Tuesday, March 13, 2007

More Market Turmoil

The news coming out of the financial markets is bad, to say the least. While the economy continues to move along, creating jobs, but the four week moving average of intial jobless claims have climbed significantly to near 340,000, US GDP was revised lower and there is talk of recession from the likes of Alan Greenspan.

The big challenge now is the credit markets, which are starting to shape up pretty much the way the bears have suggested. As long-time readers know, I have been bearish, on pretty much everything, for some time. I have been bearish on commodities, on equities and especially on housing. Not that I am patting myself on the back, but a good friend and fellow investor (he, unlike me, has substantial real estate holdings) and I predicted in 2004 that 2007 would be a disasterous year in real estate. Our reasoning at the time was that the $1 trillion in ARMs due to reset in 2007 would lead to extremely high delinquencies. What I didn't expect was the degree to which credit standards would be relaxed. Morgtage "lenders" are now little more than brokers - they take the application, they make the loan, they collect the origination and application fees and then resell the mortgage as quickly as possible. In the last few years this has obviously been extremely profitable. However, as we approached the late stages of the bull market in housing, the need for fees meant that more and more low- and no-doc loans (affectionally called "liar loans" in the industry) were produced.

The banks who purchase and securitize the mortgage portfolios are not dummies. They knew this as well. As a result, they insisted on having more credit protection if things turned sour. "Lenders" like New Century Financial ("NEW") guaranteed the loans, and now the banks want their money back. Since NEW and others make their money from making loans, not from collecting interest, being forced to repurchase billions in loan portfolios means that the liquidity with which the companies make loans, dries up. Follow the yellow brick bankruptcy road: Repurchase means no liquidity, no liquidity means no new loans, no new loans means no new fees, no new fees means no income, no income means no offsets for the loan portfolio losses which means drops in stockholders equity, pretty soon you are out of statuory capital and the exchange is delisting you. New Century announced yesterday that they lacked the liqudity to continue operations. At this point, if they cannot get some new guarantees from their lenders, they will have to liquidate.

While NEW was an exceptional case (take a look at their financials, in 2006, facing major credit problems of which they claim to have been unaware - saying that they had lost track of deliquencies - they paid a massive dividend. But pay attention to something else, while they were paying this massive dividend, they were also floating huge amounts of new capital stock. In essence, they had become a massive Ponzi-scheme).

The issues at NEW are not isolated. Today, the Mortgage Bankers Association announced that deliquencies had increased sharply, to nearly 5% of mortgages, and that forclosures were at a record! Sub-prime mortgage deliquencies are at 13.33%. While their announcement suggested that underlying housing is fine - watch what happens when these houses are dumped on the market. Supply will be increased while demand is falling, a double whammy that will bring median prices sharply lower. Demand will remain far below the pace of the last few years, because tighter lending is taking large numbers of potential borrowers out of the market. Had this happened in 2004, when it was obvious that housing prices were far outstripping their historical link to rents, this might have been averted, but the Fed was busy printing money to prop up the administration.

The problems get worse, unfortunately, because of things called Collateralized Debt Obligations (CDOs). These are a derivative security based on the risk in a loan porfolio. Essentially, investors are able to purchase certain parts of the risk (potential losses) in a loan portfolio, rather than the actual loans themselves. As an example, say we have $100 million in loans that are sub-prime. It is likely that we will see defaults of around 9%. We don't know which loans will default, so if we purchase a portion of the portfolio we would expect to have 9% of the loans go bad. But, with financial engineering, we can structure this portfolio so that the first 15% of losses go to someone else. We purchase not the portfolio, but the risk. Now if there are 9% losses, we still get all of our principal back. Since the models suggest that there is statistically zero chance of having defaults in excess of 15% in the portfolio, our portion is AAA rated. Voila, we have made Tier 1 capital out of a junk bond. With such assets, the bank can now leverage 9 times and relend.

The problem is, we are getting dangerously close to that 15%, and when we cross it, big banks are going to start to take losses in their high quality assets. This is going to require that they deleverage, and they may be forced to liquidate as well in order to maintain capital requirements. This will be VERY VERY ugly.

At the same time, central banks are tightening because of the inflation that they have created and they will be hard pressed to lower interest rates significantly (though they will do so to prop up the banks if necessary). The problem is, banks are about to find that they cannot lend, because no one is sufficiently credit-worthy. As house prices fall, most homeowners will be too heavily leveraged. Those that can borrow (retirees, for instance) mostly will not want to.

Keep your eyes peeled and your powder dry - there will be values cropping up in the next several months. At last.


  1. Great analysis. I read somewhere a couple of months ago to wait until the financials being to turn. Once they turn, the rest of the market will follow. I agree with your sentiment exactly, and I can't tell you how excited I am at the possibility of picking up some bargains in the next couple of months.

  2. Good insight. Since finanicals represent something like 21% of the total capitaliation of the S&P500, when they turn, almost by definition, so does the market.

    Nothing better than being the only guy in the house with cash when there is a liquidity crisis.

  3. Trying to time market bottom is difficult to do. There are a few themes I like and feel comfortable owning for next few years out..despite normal market gyrations. Gloom and doom will come.. but I'm just not convinced it will come just yet.

    Best bet is to have the names of companies you want to buy ready now. In other words, ask yourself, what business do I want to be in over the next 2-5 years? Who do I want to own? Then, determine a price that you would be willing to pay. If the current price is below a price you would be willing to pay, buy now. If not, wait or instead buy some of what you like that is.

    Jason Tillberg