Pictures Worth A Thousand Words

Sources:
Report on asset securitization incentives
Forbes: the global debt bomb

The Fannie/Freddie Bailout, And Lessons To Be Learned

The government yesterday announced their plans for supporting the continued functioning of Fannie Mae and Freddie Mac(The "GSEs"). The specific details of the plan can be found here, but essentially it boils down to the government stepping in and backing GSE debt obligations with the full faith of the U.S. government, thus ensuring their full principal value. What does this mean, who gets affected, and why was this necessary? These are all questions I'll try to briefly answer.

The GSE's are massive organizations which were created with the intent of promoting homeownership and adding liquidity into the marketplace. The organizations were mostly involved in two lines of business. First, they operated as guarantors in the mortgage market. Banks could sell mortgage loans qualifying under certain criteria to the GSE's. They would then package them into securities, guarantee them, and take a portion of the interest payments as a fee in return for the guarantee. The second line of business involved issuing large amounts of debt (for cheap) and then using that money to purchase mortgage loans which gave a higher interest rate and had historically performed well.

But history is a bad measure, and the institutions were hit from multiple angles. They ended up under-pricing the risk of their mortgage guarantee business, and the mortgages they purchased with debt began to decline significantly in value. These combined to completely wipe out equity, at least if you were looking at their equity from a "fair value" basis. (The company for several quarters has insisted on using its own projections to value its assets/liabilities over the market's pricing, but they provided both figures.) That lead to the questioning of their viability, and the cost to issue debt for the institutions began to rise sharply. That began to add even more devastation to their second line of business, because they could no longer fund their mortgage assets with cheap debt. It would have only been a matter of time before the companies went into bankruptcy.

Now, the government has stepped in and essentially gauranteed full value for the debt issued by Fannie/Freddie, as well as their obligations for guaranteed mortgage securities. Those combine to total over 5 trillion. Those are backed by mortgage assets, and the first losses will accrue to common and preferred shareholders. Still, that is little comfort to me, as by fair value measures these institutions have been equity-negative, and I perceive things to continue to worsen for some time. Their will ultimately be big losses for government. That means taxpayers will be suffering for the benefit of the investors in mortgage assets.

That is a redistribution I would prefer without. And there is one more negative hazard to this deal as well, but these are completely over-shadowed by the systemic necessity of the deal. But first, that negative is that government has now taken over the judgment of future mortgage risk. It makes me shudder to think that we have offloaded the task of judging risk from hundreds of thousands of banks to one central institution (although we got into this mess because there was a complete lack of risk judging by banks, in the first place). Instead, everything will now dance to the tune of the GSE guidelines. The government has committed to wind down the GSE business over time and diminish its role in the mortgage market, but that will be a long time.

Unfortunately, the move was very, very necessary. If the GSE's were to announce bankruptcy, I believe you'd have a terrible hellish limbo (and please correct me in the comments if im wrong on this point). Unlike typical bankruptcies, nothing for the GSE's could function as usual. As I understand it, they could not pay off expiring debt, and they could not pay off guarantee obligations- simply, they couldn't do anything. That is because once in bankruptcy, their debt obligations would disregard time duration and instead put them on equal footing based on their class (senior, junior, etc). That means, a senior note expiring and scheduled to be paid back in 30 years would have the same value and rights as a senior note due tomorrow. That means the institution could not pay back anyone until it figured out what it could ultimately pay back. Well in the case of the GSE's, that could be ages. I mean, their assets are long duration mortgages to individuals which can't be redeemed, meaning you'd have to wait for them to slowly get paid back. And some of their guarantee liabilities extend for 10 years or more, and can change rapidly at any time depending on the mortgage market situation. Best case, you'd have to wait until the mortgage situation clears up and you find suitable buyers of its tremendous load of assets and guarantees. But considering the size of the liability, that is very unlikely for everyone except government.

And in the meantime, you have stagnation. The company would have to preserve all its capital and pay out nothing. That means that thousands of institutions around the world would be holding pieces of paper paying them no interest, with questionable ultimate value, and no idea of when any of that value may ultimately be able to be realized. Things would shutdown, people would be furious, and foreign lending to the US would cease. That could not happen, and sadly, that means the institutions could not be allowed to fail.

What can we learn from this saga? Well, the situation does not bode well for other mega-banks on shaky financial footing, especially those with long-duration credit default swaps. If one of these institutions were too fail, the same thing would happen here- everything would freeze up until ultimate liabilities can be determined, leaving a very large class of debt and CDS holders in stagnation for a long period of time. "Doomsday" would then ensue.

Hypothetical Scenario For The Mortgage Nuts....

Something has always bugged me about credit default swaps and mortgage/bond insurers. Imagine a community with one bank, and that bank has 10 million in loans. Now the usual rules dictate that the bank should have at least a 1 million in equity as a cushion because, face it, lending has a tendency to have its bad cycles. The other 9 million is financed by deposits.

Now let's say another party comes to the bank and offers to take the credit risk on all 10 million of the bank's loans, in what is essentially a blanket credit default swap on their loans. The bank now views its operation as essentially risk-free (ignoring liquidity risk), so their equity cushion doesn't matter. But shouldn't the new counter-party now be required to have a 1 million equity cushion in case things go bad, since they are supposed to be the first and only line of defense? I think the answer to that is yes.

The problem is I haven't seen that. Look at Fannie Mae. At September 30, 2007, they had 2.8 trillion in total mortgage assets and guarantees. But their balance sheet had total capital of only 49 billion, or 1.75% of total obligations. If it were looked at like a bank, that would be an asset-equity ratio of over 50-1. That doesn't leave much margin of safety at all.

Am I missing something?

A Personal View of The Crisis

They are called risk managers, and collectively, their job is to monitor their bank's transactions for signs of trouble. So where were they in the midst of the current tragedy that is among us? This week's The Economist gives a rare treat by allowing a risk manager at a large global bank to share his view of the current credit crisis. It unfortunately conveys the message that even in the banks, the heart of the financial system, serious misunderstandings exist about the nature of finance and their fiduciary duties.

IN JANUARY 2007 the world looked almost riskless. At the beginning of that year I gathered my team for an off-site meeting to identify our top five risks for the coming 12 months. We were paid to think about the downsides but it was hard to see where the problems would come from. Four years of falling credit spreads, low interest rates, virtually no defaults in our loan portfolio and historically low volatility levels: it was the most benign risk environment we had seen in 20 years
....

The possibility that liquidity could suddenly dry up was always a topic high on our list but we could only see more liquidity coming into the market—not going out of it. Institutional investors, hedge funds, private-equity firms and sovereign-wealth funds were all looking to invest in assets. This was why credit spreads were narrowing, especially in emerging markets, and debt-to-earnings ratios on private-equity financings were increasing. “Where is the liquidity crisis supposed to come from?” somebody asked in the meeting. No one could give a good answer.

Let me begin with an elementary lesson on financial bubbles. Let us imagine a perfect world where the future was clear and I could tell you all the future payments of an asset to an exact number- let us say $1 per year. And let us say I want my investment to give me 10% a year, and using that rate, I calculate that this asset is worth $10 to me. Now, Joe comes along and offers me $12, and I say sure. That $12 to me today is worth more than the $10 I calculated that asset to be worth. And whether Joe knows it or not, by paying $12 for that asset, he is now accepting a lower return for that asset- 8.3% to be exact. But Joe doesn't deal with things like that. Joe knows Bill will pay him 15 dollars for that, so he immediately flips it, books a very nice gain, and rids the asset to Bill. Bill, being the clueless investor he is, crosses his fingers and waits. And sure enough, Bob (whose financial understanding leaves room for improvement) says, "Look, this asset has already gone from $10 to $15, I'm sure I can dump it for $20." And you know what, maybe he is right.

Unfortunately, something is missed along this way. That is, that ultimately someone has to hold on to that asset, and the money they will get for it is that original income stream- that $1 per year. So "Johnny Ultimate Bagholder", who has seen this great run-up of this asset from $10 to $30 thinks the trend is his friend, and he can make big bucks by buying it today. Unfortunately, he is then stuck with a product making him only 3.3% a year. And although maybe that doesn't sound bad and Johnny can reconcile himself with that fact, the rest of the world can't- they still want their 10%. Reality comes crashing back in, and Johnny now sees a huge loss.

This sound far-fetched? Well, it has happened to us in the last ten years- twice. In 2000 when stocks were trading at 40x earnings (or worse), those stockholders were looking at returns near 2.5% a year on their asset- and that assumed the business would be around forever and competition didn't erode those earnings. And recently during the housing boom, investors flocked into the market on the belief that house prices could only go up. And people actually invested their money in an asset that was generating negative underlying returns, as the cost of interest was well above the money they could make renting the house out. And anyone with just a common understanding of the above financial concept could have seen how this was going to lead to disaster.

So let me return to the original quote:

...but it was hard to see where the problems would come from. Four years of falling credit spreads, low interest rates, virtually no defaults in our loan portfolio and historically low volatility levels: it was the most benign risk environment we had seen in 20 years.
...
The possibility that liquidity could suddenly dry up was always a topic high on our list...

My problem is these are not ways risk is supposed to be found. Every indicator he mentions there is actually more of a signal of a bubble than anything else, but I am not advocating contrarianism either. What these guys should of been doing was asking if these transactions made sense. Did it make sense for house prices to keep going up when the underlying payment (rent, or working income) could not afford it? Was any actual wealth created when the value attributed to nationwide homes was doubled? Did it make sense to let people subsequently draw money out of their homes to use to spend? The answer to all of these is no. And I regret to say that the harsh reality is that is the only way to do finance. You have to look at what makes sense and make reasonable expectations for the future. And unfortunately, it seems risk managers of banks worldwide have been clueless to that.

My gripe doesn't end there.

Our business and risk strategy was to buy pools of assets, mainly bonds; warehouse them on our own balance-sheet and structure them into CDOs; and finally distribute them to end investors. We were most eager to sell the non-investment-grade tranches, and our risk approvals were conditional on reducing these to zero. We would allow positions of the top-rated AAA and super-senior (even better than AAA) tranches to be held on our own balance-sheet as the default risk was deemed to be well protected by all the lower tranches, which would have to absorb any prior losses.

Let me rephrase it another way- "Our business was to pool assets, mainly bonds. We would then split them up into different groups, one which was safe and one which would take heavy losses. We made it a point to make sure our customers would buy the losses. We may not be too good at understanding risk, but you should see our customers. Boy, did we make money off of them!" Nowhere in that statement do I see any ideals of fiduciary duty, of doing whats mutually beneficial for both yourself and the customer. And I hate to break the news to you, but:

That mini-liquidity crisis was to be replayed on a very big scale in the summer of 2007. But we had failed to draw the correct conclusions. As risk managers we should have insisted that all structured tranches, not just the non-investment-grade ones, be sold.

THAT is not the right conclusion.

Wait... What?

From Freddie Mac's 1st Quarter Earnings Release:

Fair Value of Net Assets

The company's attribution of changes in fair value relies on models, assumptions and other measurement techniques that evolve over time.

At March 31, 2008, the fair value of net assets was ($5.2) billion as compared to $12.6 billion at December 31, 2007, reflecting a net after-tax reduction of $17.8 billion. This change in fair value of net assets includes the payment of preferred and common stock dividends during the first quarter of 2008.

The change in fair value of net assets includes a pre-tax reduction in fair value of $28.8 billion as a result of net mortgage-to-debt OAS widening, partially offset by a pre-tax increase in fair value related to core spread income in the first quarter of 2008. In addition, the company estimates that the change in fair value of its credit guarantee activities resulted in a pre-tax reduction of $3.0 billion.

So using market prices as its determinant, Freddie Mac is now in negative equity. But rather then let that reflect into the income statements, the company has changed its accounting rules to more appropriately match its business expectations...

I'm reminded of what Buffett and Munger keep repeating about how two parties are entering into derivative contracts and then both sides are reporting gains. You know the person on the other side of Freddie's transactions aren't discounting their gains to conform with Freddie's models. Some time in the near future, one of them is going to find themselves much poorer than they think they are.

How International Is This Housing Bust?

Some anecdotal evidence to show that it wasn't just the US that got out of hand. From the New Zealand Herald:

Mr Bowie, 30, and his fiancee Charlene McFarlane, 29, have just taken out a mortgage for 100 per cent of the cost of their modest home in Birkdale, Auckland, which cost them $397,000.
...
The couple are among a growing number of first home buyers who are willingly taking on huge financial burdens by borrowing 100 per cent of the cost of their homes.

"Going back three or four years, 100 per cent mortgages were only available through non-conforming type entities and second-tier lenders," says Mortgage Brokers Association chairman Geoff Bawden.

"Now you have a situation where most, if not all, of the mainstream bank players are able to offer 100 per cent funding on reasonable terms."

Most brokers put 100 per cent loans at around 5 to 10 per cent of all new mortgages...

Easier financing has helped to push up house prices. Although brokers say they aim for mortgage payments of no more than 30 to 35 per cent of household incomes, the Reserve Bank says the average is now nudging 50 per cent (see graph)...

"We are not good savers," says Ms McFarlane.

And in England...

A collective shudder ran down the spines of British homeowners on Tuesday April 8th when Halifax, a part of HBOS and the country’s biggest mortgage lender, revealed that house prices fell in March by 2.5%. The monthly decline recorded by the Halifax house-price index was the biggest since September 1992, when the housing market was enduring an agonisingly prolonged bust.
...
Mortgage lenders are reluctant to talk down the market, so it says something that both the Halifax and Nationwide are predicting “modest” declines in house prices this year. Forward-looking indicators suggest a gloomier picture. The number of mortgages approved for house purchase was almost 40% lower in February than a year before. According to the Royal Institution of Chartered Surveyors, estate agents have been grappling with the worst conditions—measured by the ratio of completed sales to unsold stock—since September 1996.
...
Last week a study by the International Monetary Fund found that Britain’s housing market was the third most over-valued of 17 developed economies, narrowly behind Ireland and the Netherlands. House prices were almost 30% higher than could be explained by fundamental factors such as disposable income, interest rates and working-age population.

These findings are not shocking given the extraordinary house-price boom of the past decade. Between the first quarter of 1997 and the first quarter of 2007, house prices rose by 214%. This was the third highest among 20 countries covered by The Economist. It contrasts with a rise of 135% in America up to its peak in 2006.

The housing bubble seems to have been a global occurrence.

Update*- Great article from the comments.

As Mr Greenspan pointed out in his response to his critics in the Financial Times on Monday, the housing bubble was not unique to the US. On the contrary, as the background chapter on housing in the International Monetary Fund’s latest World Economic Outlook shows, US experience was far from exceptional. On the contrary, the biggest apparent overvaluations occurred in Ireland, the Netherlands and the UK.

The chart shows the proportionate increase in house prices between 1997 and 2007 that cannot be explained by the fundamental drivers: affordability (the lagged ratio of house prices to disposable incomes); growth in disposable incomes per head; interest rates (short- and long-term); credit growth; changes in equity prices; and changes in working-age population. Thus, the rises reveal the extent to which a country has experienced what seems to be a bubble. The US is in the middle ranks.

Clearing Up Some Housing Uncertainty

There is risk, and then there is uncertainty. The distinction was first made by Frank Knight in his popular work Risk, Uncertainty, and Profit. Risk exists when a probability can be attached and an expected value can be derived. Uncertainty exists when there is no objective way to place a probability on an event and so an approximate outcome can not be made. The word 'uncertainty' seems to characterize the state of the housing market today. The predictions for how bad it will end up being seem to be all over the charts because no one is quite sure about the extent of the problem.

Well today, the New York Fed posted up a new dynamic mapping and data tool which gives some valuable information towards clearing the uncertainty. The site provides many statistics on sub-prime and Alt-A mortgages, including:

• Loans per 1,000 housing units
• Loans in foreclosure per 1,000 housing units
• Loans real estate owned (REO) per 1,000 housing units
• Share of loans that are adjustable rate mortgages (ARMs)
• Share of loans for which payments are current
• Share of loans that are 90-plus days delinquent
• Share of loans in foreclosure
• Median combined loan-to-value ratio (LTV) at origination
• Share of loans with low credit score (FICO) and high LTV at origination
• Share of loans with low- or no documentation
• Share of ARMs with initial reset in the next 12 months
• Share of loans with a late payment in the past 12 months

The one I found most interesting though is the first one: "Loans per 1,000 housing units". If I'm understanding this correctly, this gives us the percentage of homes in a market which are backed by subprime or Alt-A mortgages. So let's take a look at two states which are supposed to be the worst housing market offenders: Florida and California.

Florida
Subprime loans per 1000 units: 39.40
Alt-A loans per 1000 units: 20.40
Total = 5.98%

California
Subprime loans per 1000 units: 38.60
Alt-A loans per 1000 units: 48.60
Total = 8.72%

These numbers are far from great; they also do not include many poorly underwritten home equity loans. Still, the risk of housing causing a doomsday type scenario seems pretty small to me if the share of houses with shaky loans is not even in the double digits. Some new problem will have to step up if the doomsayers are going to be proved right.

Hypothetical Question

If you were put in charge with the goal of making a better society, would you want the cost of purchasing a house to go up or down?

I'm not saying we should be happy that home prices are now falling. But as we were celebrating our increased home wealth over the last several years, not many people stopped to think how these illusionary gains were really making us any better off.

Fairfax's 2007 Shareholder Letter

To Our Shareholders:
2007 was the best year in our history. For the first time in 22 years, we earned in excess of $1 billion* after tax ($1.096 billion to be exact) or $58.38 per diluted share. Mark-to-market book value grew by 48.7% to $230.01 per share and we ended the year with almost $1 billion in cash and marketable securities in our holding company. We like lumpy but this was as lumpy as we have ever had!

Book value per share has compounded at 26% over the past 22 years and our common stock price has followed at 23% per year. While we are excited about these results, we have some way to go to make up for the biblical seven lean years that you have suffered.
...

In last year’s Annual Report, we discussed the change in our financial objectives going forward from a return on shareholders’ equity objective to a 15% compounding over time of our mark-to market book value. I mentioned the favourable impact on our rate of compounding of holding some common stock positions for the very long term. I am pleased to say we have identified one position that we feel very comfortable holding for a very long time because of its excellent track record, wonderful culture and decentralized structure of operations.

Johnson & Johnson has perhaps the best long term track record we have come across. They have compounded sales and earnings for the last 100 years in excess of 10%per year. The growth prospects for their products on a worldwide basis are unlimited.We own 5.9 million shares at a cost of $62.29 per share with amarket value of $370 million.We think in the next few years, Mr.Market may give us many more opportunities like Johnson & Johnson that we can purchase at attractive prices for the long term. Ifwe choose properly, you may be pleased with our rate of compounding of book value in the future.

...

2007 was another very good year for Hamblin Watsa’s investment results, even excluding our CDS position which is not included in the results shown above. These results are due to Hamblin Watsa’s outstanding investment team, led by Roger Lace, Brian Bradstreet, Chandran Ratnaswami and Sam Mitchell.

The very significant risks that we identified for you in the past few years have now materialized with a vengeance. In the past year, we have seen a major decline in housing prices and its collateral impact on asset backed bonds, CDOs and other instruments. As the U.S. economy heads into a recession, risk is now being identified and repriced in structured investments based upon automobile loans, commercial real estate loans, credit card receivables, leveraged buyout debt and bank loans.

Hyman Minsky, the father of the Financial Instability Hypothesis, said that history shows that “stability causes instability”. Prolonged periods of prosperity lead to leveraged financial structures that cause instability. We are witnessing the aftereffects of the longest economic recovery (more than 20 years) in the U.S. with the shortest recession (2001). Regression to the mean has begun – but only just begun!

We have witnessed credit spreads widen dramatically for mortgage insurers, bond insurers and junk bonds, reflecting mainly the problems of the housing market. We remain vigilant for the spreading of these risks into all credit markets, because the same loose lending standards and asset backed structures have been applied to these markets. Also, as we have mentioned in the past, we remain concerned about the potential decline in record after-tax profit margins in the U.S. and its impact on stock prices. Of course, the potential impact of the U.S. economy and stock prices on the rest of the world’s economies and stock prices, particularly given that most of the
world’s stock markets are trading at close to record highs, is why we continue to protect our portfolios from a 1 in 50 to 1 in 100 year financial storm.

Recently, we came across an interesting observation by the man who provided the intellectual underpinnings of “long term value investing” and to whom we are ever indebted. BenGraham made the point that only 1 in 100 of the investors who were invested in the stockmarket in 1925 survived the crash of 1929 – 1932. If you didn’t see the risks in 1925 (very hard to do), it was very unlikely that you survived the crash! We think Ben’s observation may be relevant to what we have experienced in the past five years. We reminded you in our 2005 Annual Report that “Jeremy Grantham of Grantham Mayo said that of the 28 bubbles that they have studied in all asset categories (including gold, silver, Japanese equities and 1929), this recent bubble in the U.S. stock market is the only one that has not completely reversed itself (just as it was about to in 2003, it turned and rebounded).” Caveat emptor!!

In our 2005 Annual Report, we also discussed the Japanese experience from 1989 to 2004 when the Nikkei Dow dropped from 39,000 to 7,600 while yields on 10 year Japanese government bonds collapsed from 8.2% to 0.5%. With the Federal Reserve dropping the Fed Funds rate down to 3% from 5.25%, we might be witnessing a repeat in the U.S. of the Japanese experience. In spite of record low interest rates and record high fiscal deficits, Japan went through years of mild deflation. The feelings at the time in Japan were that they were different and would not allow stock prices and land prices to fall – not dissimilar to the sentiment currently prevailing in the U.S.!!

The assumption in the marketplace that “structure” would eliminate or significantly reduce all risks collapsed as thousands of mortgage structures were downgraded, some from AAA to CCC in a single day. After five years where the average downgrades were less than 1%, in 2007 S&P downgraded nearly 16% of the 36,000+ residential mortgage backed securities it rated. In the marketplace, the prices of many of these asset backed bonds declined significantly in the second half of 2007 and have continued to decline since then. Currently, some AAA subprime mortgage
backed bonds are trading at 60¢ on the dollar and some similar AA issues are trading at 25¢ on the dollar. Please remember that there are approximately $3.8 trillion in asset backed and non-Agency mortgage backed securities where the same structuring techniques and “good times” assumptions have been employed to create “highly rated” securities. Only time will tell, but our expectation is that few of these securities will remain unscathed.

Direct Link

Roubini's Testimony to House of Rep.

This letter is a little bit technical, but it does a terrific job outlining the possibility of a vicious cycle/serious recession.

...
Start first with the recession that is now enveloping the US economy. Let us assume – as likely - that this recession – that already started in December 2007 - will be worse than the mild ones – that lasted 8 months – that occurred in 1990-91 and 2001. The recession of 2008 will be more severe for several reasons: first, we have the biggest housing bust in US history with home prices likely to eventually fall 20 to 30%; second, because of a credit bubble that went beyond mortgages and because of reckless financial innovation and securitization the ongoing credit bust will lead to a severe credit crunch; third, US households – whose consumption is over 70% of GDP - have spent well beyond their means for years now piling up a massive amount of debt, both mortgage and otherwise; now that home prices are falling and a severe credit crunch is emerging the retrenchment of private consumption will be serious and protracted. So let us suppose that the recession of 2008 will last at least four quarters and, possibly, up to six quarters. What will be the consequences of it?

Here are the twelve steps or stages of a scenario of systemic financial meltdown associated with this severe economic recession.

First, this is the worst housing recession in US history and there is no sign it will bottom out any time soon. At this point it is clear that US home prices will fall between 20% and 30% from their bubbly peak; that would wipe out between $4 trillion and $6 trillion of household wealth. While the subprime meltdown is likely to cause about 2.2 million foreclosures, a 30% fall in home values would imply that over 10 million households would have negative equity in their homes and would have a big incentive to use “jingle mail” (i.e. default, put the home keys in an envelope and send it to their mortgage bank). Moreover, soon enough a few very large home builders will go bankrupt and join the dozens of other small ones that have already gone bankrupt thus leading to another free fall in home builders’ stock prices that have irrationally rallied in the last few weeks in spite of a worsening housing recession.

Second, losses for the financial system from the subprime disaster are now estimated to be as high as $250 to $300 billion. But the financial losses will not be only in subprime mortgages and the related RMBS and CDOs. They are now spreading to near prime and prime mortgages as the same reckless lending practices in subprime (no down-payment, no verification of income, jobs and assets (i.e. NINJA or LIAR loans), interest rate only, negative amortization, teaser rates, etc.) were occurring across the entire spectrum of mortgages; about 60% of all mortgage origination since 2005 through 2007 had these reckless and toxic features. So this is a generalized mortgage crisis and meltdown, not just a subprime one. And losses among all sorts of mortgages will sharply increase as home prices fall sharply and the economy spins into a serious recession. Goldman Sachs now estimates total mortgage credit losses of about $400 billion; but the eventual figures could be much larger if home prices fall more than 20%. Also, the RMBS and CDO markets for securitization of mortgages – already dead for subprime and frozen for other mortgages - remain in a severe credit crunch, thus reducing further the ability of banks to originate mortgages. The mortgage credit crunch will become even more severe.

Also add to the woes and losses of the financial institutions the meltdown of hundreds of billions of off balance SIVs and conduits; this meltdown and the roll-off of the ABCP market has forced banks to bring back on balance sheet these toxic off balance sheet vehicles adding to the capital and liquidity crunch of the financial institutions and adding to their on balance sheet losses. And because of securitization the securitized toxic waste has been spread from banks to capital markets and their investors in the US and abroad, thus increasing – rather than reducing systemic risk – and making the credit crunch global.

Third, the recession will lead – as it is already doing – to a sharp increase in defaults on other forms of unsecured consumer debt: credit cards, auto loans, student loans. There are dozens of millions of subprime credit cards and subprime auto loans in the US. And again defaults in these consumer debt categories will not be limited to subprime borrowers. So add these losses to the financial losses of banks and of other financial institutions (as also these debts were securitized in ABS products), thus leading to a more severe credit crunch. As the Fed loan officers survey suggest the credit crunch is spreading throughout the mortgage market and from mortgages to consumer credit, and from large banks to smaller banks.

Fourth, while there is serious uncertainty about the losses that monolines will undertake on their insurance of RMBS, CDO and other toxic ABS products, it is now clear that such losses are much higher than the $10-15 billion rescue package that regulators are trying to patch up. Some monolines are actually borderline insolvent and none of them deserves at this point a AAA rating regardless of how much realistic recapitalization is provided. Any business that required an AAA rating to stay in business is a business that does not deserve such a rating in the first place. The monolines should be downgraded as no private rescue package – short of an unlikely public bailout – is realistic or feasible given the deep losses of the monolines on their insurance of toxic ABS products.

Next, the downgrade of the monolines will lead to another $150 of writedowns on ABS portfolios for financial institutions that have already massive losses. It will also lead to additional losses on their portfolio of muni bonds. The downgrade of the monolines will also lead to large losses – and potential runs – on the money market funds that invested in some of these toxic products. The money market funds that are backed by banks or that bought liquidity protection from banks against the risk of a fall in the NAV may avoid a run but such a rescue will exacerbate the capital and liquidity problems of their underwriters. The monolines’ downgrade will then also lead to another sharp drop in US equity markets that are already shaken by the risk of a severe recession and large losses in the financial system.

Fifth, the commercial real estate loan market will soon enter into a meltdown similar to the subprime one. Lending practices in commercial real estate were as reckless as those in residential real estate. The housing crisis will lead – with a short lag – to a bust in non-residential construction as no one will want to build offices, stores, shopping malls/centers in ghost towns. The CMBX index is already pricing a massive increase in credit spreads for non-residential mortgages/loans. And new origination of commercial real estate mortgages is already semi-frozen today; the commercial real estate mortgage market is already seizing up today.

Sixth, it is possible that some large regional or even national bank that is very exposed to mortgages, residential and commercial, will go bankrupt. Thus some big banks may join the 200 plus subprime lenders that have gone bankrupt. This, like in the case of Northern Rock, will lead to depositors’ panic and concerns about deposit insurance. The Fed will have to reaffirm the implicit doctrine that some banks are too big to be allowed to fail. But these bank bankruptcies will lead to severe fiscal losses of bank bailout and effective nationalization of the affected institutions. Already Countrywide – an institution that was more likely insolvent than illiquid – has been bailed out with public money via a $55 billion loan from the FHLB system, a semi-public system of funding of mortgage lenders. Banks’ bankruptcies will add to an already severe credit crunch.

Seventh, the banks losses on their portfolio of leveraged loans are already large and growing. The ability of financial institutions to syndicate and securitize their leveraged loans – a good chunk of which were issued to finance very risky and reckless LBOs – is now at serious risk. And hundreds of billions of dollars of leveraged loans are now stuck on the balance sheet of financial institutions at values well below par (currently about 90 cents on the dollar but soon much lower). Add to this that many reckless LBOs (as senseless LBOs with debt to earnings ratio of seven or eight had become the norm during the go-go days of the credit bubble) have now been postponed, restructured or cancelled. And add to this problem the fact that some actual large LBOs will end up into bankruptcy as some of these corporations taken private are effectively bankrupt in a recession and given the repricing of risk; convenant-lite and PIK toggles may only postpone – not avoid – such bankruptcies and make them uglier when they do eventually occur. The leveraged loans mess is already leading to a freezing up of the CLO market and to growing losses for financial institutions.

Eighth, once a severe recession is underway a massive wave of corporate defaults will take place. In a typical year US corporate default rates are about 3.8% (average for 1971-2007); in 2006 and 2007 this figure was a puny 0.6%. And in a typical US recession such default rates surge above 10%. Also during such distressed periods the RGD – or recovery given default – rates are much lower, thus adding to the total losses from a default. Default rates were very low in the last two years because of a slosh of liquidity, easy credit conditions and very low spreads (with junk bond yields being only 260bps above Treasuries until mid June 2007). But now the repricing of risk has been massive: junk bond spreads close to 700bps, iTraxx and CDX indices pricing massive corporate default rates and the junk bond yield issuance market is now semi-frozen. While on average the US and European corporations are in better shape – in terms of profitability and debt burden – than in 2001 there is a large fat tail of corporations with very low profitability and that have piled up a mass of junk bond debt that will soon come to refinancing at much higher spreads. Corporate default rates will surge during the 2008 recession and peak well above 10% based on recent studies. And once defaults are higher and credit spreads higher massive losses will occur among the credit default swaps (CDS) that provided protection against corporate defaults. Estimates of the losses on a notional value of $50 trillion CDS against a bond base of $5 trillion are varied (from $20 billion to $250 billion with a number closer to the latter figure more likely). Losses on CDS do not represent only a transfer of wealth from those who sold protection to those who bought it. If losses are large some of the counterparties who sold protection – possibly large institutions such as monolines, some hedge funds or a large broker dealer – may go bankrupt leading to even greater systemic risk as those who bought protection may face counterparties who cannot pay.

Ninth, the “shadow banking system” (as defined by the PIMCO folks) or more precisely the “shadow financial system” (as it is composed by non-bank financial institutions) will soon get into serious trouble. This shadow financial system is composed of financial institutions that – like banks – borrow short and in liquid forms and lend or invest long in more illiquid assets. This system includes: SIVs, conduits, money market funds, monolines, investment banks, hedge funds and other non-bank financial institutions. All these institutions are subject to market risk, credit risk (given their risky investments) and especially liquidity/rollover risk as their short term liquid liabilities can be rolled off easily while their assets are more long term and illiquid. Unlike banks these non-bank financial institutions don’t have direct or indirect access to the central bank’s lender of last resort support as they are not depository institutions. Thus, in the case of financial distress and/or illiquidity they may go bankrupt because of both insolvency and/or lack of liquidity and inability to roll over or refinance their short term liabilities. Deepening problems in the economy and in the financial markets and poor risk managements will lead some of these institutions to go belly up: a few large hedge funds, a few money market funds, the entire SIV system and, possibly, one or two large and systemically important broker dealers. Dealing with the distress of this shadow financial system will be very problematic as this system – stressed by credit and liquidity problems - cannot be directly rescued by the central banks in the way that banks can.

Tenth, stock markets in the US and abroad will start pricing a severe US recession – rather than a mild recession – and a sharp global economic slowdown. The fall in stock markets – after the late January 2008 rally fizzles out – will resume as investors will soon realize that the economic downturn is more severe, that the monolines will not be rescued, that financial losses will mount, and that earnings will sharply drop in a recession not just among financial firms but also non financial ones. A few long equity hedge funds will go belly up in 2008 after the massive losses of many hedge funds in August, November and, again, January 2008. Large margin calls will be triggered for long equity investors and another round of massive equity shorting will take place. Long covering and margin calls will lead to a cascading fall in equity markets in the US and a transmission to global equity markets. US and global equity markets will enter into a persistent bear market as in a typical US recession the S&P500 falls by about 28%.

Eleventh, the worsening credit crunch that is affecting most credit markets and credit derivative markets will lead to a dry-up of liquidity in a variety of financial markets, including otherwise very liquid derivatives markets. Another round of credit crunch in interbank markets will ensue triggered by counterparty risk, lack of trust, liquidity premia and credit risk. A variety of interbank rates – TED spreads, BOR-OIS spreads, BOT – Tbill spreads, interbank-policy rate spreads, swap spreads, VIX and other gauges of investors’ risk aversion – will massively widen again. Even the easing of the liquidity crunch after massive central banks’ actions in December and January will reverse as credit concerns keep interbank spread wide in spite of further injections of liquidity by central banks.

Twelfth, a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices will ensue leading to a cascading and mounting cycle of losses and further credit contraction. In illiquid market actual market prices are now even lower than the lower fundamental value that they now have given the credit problems in the economy. Market prices include a large illiquidity discount on top of the discount due to the credit and fundamental problems of the underlying assets that are backing the distressed financial assets. Capital losses will lead to margin calls and further reduction of risk taking by a variety of financial institutions that are now forced to mark to market their positions. Such a forced fire sale of assets in illiquid markets will lead to further losses that will further contract credit and trigger further margin calls and disintermediation of credit. The triggering event for the next round of this cascade is the downgrade of the monolines and the ensuing sharp drop in equity markets; both will trigger margin calls and further credit disintermediation.

Buffett Bids on Bond Insurance?

Bloomberg reported today: Buffett Bids for MBIA, Ambac Municipal Bonds

Billionaire investor Warren Buffett said he offered to shore up $800 billion of municipal bonds guaranteed by troubled MBIA Inc., Ambac Financial Group Inc. and FGIC Corp. in a bid to gain 33 percent of the debt insurance market.

Buffett's Omaha, Nebraska-based Berkshire Hathaway Inc. would assume the risk of the debt, he told CNBC television. The offer excludes the bond insurers' subprime-related obligations. One company has already rebuffed the proposal and the two others haven't responded, Buffett said.
...
Berkshire would put up $5 billion as capital for the plan and is offering to insure the municipal debt for 1.5 times the premium charged by the bond insurers to take on the guarantee. The insurers could accept the offer and back out within 30 days for a fee, Buffett said.

We know already that the structured product obligations of the bond insurers have and will continue to lead to large losses. Buffett's new proposal would mean that the bond insurers would have to accept losses on their municipal business as well. We can conclude that likely has two things in mind. One, Buffett is trying to take advantage of the bond insurer's liquidity problems to make a good investment. Second, Buffett thinks that they may have under-priced their municipal risk too. That would be real bad news for the bond insurers.

Economic Articles of Interest

I ran into two interesting articles on economics today that I thought worthy of re-publishing here. The first is from the folks over at Calculated Risk, who were so kind as to publish their first subscription newsletter on real estate analysis for free. The article can be accessed here. It is kind of lengthy at 14 pages, but it is an absolutely fabulous summary of everything you need to know about the real estate market today.


The second is an (unconfirmed) transcript of a speech made by legendary investor Seth Klarman on leverage and the current credit crisis. (mega hat tip to Lincoln Minor) It was published over at the Motley Fool board, and based on the content appears to be legitimate. It is pasted below.

Some investors target specific returns; a Pension Fund for example might target an 8% annual gain, but if the bundle of asset classes under consideration fails to offer that expected result, they have the choice only to lower the goal, which for most is a non-starter, or invest in something riskier than they would like. The pressure to keep up with a peer group renders decision making even more difficult. That there is no assurance whatsoever that the incurrence of greater risk will actually result in the achievement of higher returns. The best investors don’t target return, they can first focus only on risk and then decide whether the projected return justifies taking each particular risk. When the herd is single-mindedly focused on return, prices are frequently bid up and returns driven down. This is particularly so when leverage is used. Leverage doesn’t have to be dangerous. Non-recourse debt on an asset can certainly make a large purchase more affordable. Taking out a non-recourse loan on an asset you already own can actually reduce risk since the borrowed funds return your capital while the risk of loss is transferred to the lender. But recourse debt, margin debt, is something else entirely. If you purchase some investments and then borrow with recourse debt to buy more, you are now vulnerable to marked to market losses on what you owe. Depending on the precise terms of the debt, the decline of the value of your holdings could force you to either put up more collateral – which you may not have – or to sell off some of the investments you purportedly like to meet margin calls. By borrowing you cease to be the master of your own fate and allow the lender, or actually the market, to be. How ironic to allow the market, which has dished up your current portfolio of opportunity, to dictate to you the need to sell your most attractive holdings in order to survive. The availability and use of margin or recourse debt is especially pernicious. Had you purchased an investment without leverage, which declined in price, you could have used any available cash to buy more. Alternatively you could sell another investment that did not decline or declined less to afford more of the now better bargains. This is in fact a healthy discipline forcing you to choose among investments to own what you like best and necessitates that you carefully decide when to hold onto cash and when to put it to work. Recourse leverage changes this equation as you can seemingly own all the investments you want simply by borrowing to buy them. There is no healthy portfolio discipline enforcing the desire to make new purchases or the anticipation that you may want to. There is also a bit of a slippery slope in the sense that if a little leverage is good, why isn’t more leverage better – when do you stop?

...during our parents’ lifetimes and our own, credit has become increasingly available and standards increasingly lax, to the point where credit cards and checks backed by credit lines arrive unrequested in the mail. Where your house can be used as an ATM, where people with dismal credit histories are eagerly sought after to provide them with loans, where investors flock to buy junk bonds and shady companies seek to issue them, and where investment funds are offered the opportunity to enhance their returns through structured products, derivatives and exotic finances, all of which enable high amounts of leverage. The moral imperative of repaying the banker, your neighbor, who granted you the loan across his imposing desk has been replaced by the moral vacuum of anonymous lenders using credit scoring who quickly resell your loan to someone you’ll never meet, who are actually comfortable with the actuarially determined probability that you may in fact default. Credit rating agencies have embraced the debt or-gy (offensive word detected) with lax standards and naïve models, brewing conflicts of interest and accepting healthy fees to label toxic waste as investment grade. A similar risk exists as a result of the burgeoning increase in capital allocated to alternative investments – venture capital, private equity and hedge funds. While returns start to come down as the pension funds have looked to alternatives to add excess return and diversification, they are hardly a panacea. Some alternative managers have historically added considerable value while for others the jury remains out. For alternatives in their entirety, high performance and management fees truncate upside potential – increased competition has forced many alternative managers to incur greater risk to achieve their accustomed returns. For some this means incurring greater credit risk while for others this means utilizing considerable amounts of leverage.

The pendulum may be starting to turn as recent developments in the mortgage and hedge fund markets suggest. Because the scale of today’s leverage so greatly exceeds historical levels , it seems possible that we are only at the early stages of the credit contraction. Not surprisingly, it may take time to work off these excesses. Intervention by the Fed, as it recently has, seems likely to give license to further speculation, while failing to address and perhaps even exacerbating the underlying problem of lax lending standards, poor credit quality and excessive use of leverage. Indeed, many market participants believe the solution to these problems of over-leverage and bad credit is more debt. Recently many funds have been formed to make leveraged purchases of loans that are expected to trade in the mid to high nineties instead of par, with 5x leverage or more, bringing the yield to a 15% or 20% return. It seems to me incredibly unlikely that the end to the debt crisis can be near at hand when the solution offered – more debt – is in fact what caused the problem in the first place. Many investors lack a strategy that equips them to deal with a rise in volatility in declining markets. Momentum investors become lost when the momentum wanes, growth investors who paid a premium for the fastest growing companies don’t know what to do when expected growth fails to materialize. Highly leveraged investors, like some quant funds in the headlines, were recently forced to sell regardless of value when their methodology produced losses instead of gains. Counting on a government bailout for every crisis seems a dicey proposition, especially when supposedly impossible events happen on Wall Street every few years. By the time the market drops and bad news is on the front pages, it is usually too late for investors to react. It is crucial to have a strategy in place before the problems hit precisely because no one can accurately predict the future direction of the stock market or economy.

RGE: Time To Downgrade the Monoliners

The forest issues is simple: a business – the monoliners’ insurance of securities and holding of risky ABS securities – that is fundamentally based on having a AAA rating is a business that does not deserve a AAA rating in the first place: it is clear to all that if a monoliner were to lose its AAA rating the essence of its business model would fail and such monoliner would have to close shop. But in any industry you have firms that can do business and thrive with an AA or A or even lower rating, even among major financial institutions. Here we have instead an industry that would go bankrupt as soon as its AAA rating is lost: by definition this is not an industry that can deserve a AAA rating. So the issue is not one of how sound these monoliners are managed or whether they have enough capital or whether they can raise new capital to maintain their AAA status. There is a fundamental and conceptual flaw in a business model that is conditional on a AAA rating and that is in a business that insures assets and firms that do not have a AAA rating. This is analogue to the voodoo finance of taking subprime and BBB mortgage backed securities and turning them into AAA by the black magic of CDO tranching.
...

Roubini brings up an interesting point.

Direct Link

@Google

I happened to stumble across @Google today. It appears that Google regularly hosts famous authors at their headquarters to give talks about their books or whatever is on their mind. And even better, they videotape these discussions and post them on YouTube for everyone to view. You can search through the list here, and there are a lot of notable authors and academics, i.e.

George Soros
Michael Lewis
Paul Krugman
Joseph Stiglitz
Michael Bloomberg
Phillip Zimbardo

There is also Candidates@Google, with discussions from many of the presidential candidates, such as Obama, Ron Paul, McCain, Edwards, and more. This, along with TED.com, has given me a large backlog of informative and interesting videos to watch.

I watched the Authors@Google on Paul Krugman, a respected economist, and took notes on what he had to say. This is my shortened summary of a slightly over one hour discussion.

How we got to our current credit crisis? We had this amazing bubble in housing, which had its origins from the technology bubble before it. Back then the Fed cut rates to 1%, and at the same time money was pouring into the US from outside. Long term rates went down and house prices started to pick up. Afterwards, it was just classic bubble experience, as the price rises attracted more and more speculators. The price-to-rent ratio went up about 50% above historic averages. The housing bubble led to more construction jobs and higher consumer spending.

But, you have to remember Stein's law: if something cannot go on forever, it will stop. The national averages underscored the true regional imbalances in places like California and Florida. There is now huge havoc in the system, yet interestingly financing from abroad still hasn't stopped.

What really happened was lenders were giving loans to people with little or no cushion in the collateral. The Fed has found the rate of change of home prices is the best determinant of foreclosures. If house prices fall 20%, we will have 13 million houses with negative equity. If a 30% fall occurs, 20 million houses with negative equity. That's 40% of U.S. households.

Financial institutions are taking these losses and we don't know where it is. Fed tried to step in August like it was business as usual, similar to previous crisises. This time, it didn't work. We are facing today a solvency problem, not a liquidity problem. The Fed's policies are meant to step in and provide short term lending to prevent an unnecessary loss of confidence and a run on a bank. But this time we have a lot of loans not worth their full value. The question is if this will lead to a recession, and I don't know.

Assume we don't have a complete financial meltdown. It is hard to see what policy or financial engineering we could do. I think it is plausible that financial markets will remain crippled until house prices fall enough, enough loans and bad institutions get cleansed, and then we can continue.

What strikes me is during the tech bubble, we had a new technology with lots of possibilities and no one really knew how to correctly value this potential. But this time, it is just houses...

Roubini: Uncertainty and Risk

This was posted a few months ago, but it is a great read discussing risk and uncertainty in today's financial markets. Direct Link

In brief, “Risk is present when future events occur with measurable probability” while “Uncertainty is present when the likelihood of future events is indefinite or incalculable”.
...

Indeed, for many reasons the current market panic has to do with unpriceable uncertainty rather than measurable risk.
...
This increased financial uncertainty is in part due to the increased opacity and lack of transparency in financial markets.

As pointed out by Gillian Tett in a January FT article the opacity of financial markets vastly increased in the last few years thanks to the rise in credit derivatives...

But it is not just credit derivatives that create market opacity. This increased lack of transparency in financial markets is much broader: thousands of hedge funds that not only are unregulated but whose activities are opaque and not measured by any supervisor; shift of the corporate system from a public to a private one via LBOs and private equity transactions; increased size of unregulated over-the-counter trading in derivative instruments rather than on regulated exchanges; development of complex financial instruments whose correct pricing and rating is increasingly difficult; mis-rating of these new instruments by credit rating agencies saddled with severe conflict of interest as a large part of their revenues come from rating these new structured finance instruments; a laissez faire attitude among US supervisors and regulators that allowed reckless lending to foster.

So combine an opaque and unregulated global financial system where moderate levels of leverage by individual investors pile up into leverage ratios of 100 plus; and add to this toxic mix investments in the most uncertain, obscure, misrated, mispriced, complex, esoteric credit derivatives (CDOs of CDOs of CDOs and the entire other alphabet of credit instruments) that no investor can properly price; then you have created a financial monster that eventually leads to uncertainty, panic, market seizure, liquidity crunch, credit crunch, systemic risk and economic hard landing. The last two asset and credit bubbles in the US – the S&L real estate bubble and bust of the late 1980s and the tech stock bubble of the late 1990s – ended up in painful recessions. The latest credit and asset bubble was much bigger: housing, mortgages, credit, private equity and LBOs, credit derivatives, corporate re-leveraging. So, the current bust and de-leveraging of the financial system is likely to lead to another painful economic hard landing.

It has been my own observation that this is true. Many financial companies can just not be valued and have to be thrown into the "too hard" pile. It is not that there is just uncertainty- it is that there is very highly leveraged uncertainty that could very easily wipe out many of these companies. The risk to investors can not be measured, and there is no comfortable margin of safety.

Some financial companies were better and more transparent than others (Wells Fargo, Bank of America come to mind), but they're stock prices have also been only very minimally affected. It has mostly been the most opaque and complex institutions where prices have fallen the most. Credit derivatives, level three assets, low loss reserves, unmentioned counter-party risks... investors can not value these themselves with the information given in financial statements. An investor would be forced to trust in management's estimates, but these are the same management's that were doing some really silly things a few months ago.

Bill Ackman: How To Save The Bond Insurers

Last month, I took A Practical Look at the Bond Insurers and concluded that bond insurance was a terrible business. They face competitive forces with Mr. Market, with each other, and with their clients. Meanwhile, their accounting profits were largely fictional and reserves could quickly prove inadequate if the credit cycle turned negative.

So it was to my surprise tonight when I saw that Bill Ackman made the same exact point in his Value Investor Congress Slides last weekend in the section he entitles, "Does the Bond Insurance/ Financial Guarantee Business Make Sense?" To show a slide which summarizes the argument:


Overall, it is an interesting read, although it gets a bit technical.

A Tribute to Minsky, Part I

Hyman Minsky is someone who I have mentioned a few times on this blog, yet I've noticed that I have not ever shared my own interpretations on his work. So in Part 1 of my tribute to Hyman Minsky, I will be going over "The Financial Instability Hypothesis", and what I have built on his idea.

The first thing to understand is the idea of debt-income relationships. This term refers to the idea that a borrower's debt relies on the borrower's income to get paid back. But I think underlying this is an even more general and important relationship: price-value. Below is a chart I came up with.


For now, we will focus just on debt and investment ( I threw the idea of consumption in there just because I know it too plays a part and to remind myself about this later) Debt is a relationship whose value is derived from the borrower's income, and an investment is similarly has its value derived from the underlying cash flow. Now there are some differences between these two. For example, with debt the upside is capped. The borrower's income can triple, but he will most certainly not start paying any increased amount to his bank. But in an investment, any increase in cash flow accrues to the owner. So, we see that:

With Debt, the maximum upside is known and quantifiable. All that exists is downside.
With Investment, the range of values is infinite, meaning there is no limit to your potential gain.

Nassim Talib described this phenomenon as negative and positive black swans. (debt and investment, respectively. See Post) Otherwise, I think you can see that the relationships are fairly similar.

Now the essence of Minsky's work revolved around the idea that debt-income could be characterized into 3 broad categories- hedge, speculative, and ponzi. In hedge financing, the borrower's income can cover both his interest payments and his eventual principal payments. In speculative financing, the borrower's income can cover his interest, but he must either refinance or sell assets to pay the principal. Finally, in Ponzi financing the borrower's income can not cover either the principal or the interest payments. Some people might already be thinking something along the lines of:

"Hey, not even able to afford their interest payments? Isn't that what is causing this mortgage crisis right now, with loans being made to people who could not afford it?"

With the answer being yes. But what is interesting for value investors is that these three classifications apply to the broader price-value spectrum as well. Let's take common stocks for example. We have a purchase price, which is the market capitalization we are paying, and we have the value, which is the company's cash flow. If the company's cash flow can cover both our interest (cost of capital) and the principal (purchase price), then we have a hedge financing relationship. Worded differently, if we can discount the cash flow(cost of capital) and get a value more than the principal (purchase price), then we are hedge financing. Sound familiar? It should, because this is the dictum that value investors live by: A common stock is worth the discounted value of its future cash flow. Our goal is to buy something for less than that.

So let's move down the chain a bit. A speculative arrangement in stocks would mean that the cash flow can cover the cost of capital, but it can not cover the purchase price. And with Ponzi, the cash flow can not even cover the cost of capital. Now in the world of stocks, this environment has usually been referred to as a bubble. Think of the tech bubble as an example. Many companies were trading at earnings yields of 2% or less, while treasury rates were north of 6%. So, an investor in common stocks at that time could not cover his cost of capital out of cash flow.

This analogy has helped me describe the current mess we're in as a true Credit Bubble, or as Minsky would say a Ponzi. Loans were made on a large scale to people who could never afford to make the true cost of interest out of their incomes, yet adjustable rate mortgages helped mask this for some time.

Now some people have tried to claim that the problem will not be so bad because these loans are secured by homes, which have real value. But again, we can apply the all too familiar concept from value investing to show this is not the case. An asset is worth the discounted sum of its future cash flows. We've seen how this is the case for common stocks. A home is the same thing, although with the value being derived from the property's rent. And using current rents, homes as an asset are also in a Ponzi relationship, not being able to cover the cost of capital.

Now it is important to also realize that just because current cash flow does not cover interest doesn't mean it is necessarily a bad deal. I'll use another stock example to make the point. It is perfectly reasonable for me as an investor to invest in Coke at lets say a 4% earnings yield when the cost of capital is 6%, and for it to still be a value. This is because I expect Coke's cash flow to continue to grow into the future. So although currently my cash flow can not cover interest, in the near future it will. If I am correct and Coke's Net Present Value is greater than the price I am paying for it, then it is in actuality still a hedge financing arrangement.

So is there a similar hope for mortgage debt and housing? Well, mortgage debt is based off borrower's income. And housing is derived from rent, but rent is also a function of income. So for these loans to work out, we would need to see incomes rise in the future. And the recent trend is not encouraging. Below is a graph of REAL household income from 1967 to 2005. Nominal would be more appropriate, but I could not find a chart for it, and real incomes is suitable. Since 2000, household incomes have actually declined. An important factor in this has likely been globalization, which I have discussed in the "Tectonic Shift" series. With the competition of the entire world's labor market, it is difficult to assume incomes will be able to rise considerably in the near future.




So for now, that is the dilemma we face. In part two, I will try to expand on this concept and describe some of the possible effects.

Hoisington Third Quarter Review and Outlook

Hoisington Investment Management has released their Third Quarter 2007 Report. I am a big fan of their work and I share very similar opinions as they do. I think those who read this to the very end will find this very informative. Some notable remarks:

More amazing, perhaps, is the fact that over the past 5 1/2 years, $1.1 trillion in equity has been extracted from homes. This represents 46% of the increase in total consumer spending over the same period (Table 2). The tightening of credit standards and declining home prices will virtually guarantee that $1.1 trillion will not be extracted in the next few years. Consequently, slower consumer outlay growth can be expected for an extended period.
...
The Fed’s reduction of short-term rates serves to lessen slightly the finance charges of these massive debt burdens, but it does not reduce the magnitude of those obligations relative to income. Moreover, the reduction in short-term interest rates will not serve, at least for the next year or two, to make the household debt more manageable in relation to home prices to which those debts are also directly tied. Thus, credit losses stemming from the debt binge of this decade are far from being realized, and the recent tremors of the credit markets may be a sign that all is not well.

Four considerations suggest that the current housing depression will continue for at least the next two years. First, home prices remain near record highs in spite of the largest yearly decline on record...

Second, housing starts and building permits are still well above prior cyclical lows, despite the 42% decline in both...

Third, there is a record inventory of unsold homes relative to sales--nearly ten months for existing homes and 8.2 months for new homes...

Fourth, nearly $800 billion of adjustable rate mortgages will reset between October 2007 and December 2008, with the peak in the first and second quarters of 2008....

While a decline in wealth would be spread out over time, the housing sector would impair consumer spending in other ways. Falling home prices will result in additional losses for the financial sector, which, in turn, will tighten lending standards and reduce credit availability for consumer spending. Also, job losses in housing and related sectors will limit the growth in household income, putting consumer spending under downward pressure. Accordingly, domestic demand growth should continue to weaken, serving to transmit the U.S. growth recession to the rest of the world.

A continuing contraction in both the growth of total reserves and the transactions-based monetary aggregates, as well a downturn in the velocity of money, suggest that monetary conditions remain restrictive. These monetary considerations, combined with greater slack in the labor markets, will serve to put additional downward pressure on the inflation rate. Even though a weak dollar and increases in commodity prices suggest that inflation will rise, this is not likely to be the case. Demand will be too weak to allow cost increases to be passed along to consumers. Thus, weakness in domestic demand suggests that profit margins will be compressed in this environment.

CR: What is Subprime?

The main impact of subprime lending on the overall mortgage business was the take-out function. As subprime lending grew, you saw better “performance” of prime or near-prime mortgage portfolios. This was not because subprime lending did away with the traditional default drivers of job loss, illness, divorce, or disorderly conduct; it was because loans in that kind of trouble had a place to go besides foreclosure. Prime lenders could and did congratulate themselves on their low foreclosure rates as if it were a matter of their superior underwriting skills, but that involves a high degree of naiveté. It’s really important to understand this issue, because it gets to the heart of the “contagion” thing. It is not that subprime delinquencies are “spreading” to prime loans as if some infectious agent were in play. It’s that the drain got backed up: when subprime lenders go out of business, or investors won’t buy subprime loans, there is no place for the inevitable prime delinquencies to go except foreclosure. Prime delinquencies become “visible” because they don’t move out of the prime portfolio via refinance into the subprime portfolio, where we “expect” to see them.

Direct Link

Prem Watsa: He Has Never Been More Bearish

In a rare interview, the chairman of Fairfax Financial Holdings Ltd. said he thinks it's possible the United States is on the cusp of a prolonged market slide, similar to the one endured by Japan between 1990 and 2003, when the Nikkei index plunged 80 per cent.

...
Mr. Watsa suggested the decision to put 75 to 80 per cent of Fairfax's portfolio .into government debt - "for the first time, I think, ever" - reflects his view that credit markets will take a long time to digest the problems in the U.S. real estate and mortgage business.

"We don't know how bad the recession's going to be, so credit is going to be tough," he said. "You're going to have these big losses, the banks are going to have big losses. So we are worried."

Mr. Watsa took particular aim - not for the first time - at the structured-products industry on Wall Street and Bay Street. Many of those securities got high ratings from the credit agencies, but have cracked under the strain of rising U.S. mortgage defaults.

The Fairfax chairman said the products were always flawed because they shifted the risk away from the person making the lending decision - which encouraged auto finance or mortgage companies to give loans to almost anyone, since they would not have to bear the losses on defaults.

Direct Link