back spending a tad this spring. Old school types like us have to imagine that the perfect storm of rising fuel and food prices and declining home values will soon hit consumers where it hurts - in the pocketbook.
Housing bulls say real estate prices have hit bottom. They take comfort in the increased sales velocity and slightly higher prices during the past few months in a number of hard-hit markets, including the Inland Empire region in southern California and Las Vegas. Barron's, our favorite financial publication, makes a fairly compelling case that the worst is over in its July 14 cover story "Bottom's Up: The plunge in home prices is nearing an end as the U.S. housing market shows signs of revival." (It doesn't happen often but even Barron's gets it wrong now and again.)
Bears remain concerned about the half a million foreclosures completed to date and the threat of several million more before this cycle ends. In May, 73,000 American homes were repossessed, a 158% increase from May, 2007 levels. In case you were wondering, May marks the 29th consecutive month in which the yearly foreclosure rate increased. As the first half of '08 came to a close, there were 681,000 homeowners with first mortgages in default, up from 313,000 a year ago.
While it is a bit too early to tell if we have bottomed, markets can remain on or near the bottom for months or years. (To quote Chico Marx in Duck Soup: "Who you gonna believe, me or your own eyes?") Here are six reasons why we believe the soft economy makes this "bumping along the bottom" scenario rather likely:
1. Home prices continue to fall - The median price of a home in Sacramento, CA was down 35% during the three months ended May 31, compared to the same period last year, according to the real estate web site Trulia.com. In Riverside, CA, prices fell 29%, while San Diego prices dropped 26%. Cities in California's central valley - like Stockton Modesto and Bakersfield - also posted steep declines (-39%, -37% and -29%, respectively). Other hard-hit markets include Phoenix (-19%), Las Vegas (-22%), West Palm Beach (-32%) and Cape Coral, FL (-35%).
Futures trading in the S&P Case/Shiller Home Price Index suggest investors expect prices to continue to trend lower. The index, which tracks the sale price of specific homes as they are sold and resold over the years, is considered to be one of the most accurate home price indicators. Specifically, Case/Shiller investors are betting that prices in selected markets will fall another 20% by November, 2009. Prices in Las Vegas are projected to decline another 22%, those in L.A. are forecast to plummet 24% and Miami is thought to be in for another 22% fall. The price declines reflect massive supply of distressed bank-owned properties and discouraged sellers.
The chart above, courtesy of Agora Financial, doesn't require much ink to explain. Check out the inverted hockey stick between 2005 and 2008. The Home Price Index's 20-city composite has fallen about 13% year over year. Negative annual returns are being reported by 19 cities; 17 cities are showing record declines.
2. Home buyers remain concerned about overpaying - Many prospective homebuyers are sitting on the sidelines, afraid to overpay. This fear of trying to catch a falling knife is perfectly rational and characteristic of declining markets. That helps explain why price depreciation seems to be accelerating. "The most severe declines are happening right now," said Mark Zandi, chief economist for Moody's Economy.com.
3. Home sales volumes are in decline - New home sales in April, generally the peak of the spring selling season, were running at a seasonally-adjusted annual rate of 526,000, the lowest in nearly 20 years, according to John Mauldin's Investor Insights. Overlaying current sales volumes on this data means it would take 11 months to work off the inventory, up from 8.4 months last fall, according to Weldon Financial. While inventories fell slightly in May, at the current sales level, the supply of homes remains at 10.8 months, according to the National Association of Realtors.
Meanwhile, April housing starts were running at an annual rate of 947,000, which means homebuilders are constructing 400,000 more homes than are being sold. Factor in a million foreclosures and make it really hard for buyers to get a loan and it doesn't bode well for housing. Those predicting a big rebound anytime soon had better dust off their slide rules.
4. Homes remain unaffordable, relative to incomes - Many economists believe declines in home prices became inevitable because home price appreciation had run away from incomes. Historically, home prices have averaged four times incomes. Whenever homes got significantly more expensive, people could not afford to buy and home prices came back down to earth. In some markets, price-to-income ratios are still out of whack even after steep corrections, suggesting they have further to fall. In Los Angeles, the ratio peaked at 22.7, according to Michael Youngblood, a portfolio analyst at FBR Investment Management. Even after the recent correction, the ratio is in the high teens. L.A. home prices would have to come down another 40% to get that ratio back to single digits.
5. Consumers are tapped out - Declining home prices will inevitably cause consumer-spending to slump. The cash consumers tapped from their home-equity loans amounted to 5% of gross domestic product, says Robert Arnott, Chairman of investment advisory firm Research Affiliates. Roughly half of the $600 billion in home-equity withdrawals in 2005 was spent on consumer goods, according to Arnott. Now that home prices are declining and equity is shrinking, the implications for consumer spending and future home sales trends are fairly obvious.
6. A softening economy exacerbates the situation - According to FBR Investment Management's Youngblood, "Bubble cities are now seeing fleeing employment conditions." In Miami, the unemployment rate rose 34.3% in the 12 months ending April, 2008. And the job picture in California cities, where many jobs were housing-related, has been even worse. Housing was a key economic driver for Riverside, Stockton and Modesto during the boom, according to Economy.com's Mark Zandi. Builders, real estate and mortgage brokers and lenders depended on growth in the sector. Home improvement retailers like Home Depot and Lowe's built 100,000 square foot "big box" stores to cater to these growing communities.
So, where are we now? Analysts estimate that at the end of the first quarter, 8.8 million homeowners had mortgage balances equal to or greater than the value of their homes. Of subprime loans written in 2005 and 2006, 30% are already underwater and 20% are delinquent (the number is rising rapidly). Nearly three million homeowners (5.82% of all mortgages) were behind on their mortgages at the end of 2007, the highest level in 23 years. Analysts say a million homeowners are at risk of imminent foreclosure. An estimated 0.83% were in the foreclosure process, an all-time high. The average American's percentage of equity has fallen below 50% for the first time since 1945.
This explains why Financial Times columnist Martin Wolf describes the coming slump in the U.S. as the "mother of all meltdowns." Wolf refers to the work of NYU economist Nouriel Roubini, who thinks the housing decline will put 10 million homeowners upside down, with more mortgage than house. It will lead to collapsing credit, defaults and huge losses to lenders. It will also bring about a big cutback in consumer spending and unavoidably push the U.S. into a deep recession. So, while hope springs eternal, fasten your seat belts.
Mitch Siegler is a co-founder and Managing Director of Pathfinder Partners, LLC. Prior to founding the company in 2006, Mitch was a partner with a management consulting firm, founded and served as CEO of several businesses and was a partner with a boutique investment banking and venture capital firm.
|Finding Your Path |
Why Does the Rest of the World get it This Time Around?
By Lorne Polger, Managing Director
The "in your face" signs of the continuing U.S. financial crisis that we have seen this summer (major bank failures and record stock price declines for financial institutions), received a temporary reprieve following the government's decision to prop up Fannie and Freddie. This seems like a temporary patch of the hole in the hull of the Titanic. Everyone knows that ultimately the ship may sink, but if we can just cover up the hole for awhile and not inspect the hull too closely, it will be smooth sailing. (Or, as noted in a commentary authored by Tom Millon: "Welcome to the Titanic. Would you like a refreshing drink while I rearrange your deck chair?").
The major investment banks - like Citicorp, Goldman Sachs, Morgan Stanley and Lehman Brothers - appear focused on turning around prior bad business decisions by shedding unprofitable investments, recognizing losses and cutting employees. While the Wall Street firms are not quite poised to soar like an eagle, the steps taken by many major commercial banks are more reminiscent of an ostrich.
While we continue to see meteoric rises in loan defaults and the FDIC's "Watch List" no longer fits on a single sheet of paper, there is, as yet, no industry-wide strategy for a permanent repair of the U. S. S. Banking System. Bank analyst David Ellison, who runs the FBR Small Cap Financial Fund, recently pumped up the cash levels in his two funds to as much as 50% of assets, noting that "too many financial executives remain in denial." From last week's Wall Street Journal: "While he is heartened by the industry's recent upturn, he remains wary of chronic woes such as weak loan demand at banks. The timing of a sector turnaround is impossible to predict," said Mr. Ellison. His downbeat themes: No one has any idea how much worse things will get amid poisonous debt lurking inside financial outfits, and this is just the beginning of a complete regulatory overhaul needed to eventually fix the problems."
What is interesting to note is how, from a global perspective, the current crisis differs from prior recessions. (When it costs $110 to fill up the SUV and $250 to purchase groceries and the stock portfolio is oozing red, one can't help but use the "R" word.)
In days of old, as the U.S. goes, so goes the world. Financial trends generally started here and then circled the globe. This time around, in the financial sector, that doesn't appear to be the case. Leading European, Asian and Canadian banks have shown relatively strong performance over the last couple of years, and a certain degree of immunity from the crisis facing U.S. financial institutions. As a result, their stock prices are, for the most part, hanging on fairly well.
Contrast U.S. banks Corus (CORS) and Wachovia (WB), with Canada's Bank of Nova Scotia (BNS) and Europe's HSBC (HBC). Two years ago, Corus was trading at $23/per share and Wachovia at $55/share. At press time, those prices were, respectively, $3.80 and $14.50, declines of 74% to 83%. Meanwhile, up north, BNS traded two years ago at $42/share and closed last week at $48; while, across the pond, HSBC was at $91 two years ago and closed last week at just under $84. These are just a few of many examples here and abroad.
Why the difference? In a nutshell, U.S. banks are being pummeled for their aggressive lending practices. During the past five years, many U.S. banks abandoned their Brooks Brothers suits in favor of trendy American Apparel outfits. Conservative 70% loan-to-value ratios were abandoned in favor of 80% loans with a 15% mezzanine piece grafted on. Underwriting based on historical data was abandoned in favor of underwriting based on future pro formas. Geographic restrictions gave way to broader regional measures.
This did not occur everywhere, of course, and a fair number of well-managed U.S. institutions stuck to their tried and true ways. Although those "stodgy" institutions "suffered" in the context of limited deal flow over the last few heady years, today those banks are avoiding massive write-offs and enjoying relatively healthy balance sheets.
Most overseas banks didn't quite see the world like the maverick U.S. banks. Many leading international banks appear to have come through the current crisis relatively unscathed. Generally, foreign lenders appear to have stuck to their tried and true lending practices - underwriting borrowers on their abilities to repay; not over-leveraging deals, not betting that increased values would rescue bad business decisions. Certain hyper-aggressive foreign lenders, who bought into the new U.S.-style financial alchemy, are now taking their lumps. UBS, abandoning its centuries-old, staid approach to underwriting, joined the hoopla in the U.S. and was rewarded with tens of billions in write-downs in the past year.
A second dynamic was at work as well. The eroding value of the U.S. dollar strengthened the relative financial positions of foreign lenders. The Euro, Pound and Canadian dollar have soared to unprecedented levels, relative to the U.S. dollar, increasing the relative position of foreign banks from a cash and collateral perspective. Even those foreign lenders who made risky U.S. real estate loans are buffered by the strength of their currencies.
The likely result: a dramatic increase in the failure rate of U.S. banks and a corresponding likelihood of increased foreign investment into U.S. financial assets at knock-down prices. Don't be surprised if today's troubled U.S. banks and floundering American commercial real estate assets are tomorrow's German-owned international financial institutions and Saudi-owned trophy properties.
It's interesting that so many of these present day issues hearken back to lessons I learned during my freshman year of college. Lesson #1, from Econ 101: the Law of Supply and Demand - too much money chasing a finite number of good investments drives investment in marginal (or worse) projects. Lesson #2, from Physics 101: Newton's Laws of Motions - what goes up must come down.
Today, it seems that U.S. banks which employed the most aggressive lending practices appear to display the least responsive reaction times in dealing with their defaulted loan portfolios. As loan volume plummets, loan losses rise along with restructuring costs. Many of these institutions appear poised to fail, both because demand has dramatically eroded and their costs (from write-offs and workouts) are escalating. The root cause, though, was poor lending practices. As Darwin postulated, the strong survive and prosper and the weak will be absorbed by more efficient domestic or foreign buyers or rescued by the government and, ultimately, taxpayers. Profits will be made by those with conservative but opportunistic positions.
The current financial downturn looks like it will be steeper than the last one, in the 1980s. But, if foreign financial institutions remain healthy and larger U.S. investment banks continue to take their lumps, the cycle may be shorter this time around.
Lorne Polger is a co-founder and Managing Director of Pathfinder
Partners, LLC. Prior to founding the
company in 2006, Lorne was a partner with the law firm of Procopio, Cory,
Hargreaves & Savitch in San Diego, where he headed the Real Estate, Land
Use and Environmental Law group.
|Snippets: Truth is Stranger Than Fiction|
A Collection of Comical, Outlandish and Bizarre True Stories
A compendium of notable news articles relating to commercial lending which we've edited and commented upon
|U.S. household net worth fell $1.7 trillion in first quarter.
||Source: Agora Financial
That's the biggest drop since 2002, the end of the last recession. How's that for a recessionary indicator? According to a recent Federal Reserve report, total household worth declined 3% in the March quarter, to $56 trillion. During the 2000-2002 recession, American net worth dropped 6.2%. So, if the current crisis is of any comparison to the tech bust, we're halfway through.
And, the primary culprit? You guessed it - home equity fell to 46% by the end of the quarter, the lowest amount since the Fed began keeping records in 1951.
|Indymac Bancorp placed under FDIC control.
Regulators closed $32 billion Indymac Bancorp on July 11 and placed it under FDIC control because of a liquidity crisis. Initially started by Countrywide Financial, Indymac is the second largest financial institution to be closed by regulators in U.S. history (Continental Illinois holds the record).
|Level three assets exceed capital at ten companies.
||Source: Marc Faber's Boom,
Doom and Gloom Report
Here's a bombshell from über-analyst Marc Faber, long-time member of the venerated Barron's Roundtable. Readers of this newsletter will recall earlier mentions of this category of extremely illiquid balance sheet asset, which since the spring must be specifically reported. Not only are level three assets hard to value, they're also notoriously difficult to sell. With the deterioration in the mortgage market, more mortgages now must be categorized as level three. Care to guess what types of businesses have the highest proportion of level three assets? Here's Faber's top ten list, ranked by percentage of total shareholder equity:
|1. Bear Stearns
|2. Morgan Stanley
|3. Merrill Lynch
|4. Goldman Sachs
|5. Lehman Brothers
|6. Fannie Mae
|7. Northwest Air
|Californians may be laid back but we can spot a trend.
||Source: Agora Financial
And a big trend today in California is recession. House prices have fallen more in California than anywhere - down 29%, according to the usually ebullient California Realtors Association. A thousand foreclosed homes are auctioned every day in California. And joblessness in the Golden State hit 6.8% in May.
Californians' response? "Cutting back on spending," says James Saft in the International Herald Tribune. "Besides causing woes for state and local government, the cutback is giving California's economy another knock and makes further job losses, home repossessions and banking problems more likely."
Nordstrom, with a third of its sales from California, says sales were down 6.5% in the first quarter. Starbucks isn't selling as many lattes in California as before. Jack-in-the-Box says Californians aren't buying as much of its fabulous food either.
In the central valley, cities like Modesto, Stockton and Merced have 60% of their homeowners "upside down" on their mortgage. Unemployment rates in these towns are north of 10%. And Vallejo, a city in Northern California, has declared bankruptcy.
|Tough times for Fannie and Freddie.
||Sources: Barron's, Wall Street Journal,
Agora Financial, New York Times
And, that's putting it kindly. Fannie Mae and Freddie Mac, the two government-sponsored enterprises (GSE's) which hold more than 80% of all U.S. home loans, are running out of money. At the end of 2007, the two firms held $83 billion in cash reserves underpinning a staggering $5 trillion (with a "T") in debt and mortgages.
Fannie's stock price is at a three-decade low; Freddie's stock is down 90% during the past year. As mortgage defaults have risen and home prices have fallen, the firms have reported billions in losses. The value of the firms' collateral continues to be marked down monthly. Analysts report Fannie and Freddie need to raise $75 billion. A few years back, before the housing market tanked, that would not have been a problem.
The ostensible reason for their woes was the news that Fannie paid a record-high interest rate (relative to Treasury yields) in July to sell $3 billion of two-year notes. To be precise, Fannie paid 74 basis points over the Treasury bill rate; triple the spread it paid just two years ago. This is newsworthy because 74 bps over Treasuries doesn't jive with the story the two GSE's have spun for two decades that their bonds are "as good as Treasuries."
Now that the cat's out of the bag, investors worry that Fannie and Freddie might be the next Bear, Countrywide or WaMu. Absent the Federal government's backing, Fannie and Freddie ain't the AAA credits they have appeared to be. Former St. Louis Federal Reserve President, William Poole, has been predicting a meltdown in the two GSE's since March, calling the two lenders "insolvent".
According to Poole, Freddie owes $5.2 billion more than its assets are worth. That's significant, since the two bought 80% of new mortgages in the U.S. this year from banks and mortgage lenders. "Congress ought to recognize that these firms are insolvent," Poole says. "It is allowing these firms to exist as bastions of privilege, financed by the taxpayer."
While Fannie and Freddie might not be insolvent, they are both highly leveraged firms - leverage ratios in the neighborhood of 60-to-1. While home prices were heading north, that was just hunky-dory. But, now that the housing market is in free-fall, big leverage creates big problems.
Peter Schiff, president of Euro Pacific Capital, predicted that the companies would have trouble raising capital from private sources. "That's like selling tickets for the Titanic after it's already hit the iceberg," he said.
While we doubt Fannie and Freddie will go under, it's a safe bet they will become two major new line items in the Federal budget. Witness recent statements from NY Senator Chuck Schumer ("too important to go under; Congress will act quickly, if necessary.") and John McCain ("They must not fail"). There's a solution only a politician would dream up: How to solve a problem caused by too much credit? More credit, of course.
A study by Bridgewater Associates, one of the world's largest hedge funds, estimates that total credit crisis losses will reach $1.6 trillion worldwide - four times the $400 billion lost to date.
|Global financial crisis only 25% complete.
||Sources: Agora Financial,
London Daily Telegraph
In a confidential report leaked to the Swiss newspaper Sonntags Zeitung, Bridgewater says, "We are facing an avalanche of bad assets. We have big doubts as to whether financial institutions will be able to obtain enough new capital to cover their losses. The credit crisis is going to get worse."
According to Ambrose Evans-Pritchard, who wrote the story for The London Daily Telegraph, "Bank losses on this scale would have far-reaching effects. Lenders would have to curtail loans by roughly ten-to-one to preserve their capital ratios. This would imply a further contraction of credit by up to $12 billion unless banks could raise fresh capital."
While we don't expect the Fed to allow credit contraction of anywhere close to this magnitude, the write-offs Bridgewater forecasts are staggering and their analysis is founded on simple mathematics. The firm estimates financial institutions hold more than $26 trillion in debt-based assets. If such assets were valued at today's market rates, around $1.6 trillion would be vaporized.
The good news: About 90% of the losses from subprime assets have already been written off. The bad news: the losses aren't all subprime.
Losses on the prime and Alt-A loan portfolios could be much bigger than the subprime problem since these loan books are more than six times the size of subprime. Quoting from the report, "U.S. commercial banks are in a position to suffer the greatest losses, because the core of their portfolio is risky U.S. debt assets. If we use current market pricing as a guide, there is a long way to go as these institutions have only acknowledged about 1/6 of the expected losses they will incur as a result of the credit crisis."
Furthermore, write-offs on more than half, $800 billion, come from commercial loans. This includes $550 billion with no impairments taken to date. We'll spare you the ugly details but the bottom line is that Bridgewater estimates there is at least another $1.1 trillion of losses that will have to be taken by financial institutions worldwide, including very large potential write-offs from U.S. banks and insurance companies.
|Sub-prime guru warns it's not over.
||Source: The London Daily Telegraph
John Paulson, the eponymous hedge fund manager who made $3.7 billion from the sub-prime mortgage collapse last year, warns that the credit crisis is not over. Paulson predicts losses in the financial sector of $1.3 billion, compared with the IMF's latest estimate of about $900 million.
"I don't think we're through the credit crisis. There are lots of problems out there and I think we will continue to experience problems for the remainder of the year," Paulson said. Paulson & Company manages $33 billion. In 2007, it bet subprime mortgages would fall because they were art "bubble-like" prices. The firm's main fund soared nearly 600% in 2007 by shorting subprime debt.
|U.S. foreclosures surged to a record high in first quarter.
According to the Mortgage Bankers Association, 2.4% of all American home loans were in some form of foreclosure during the period, an all time high. An ominous sign: mortgage payment delinquencies surged to a rate of 6.3%, also an all-time high. That's about 1 in 16 American mortgages which are past due.
In the last quarter of 2007, 5.8% of homeowners were behind on their payments and the first quarter's record foreclosures were the result. As home prices continue to fall and more bank-owned homes come on the market and more adjustable mortgages reset...haven't we've seen this movie before?
|California foreclosures skyrocket 77% in June.
||Source: Sacramento Business Journal
The number of foreclosure filings on California homes was up almost 77% year-over-year in June, RealtyTrac Inc. reported.
Foreclosure filings were reported on 68,666 properties in the state last month, down 4.5% from May but up 76.9% from June, 2007, according to RealtyTrac. The California filings total was the highest nationwide for the 18th consecutive month.
One in every 192 California properties received a foreclosure filing in June, the nation's second-highest state foreclosure rate and 2.6 times the national average. Seven California metro areas were in the top 10 for foreclosure filings nationwide: Stockton (ranked 1), Merced (2), Modesto (3), Riverside-San Bernardino (5), Vallejo-Fairfield (7), Bakersfield (8) and Salinas-Monterey (10).
Florida ranked second, with foreclosure filings on 40,351 properties in June, up 7.9% from May and 91.8% from a year ago. Ohio was third with 13,194 foreclosure filings last month, followed by Arizona, Michigan, Texas, Georgia, Nevada, Illinois and New York.
RealtyTrac found 252,363 total foreclosure filings were reported nationally last month, down 3.4% from May but 53.2% above June 2007. That's on top of a 112% increase in U.S. foreclosure filings in the first quarter of 2008. During the first quarter, an incredible 1-in-54 homes received some sort of foreclosure filing.
Still, the bottom is a ways away, thanks to the $362 billion worth of ARMs yet to reset in 2008. "We expect to see another foreclosure peak in the late third or fourth quarter because of the record number of resets coming," says RealtyTrac's Rick Sharga.
|Fed hands $160 billion to investment banks since March.
||Source: Agora Financial
Since March, the Fed has conducted nine Treasury Secured Loan Facility (TSLF) auctions, exchanging its Treasury notes for banks' unwanted mortgage- and asset-backed securities. The major brokerages have dumped around $160 billion of this "alphabet soup" (ABS's, CDO's and CMBS's) on the Fed since these weekly auctions began in March.
As such, "Illiquid collateralized debt obligations, including mortgage-backed securities," says Agora Financial's government statistics guru John Williams, "now total in excess of 20% of the collateral backing the Federal Reserve Notes." That's a fifth of the assets backing the U.S. dollar comprised of illiquid mortgage-backed securities - and some think the dollar ain't what it used to be.
The Fed has also been conducting Term Auction Facilities (TAF), lending over $510 billion since the TAF was introduced, in December, 2007. Meanwhile, the discount window is wide open, allowing commercial banks access to cheap overnight loans. Since the Bear Stearns debacle, investment banks can visit the discount window, too - they've been borrowing $10 to $15 billion a day here.
We won't be surprised to see our local fishmonger walking up to the Fed's lending window soon to exchange his excess inventory for Treasury bonds. And, why not? The value of day-old fish may actually be more predictable than some of the collateral the Fed is actually accepting.
Not the best time to be a homebuilder.
Hovnanian reported contracts for the first quarter were down 41% from the same period last year. The actual dollar value of those contracts fell as well, by 50% year over year. For the first quarter, the homebuilder reported a net loss of $130 million, double the size of its 2007 first-quarter loss.
KB Home, another struggling homebuilder, announced it is closing operations in New Mexico, Illinois, Maryland and Virginia. The company posted a $772 million fourth quarter loss, 15 times the size of its 2006 fourth-quarter loss.
Between them, D.R. Horton and Pulte Homes have laid off 5,000 employees and taken $3.8 billion in impairments for land and houses. Many builders - including K.B. Home, D.R. Horton, Pulte Homes and Standard Pacific - are in danger of breaching bond covenants because of their financial distress. Such breaches could trigger provisions requiring immediate repayment of outstanding principal, which these builders are not in a position to do.
|What's in a name?
||Source: Agora Financial
First Integrity Bank - an ironically named Minnesota institution - was shut down by the FDIC on June 1. "A series of unsound practices," according to the FDIC, put the bank's core capital at negative 0.2%. The number of banks on the FDIC's "problem list" - like First Integrity - swelled 20% in the first quarter to 90 institutions. That's a 70% increase over the same period last year.
Meanwhile, a March 14, 2008 article in the Financial Times tells of three more hedge funds in trouble. Global Opportunities halted redemptions. Drake Management is shutting down one of its funds. And Blue River will close down after losses of more than 80%.
One of the funds going under was called "Absolute Return and Low Volatility." That sounds pretty safe. Apparently, the absolute return went the wrong direction and the volatility was above target levels. Oops.
|Lenders dumping loans; regulators see more losses.
||Source: The Wall Street Journal
"Federal regulators warned that banking-industry turmoil would continue as financial institutions come to terms with piles of bad loans they made to finance the construction of homes and condominiums," the Wall Street Journal reported.
"As long as the housing market is on a downward path, as long as those prices continue to fall, I think there's a risk that the losses could continue to mount on a variety of loans," Federal Reserve Vice Chairman Donald Kohn told the Senate Banking Committee.
At the same hearing, FDIC Chairperson Sheila Bair said banks that aren't diversified, or those with high exposures to residential construction and development, are of particular concern. "That's where we are really seeing the delinquencies spike," she said.
According to the Journal article, "Banks with swelling portfolios of troubled loans tied to land and housing are struggling to unload their real-estate debt. Before it was seized by the FDIC, IndyMac Bancorp was trying to sell $540 million in loans made to finance land purchases and housing construction projects. Winning bids on many of the loans were, on average, about 60 cents on the dollar, according to people familiar with the matter. But some winning bids were only about 20 cents on the dollar." The Journal reports that "Cleveland-based KeyBank, is trying to unload $935 million in loans tied to land and residential developments, while Wachovia Corp. is shopping a $350 million loan portfolio."
The sales are a response to the fact that home builders are defaulting on loans and the value of the land and housing developments that serve as collateral is plunging. A recent report by housing research firm Zelman & Associates says "Over the next five years, U.S. banks could 'charge off' as bad debt between 10% and 26% of their loans tied to residential construction and land assets, which would amount to about $65 to $165 billion. That compares with charge-offs of about 10% of construction-related bank assets, totaling $31.6 billion, when adjusted for inflation, during the last housing downturn in the late 1980s and early 1990s. In 2007 and the first quarter of this year, banks wrote down just 0.7% of such assets, according to Zelman. "We believe this period of procrastination is nearly over," says Ivy Zelman, the firm's CEO.
The prospect of a new wave of losses worries federal regulators, given the large proportion of loans to housing developers held by many banks and thrifts. The problems are worse at small banks that can't easily absorb losses, and at banks with big exposure in states hit hard by the housing crisis. Banks in Arizona, for example have 36% of their total loans tied to construction and development. Zelman says construction and development loans, as a percentage of total loans, are at their highest levels since 1975.
We've seen a real change in the market," says Ricardo Chance, a managing director at KPMG Corporate Finance LLC, who is helping troubled builders restructure their businesses. "Finally the banks are capitulating and saying, 'Let's mark to market and flush this all out.' The market is going to get worse. We don't want to hold on to this stuff."
|Buyers Snatch up Foreclosures After Price Cuts.
||Source: The Wall Street Journal
Lenders' inventory of foreclosed homes has steadily increased in the past two years to an estimated 500,000 homes today. Many lenders initially were slow to slash prices, partly because they hoped to avoid huge losses. But more lenders have been capitulating as it becomes clear that delays often merely result in lower proceeds and higher costs for taxes, insurance and maintenance.
In much of the U.S., there is still a huge supply of homes for sale and foreclosures continue to add to that supply. Realtors report that the number of single-family homes on the market in May was enough to last 10.8 months at the current sales rate, the highest since 1985. During the housing boom during the first half of the decade, the supply was typically four to five months.
In Detroit, 3,360 homes were sold during the first four months of the year, an increase of 48% over the same period in the prior year. The average price, $20,514, declined 56% during the same period. "The homes are selling because they're dirt cheap," says Carl Williams, president of the local Association of Realtors.
In California's Sacramento County, sales of single-family homes totaled 1,669 in April, a 41% increase over the same period in 2007, according to DataQuick Information Systems. The median sales price of $226,250 represented a 34% decline. The rise reflects aggressive pricing by lenders. "They've got to liquidate inventory - they're taking that house and dropping $100,000 off the price and, all of a sudden, they've got multiple offers," says Alan Wagner, president of the Sacramento Association of Realtors. Wagner says some homes that sold for more than $400,000 in 2006 now go for $225,000 to $260,000.
In Las Vegas, properties sold by lenders account for more than half of recent sales. April home sales in Las Vegas were 30% above year earlier levels.
|U.S. hopes of housing recovery subside
||Source: The Financial Times
The much ballyhooed National Association of Realtors (NAR) index, which tracks pending real estate sales contracts and is a leading indicator for future home sales, fell from 88.9 in April to 84.7 in May, surprising pundits who had been calling for a decline of about half that level. An increase in pending home sales in April had fueled hopes that the housing market was nearing a bottom.
"The overall decline in contract signings suggests we are not out of the woods by any means," said the usually ebullient Lawrence Yun, NAR's chief economist. Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, says "Most observers are very hesitant about calling a bottom in housing construction, sales or prices - hesitancy I share. And even if housing market activity does manage to bottom out later this year, it is likely that any recovery would be exceedingly slow."
|Home builders see no improvement in May.
U.S. home builders continue to report a disappointing spring selling season, according to the National Association of Home Builders. After stabilizing at 20 the past three months, the NAHB/Wells Fargo home builders' sentiment index fell back in May to 19, only one point above the record low of 18 set in December. At 19, the index shows about one in five builders have a positive view of the market.
The index peaked at 72 nearly three years ago. Builders' assessments of current sales have never been gloomier in the 23-year history of the survey. "The housing market has shown no evidence of improvement thus far," said David Seiders, NAHB chief economist.
RBC CASH Index: Consumer Expectations Continue To Deteriorate
Pessimism among U.S. consumers continues to spread as Americans' sentiments concerning the future turn gloomier, according to the most recent results of the RBC CASH (Consumer Attitudes and Spending by Household) Index. The survey found that while consumer attitudes regarding current conditions and investments show signs of stabilizing, Americans' confidence in future personal financial conditions continue to weaken. As a result, the overall RBC CASH Index dropped to an all-time low of 14.6 in June, 8 points below June's 22.5 level and nearly 25 points below May's 39.0 level.
"The decline of the RBC CASH Index suggests that consumer sentiment has fallen to the dismal level of the early 1980s. Consumers are being ground down by the cumulative effects of high gasoline and food prices, a falling stock market, weakening housing values and a shaky job market," said T.J. Marta, Economic and Fixed Income Strategist for RBC Capital Markets. "Unfortunately, these negative conditions are likely to persist well beyond when the last of the tax rebate checks is cashed in July. Consequently, consumer sentiment is unlikely to reach healthy levels anytime soon."
The RBC CASH Index is a monthly national survey of consumer attitudes on the current and future state of local economies, personal finance situations, savings and confidence to make large investments. The Index is benchmarked to a baseline of 100 assigned at its introduction in January, 2002.
|Condominium inventory skyrockets to an all-time high.
||Source: Wall Street Journal
There's a more than 10-month supply, the largest since the National Association of Realtors has kept records. And, that's if new construction halts tomorrow, a fantasy for those who have seen the cranes in downtown Miami, Las Vegas and San Diego.
Chicago will add over 6,000 condos this year, despite current inventory of more than 5,000. Atlanta and Phoenix will both add 4,000 new condos to their already frothy markets. And gold and silver medalists in the condo competition, Miami and Fort Lauderdale, will add more than 10,000 new condos this year.
Oh, and this will likely knock you out of your chair - condo mortgages have the highest levels of property loan delinquencies.
Notables and Quotables "I think the tidal wave that hit various financial institutions since last August has largely been recognized and felt. In terms of the effect on the U.S. economy...I think it will be longer and deeper than many people do. There could well be a lot to come."
- Warren Buffett
"The harm will radiate for another year."
- Bruce Wasserstein, CEO of investment bank Lazard, on the credit crunch
"The housing boom was unprecedented in U.S. history; the correction will be as well."
- Michael Youngblood, Portfolio Analyst, FBR Investment Management
"The banking system is facing the 21st-century equivalent of the wave of bank runs that swept America in the early 1930s. And your money is rushing in to help, with hundreds of billions from the taxpayer, and hundreds of billions more from tax-sponsored institutions like Fannie Mae, Freddie Mac and the Federal Home Loan Banks."
- Paul Krugman, writing in the New York Times
"Big banks are more focused on their balance sheets than on making loans and all banks have tightened their lending standards."
- James Cooper in the May 12, 2008 edition of Business Week
"...the possibility that future failures could include institutions of greater size than we have seen in the recent past."
- FDIC Chairperson Sheila Bair; in preparation, the agency has brought staffers out of retirement
"Many banks have taken prudent steps to manage their [commercial real estate] concentrations...Others, however, have not been as effective in their efforts and we have uncovered cases in which interest reserves and extensions of maturities were used to mask problem credits, appraisals had not been updated despite substantial recent changes in local real estate values, and analysis of guarantor support for real estate transactions was inadequate. Based on these findings, we are currently planning a further series of targeted reviews to identify those banks most at risk to further weakening in real estate market conditions and to promptly require remedial actions. We have also developed and started to deliver targeted examiner training so that our supervisory staff is equipped to deal with more serious [commercial real estate] problems at banking organizations as they arise."
- Federal Reserve Vice Chairman Donald Kohn
"I wish I could agree with Treasury Secretary Henry Paulson that we'll have a second-half rebound. The American consumer is both tapped out financially and psychologically, so I don't see any reason that, miraculously, three weeks from now, the whole world will change. The tragic attrition in home values has to have a negative wealth effect, a poverty effect, just as when homes were going up it made people feel more prosperous. I don't see the housing market turning, and I believe the psychological impact will get worse.
Economists seem to think that a change in housing prices has a 3.75% to 7.00% effect on consumer spending in either direction. So, at the low end you have an impact of $135 billion less in consumer spending. People were using their homes as an ATM with bedrooms attached. That's over with. In the last five years, consumer debt rose from $9.0 trillion to some $13.5 trillion. In 2006 alone, Americans took out $350 billion from their homes in home-equity loans or second mortgages."
- Wilbur Ross, billionaire investor
"The economy will rebound in the second half of the year, although there is a good chance it will be a 'dead-cat bounce.' The key is the rebate checks taxpayers are receiving this summer - worth $100 billion. Without the rebates, households would be cutting back on spending, and there would be no debate about whether we are in a recession. If history is a guide, about two thirds of the rebate money will be spent by the end of the year. Surveys of what people say they will do with the money suggest that this time more will be saved and used to repay debt, but what people say is not the same as what they do."
"But the rebate checks don't address the economy's fundamental problems, most importantly, the free fall in the housing market. By my calculation, the decline in house prices has slashed $2.5 trillion from household wealth (more than $25,000 for the average homeowner), and prices continue to decline rapidly in much of the country. By early next year, the rebates will be spent and households will be poorer."
- Mark Zandi, Chief Economist of Moody's Economy.com
"It's unambiguously ugly. The average American already knows that gas prices are up a ton and it's really hard to find a job. Sally and Sam on Main Street are already well aware of this, and that's why sentiment surveys are lower than they were in each of the last two recessions."
- Robert Barbera, Chief Economist at research/trading firm ITG, Inc.
"What we haven't seen yet is the impact on the consumer of falling house prices, rising energy prices, higher food prices and higher unemployment."
- John Thain, CEO, Merrill Lynch
"This is the worst credit bubble we've ever had in American history. Never in American history have people been able to buy a house with no money down. That's never happened anytime in the world. It's going to take a long time to work its way out. You don't cure a bubble in five or six months...it takes five or six years."
"The U.S. is in recession. It is going to get worse. The U.S. central bank is printing money and trying to prevent the recession - they are putting on Band-Aids. The Japanese did it and the Japanese still have not recovered 18 years later. As long as the central bank and the federal government keep making the mistakes, you will have a longer period of slowdown and it will be perhaps one of the worst recessions we have had in a long time in America. This is worse than the S&L crisis."
- Jim Rogers, investor and economic commentator and co-founder, with George Soros, of the Quantum Fund
"One thing about accounting, the liabilities are always 100% good. It's the assets you have to worry about. My nomination for the next crisis will be in the derivative books. I'm not sure when the denouement will come, but there will be one helluva mess in the derivatives books. When Berkshire bought General Re a few years back, it had a derivatives book. Gen Re needed a derivatives book like I needed a case of syphilis. When we went to sell these derivatives, we discovered that we couldn't get the prices that they were supposedly worth. They were Good-until-reached-for assets."
- Charles Munger, Berkshire Hathaway Vice Chairman and Chairman, Wesco Financial Corp. at the Wesco annual meeting
"How do you get a depression from a financial crisis? The national hockey league shows the way. Now hockey is a violent sport. To reduce injuries, therefore, officials have armored the players with face masks and neck protectors. Therein lies the trouble, according to no less than Kevin Greenstein, Editor-in-chief of Insidehockey.com: 'With each passing innovation, the players feel as if they are more and more invincible, their armor protecting them from all perceived risk. And the recklessness with which they conduct themselves under that veil of invincibility only makes the sport even more dangerous for the participants.' Does that remind you of anything?
"Potential safety benefits tend to get consumed as a performance benefit. For example, consider a case of a winding country road, and a safety-minded highway department. They straighten out the lines and improve the lanes. But, what then? There might be fewer accidents, but on account of people driving faster, there might be more fatal accidents. ..So it is on Wall Street."
- James Grant of "Grant's Interest Rate Observer" at Grant annual conference
"There are a lot of people that are jumping in and buying mortgage securities today and providing capital to financial firms that are restructuring. So far, anyone that has done that has lost money. So there have been a lot of people that have jumped in...Abu Dhabi, China Investment Corp, Singapore, Warburg Pincus and many, many other investors. They all jumped in too early...Jumping in too early in the credit cycle can be disastrous investment situation...Only time will tell if these investments will accrue. The biggest factor which influences whether those investments turn out to be good ones are bad ones is really the direction of the economy at this point on.
I think that we're not over the crisis, the problems will get worse. Our outlook for the economy is that house prices will continue to fall and consumer spending will decline, credit costs will rise, the recession will be worse than anticipated, and fiscal and monetary stimulus will not be enough to halt the decline. But that means for our own portfolio, in this environment, we would like to minimize our exposure to the equity market...I think the stock market has further to fall. We continue to maintain a short credit bias."
- John Paulson, president of Paulson & Co., a hedge fund that, in the words of James Grant, "earned more in 2007 than the GDP of Kyrgystan or Rwanda" by betting on the falling prices of mortgage-backed securities
"[Treasury Secretary Henry] Paulson would probably say he'll deal with the dollar when the financial crisis has passed but that's like saying you'll deal with those pesky mosquitoes after you deal with the spread of malaria. The man has it backwards - the weak dollar is the problem."
- Steve Forbes, Editor-in-Chief, Forbes magazine, May 19, 2008
"Sellers are not very realistic in their pricing expectations. They still seem to be drunk on the glorious wine of the past several years, when funding flowed like smooth merlot, and at great terms, driving sale prices up. It will probably take a while longer before they see the effect that tightening of financing sources will surely have on property pricing."
- Judy Brown, Broker/Owner, Swan Real Estate, Louisville, KY, commenting on current commercial real estate seller mentality
"Two unusual and unique factors hang over this stock market: First, there are four bubbles (a very rare occurrence) now imploding - housing, retail sales, industrial-manufacturing commodities and international markets. Second, even though the Fed has pushed interest rates dramatically lower (and will continue to do so), money and credit are actually tightening, not easing - and in some areas, seizing up."
- The Major Trends, by Sadoff Investment
"It was easy to generate increasing caches of mortgage loans: just lend at higher LTV's with super-low teaser rates, to folks who had no business borrowing and don't bother to verify their incomes. Liar (er, "stated income") loans and "Family" ("fog a mirror - I'll loan you") loans were the order of the day. Since house prices only go up, what's the problem? Well, on the odd chance that they go down, you might not be repaid. Today, home prices are plummeting, the mortgage market has seized up, refinancing is an impossibility, more than $400 billion of mortgages are poised to reset in 2008 and foreclosures and defaults are skyrocketing. We are seeing only the tip of the iceberg: an enormous wave of defaults, foreclosures and auctions is just beginning to hit the U.S. We believe it will get so bad that large-scale federal government intervention is likely."
- New York hedge fund T2 Partners in a 75-page report issued in March, 2008
"The credit crisis will extend well into 2009 and perhaps beyond. Multitrillion dollars of loans were underwritten with the false assumption that home prices would go up in perpetuity on a national basis. We see no near- or medium-term comeback. We believe losses will accelerate further and be far worse than even the most draconian estimates. Due to continued deterioration in consumer liquidity, we are raising our loss expectations significantly for the group and lowering our earnings estimates significantly."
- Oppenheimer analyst Meredith Whitney, who became somewhat of a contrarian soothsayer last year when she forecast Citigroup's massive write-downs before the news dominated headlines.
"There are three 'vicious cycles' that the U.S. economy must face. The first is a liquidity cycle, a kind of wash cycle in which unreasonably high asset prices are laundered out of the system. People are forced to sell, thereby sending prices down further. The second is a 'Keynesian cycle,' in which a slump in the economy rinses out the habits of the bubble period. People begin to spend less and save more. This, in turn, gives rise to the spin cycle - where, as we imagine it, people get dizzy and depressed because their incomes are going down; they can't borrow; their costs are rising; and they're getting poorer."
- Former Treasury Secretary Larry Summers in the Financial Times
Credits: Agora Financial, Barron's, Business Week, CoStar, DataQuick Information Systems, Financial Times, Fortune, Grant's Interest Rate Observer, John Mauldin's Investors Insight, London Daily Telegraph, MarketWatch, Moody's Economy.com, New York Times, Reuters, CNN Money.com, Sacramento Business Journal, San Diego Union Tribune and Wall Street Journal.