In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $724,000.
—Michael Lewis, The Big Short: Inside the Doomsday Machine
During the 17 years that I have contributed to TheStreet, the most significant period (in terms of its near- and intermediate-term influence on the global markets and economies) was the Great Decession of 2007–2009.
Much of the blame for the recent downturn lies on the shoulders of the banking industry, whose appetite for leverage and financial steroids rivaled that of the New York Yankees' Alex Rodriguez.
The banking industry's exporting of financial weapons of mass destruction (based on the faulty assumption that home prices would never experience an annual decline) undermined and nearly bankrupted the world's financial system.
During the mid-2000s' run-up to the downturn, I strenuously warned of the consequences of this financial innovation, increased leverage, as well as the egregious lending (especially of a mortgage kind from a rapidly growing shadow banking industry).
In this chapter, I chronicle, at length, the ensuing market and economic devastation that followed in 2007–2009—and how, in the process, investors lost their innocence.
Fed Chairman Alan Greenspan took center stage this week, and his comments have important implications for housing, the consumer and the economy.
Specifically, Greenspan suggested that the government-sponsored enterprises that finance and provide liquidity for the housing industry, Fannie Mae and Freddie Mac, have become too levered; if the companies miscalculate the risks inherent in their bloated balance sheets (like duration mismatches), there could be serious system-wide financial ramifications.
Importantly, the growth of government-sponsored enterprise (GSE) portfolios has a significant bearing on the future course of homebuilding, as changes in credit growth are almost always a sign of an industry slowdown. Already, the year-over-year change in Fannie Mae's purchases of securities is narrowing, while the year-over-year change in homebuilding share prices appears to be stalling.
Should Greenspan's words lead to pressures to slow down balance-sheet growth at the GSEs or to reduce their preferred lending status, homebuilding and homebuilding shares will suffer as credit extension to homebuilders will be reduced and the cost of home financings will almost certainly rise.
With the benefit of hindsight, the homebuilding industry has been the chief beneficiary of massive stimuli over the past three years, leading to artificial lows in mortgage rates (and a general improvement in consumers' ability to service an ever-expanding mortgage loan base), but a world without stimuli holds headwinds aplenty for the sector.
If I am accurate in my general assessment and absent the pricing umbrella of ever-rising home prices, the favorable operating history of rising margins for homebuilders will be threatened shortly on several fronts.
The sheer force of rising home prices over the past decade has provided the homebuilding sector with pricing power, allowing builders to raise their products' prices to levels barely foreseen even five years ago. Conditions are slowly changing as homebuyers are now threatened with their ability to afford ever-rising home prices, and the potential is for heightened consumer resistance to these price hikes.
The almost parabolic rise in home prices in certain markets has increasingly forced out buyers' (especially first-time buyers') ability to afford housing. We are already seeing moderating home-price increases on a national scale. Nationally, the rate of gain in home prices peaked a year ago at close to an 8% increase. Fourth-quarter 2003 prices rose by less than 5%.
The trend of decelerating home prices will likely be a feature of 2004–2005, and its ramifications for homebuilding growth are potentially profound. Of course, the aforementioned 5% rate of increase nationally is still historically high and points to its vulnerability, as it is nearly double the average home-price increase over the past 30 years.
Indeed, Hovnanian Enterprises has guided to a 3% reduction in its average realization in 2004. More builders will say the same in the months to come (serving to compress margins by 100 basis points this year after experiencing a 350-basis-point rise last year!).
Toll Brothers missed revenue guidance Thursday morning, citing bad weather's effect on closings. It also reduced the top end of 2004 estimated deliveries. Toll has an important presence in New Jersey and, as a high-end builder, seems vulnerable to Gov. McGreevey's recommendation to issue a $10,000 McMansion tax on homes in excess of $1 million in New Jersey, detailed in his budget for the upcoming fiscal year.
Rising home prices have been the underpinning of better margins as homebuilders' operating leverage is dependent on higher sale prices. On average, homebuilder margins have risen by a dramatic 275 basis points, to around 22%, since 1999, with Ryland Group and Hovnanian experiencing a nearly 500-basis-point improvement.
By my estimates, about 30% of the gross profit improvement in the past year for the homebuilders was a direct reflection of margin improvement, which came from an ability to raise home prices.
The rapid price rise in the homebuilders' cost of goods sold (principally land and building materials such as lumber) will further exacerbate margin pressure.
If home prices retreat, or even if the rate of increase in prices materially decelerates in the face of rising costs for land and building materials, homebuilder EPS growth in 2004–2005 will be increasingly dependent on unit growth.
But we already established the thesis that activity will be tempered by:
The likely diminution of pricing power could lead to rising incentives by homebuilders in the last half of 2004 or early 2005, further pressuring profitability. There are already some signs of a loss of pricing power by homebuilders as house-price appreciation is slowing. This is seen vividly in the greater-than-seasonal drop in gross margins at the leading homebuilders from the first quarter of 2003 to the fourth quarter of 2003.
From my perch, the cycle position of homebuilding is very much like that of technology in late 1999. Low-cost capital enabled technology to prosper, but it was ultimately the death knell for that sector, which experienced a crisis in profitability as pricing power completely eroded. In the same manner, housing's exposure to generational lows in mortgage rates has had the unintended consequence of moving home prices to levels where consumers will not only resist the prices, but increasingly can't afford to buy homes, especially if interest rates rise.
I have previously mentioned that cycle peaks are established when capital/debt is plentiful and cheap, whether it is technology or housing. And similar to the 1999–2002 legendary implosion in technology, it will happen equally as fast and as unexpectedly in housing.
Because of the pressures on the GSEs, upgrades decelerating, evidence of moderating home prices, pressures on disposable incomes (which will negatively affect consumers' ability to afford a home), and the rising cost of materials and labor, the outsized improvement in gross margins will likely not be maintained, ultimately pressuring homebuilder profitability.
At the risk of stating the obvious, the U.S. consumer has too much debt. I continue to believe that market participants have a flawed view of the sustainability of world economic growth. The root cause of my concern remains a levered consumer, and signs have emerged of the unwinding process. So for 2005 (as in 2004), I am taking smaller positions and fewer long-term positions. I think that an opportunistic trading approach makes sense until consumer debt unwinds.
Lest we forget the origins of the recent housing mania, I remind you that the recession of 2001–2002 was an unprecedented historic anomaly. It was a recession in which credit card and mortgage debt ramped ever upward, greased by an unprecedented series of interest rate reductions to practically zero. This translated into generational lows in mortgage rates, which had a twofold effect: Cash-out refinancings soared, and monthly payments fell (even as both housing prices and overall mortgage debt rose). In addition to mortgage debt, interest-free automobile financing has been rampant in recent years. The net result is total household debt of more than 80% of GDP, far greater than the 64% level at the beginning of the economic recovery in the early 1990s.
The Fed fueled a spending spree to offset the slow economy, so the real estate bubble served its purpose: it cushioned the U.S. economy from a collapse after the titanic tech bubble of the late 1990s.
Despite a wrenching recession and millions of layoffs, more Americans have big houses, big cars, and big-screen TVs than ever before. So there is no pent-up demand for large-ticket durables, which typically provide the catalyst for cyclical growth once a recession ends. This time around, however, there is little if any pent-up demand. Instead, most consumers have a mountain of debt. And much of the debt is backed by residential housing, where pricing defies logic and affordability. (When mean reversion does finally kick in, the result will be painful for both the consumer and the debt holder.)
In a nutshell, my thesis is that the consumer is spent-up, not pent-up, so a general rise in interest rates will have a speedier and more profound impact on the economy's growth path than investors anticipate. I say this because the equity market is priced close to perfection and certainly does not discount either slower growth or rising bankruptcies.
While these facts are blindingly obvious, most investors still underestimate the difficulty of unwinding all of this consumer leverage in the face of higher interest rates. I think that there is a fair chance that U.S. economic growth will be disrupted and maybe even derailed, as consumer spending stalls and bankruptcies soar. In fact, consumer bankruptcies have already begun to rise, though the impact on banks has been obscured by two factors: the securitization of consumer debt and a decline in corporate defaults. (Ironically, while consumers went on a debt-fueled spending spree, most companies slashed spending and have rebuilt their balance sheets.)
More recently, after the recovery in global equities in late 2004, I have warned and held steadfast in my belief that market participants have lost sight of or ignored building economic risks. And I continue to think that both the economy and corporate profits (especially margins) will disappoint in 2005. Despite my protestations, investors seemed to have feared nothing of late, and instead have adopted the mantra of Mad Magazine's Alfred E. Neuman: “What, Me Worry?”
Evidence of complacency is widespread. Sentiment is at record bullish levels, with Investors Intelligence bull readings recently at the highest level since the October 1987 crash, and the CBOE Market Volatility Index (VIX) at decade-low levels. This complacency, combined with interest rates near record lows, has brought out the worst in herd behavior as desperate, momentum-based investment pros have grown immune to the risk side of the equation. Indeed, the move in the speculative darlings of the new millennium—for example, Travelzoo, Taser, Google, Sirius Satellite, and many others—has become reminiscent of the late 1990s bubble.
It's as if fear and doubt have been driven from the marketplace.
I highlight five warning signs from the fourth quarter that suggest that the U.S. consumer is now at the tipping point:
The Fed revealed in the minutes of its most recent meeting that it is concerned about several forward-looking issues that I have repeatedly harped on. Stated simply, there might be unintended consequences from the protracted period of easy money.
All this said, the world is not coming to an end, nor does it preclude market rallies. But we should all recognize the consequences of policy decisions and remember the wisdom and lessons of history and adjust our risk profiles accordingly. For it seems as if in almost any cycle of speculative activity we forget Benjamin Disraeli's words: “What we have learned from history is that we have not learned from history.”
Lest you think I have forgotten my humility as an investor, I'll repeat Warren Buffett's comment to shareholders of Berkshire Hathaway from 2004: “The cemetery for seers has a huge section set aside for macro forecasters.”
“Nor is the people's judgment always true:
The most may err as grossly as the few.”
—John Dryden
History and Blood, Sweat & Tears teach us that “what goes up must come down.”
Physics and Isaac Newton teach us that “for every action there is always an equal and opposite reaction.”
While the hedge fund bubble and the convertible debt bubble have garnered most of the attention over the past two months, the markets have ignored—or put on the back burner—concerns regarding the real estate boom/bubble.
As seen by my analysis below, however, I remain a firm believer in mean reversion and that housing is heading for a hard landing as the issue of affordability will soon trump the historically low level of interest rates. Or, as Newton proclaimed, “A body in motion tends to remain in motion, or remain stopped unless acted on by a force.”
From my perch, the ramifications of an unwinding in home prices could potentially prove as grave (in the 2006–2008 period) as the effect that the bursting of the stock market bubble had in 2000–2003.
And that is quite a bold statement.
How severe might the housing correction be?
In order to gauge the magnitude of the risk, it is interesting to look at the ratio of home prices as a multiple of average household incomes in England and in Boston, two geographic areas whose housing markets are exhibiting parabolic rises and appear eligible for the Bubble Hall of Fame.
In the United Kingdom, average housing prices divided by average earnings now stand at over three standard deviations above trend line (measured over the last 50 years); as recently as 1995, the ratio was one standard deviation below the average! Today, the variance in home prices to household earnings in England is even larger than the standard deviation imbalance of U.S. equities in March 2000, which represented the most conspicuous overvaluation in modern U.S. equity history. In order to move back to the historic trend line, home prices in England would have to fall by 38%.
In Boston—a good example of the red-hot coastal U.S. housing markets—median home prices stand at 2.5 standard deviations above the historical distribution. Twenty years ago, home prices were 1.5 standard deviations below the average experienced over the last half-decade.
In a recent CNBC special on housing, “The Real Estate Boom,” I mentioned that the price-to-earnings (P/E) ratio of homes in the United States (average home prices divided by rental prices attainable) now approaches 34—eerily reminiscent of the bubble multiple on the S&P 500 in early 2000. If that ratio were to decline back to 20 (the average over the last 50 years), home prices would drop by 40%.
According to The Economist (March 3, 2005), based on the value of house rentals today, the housing market is roughly 30% overpriced in the United States.
Another way to look at house price vulnerability is to call upon the speculative rise in London home prices in the 1982–1988 period (when it peaked at two standard deviations above trend) and its subsequent deflation in the early 1990s. During that time frame, the ratio of home prices to average earnings fell from 5× to under 3×, signifying a meaningful drop in home prices.
It is important to note that although the break in the real estate markets was responsible for a considerable amount of damage in the world recession of the early 1990s, improving real wages buffeted its overall impact. In contrast, today's low inflation and lower income growth will likely be less of a cushion to a housing price decline than in the previous cycle.
Every single two-sigma event (a.k.a., bubble) in economic history has ultimately been broken, and with the piercing of an important asset class's bubble (such as real estate) invariably comes lower consumption and lower investing intentions, regardless of monetary or fiscal policy responses.
Remember above all else: When everybody else is doing it (as is the case in real estate!), don't. The more certain the crowd is, the surer it is to be wrong. If everyone were right, there would be no reward.
I have long felt that the consumer is spent-up not pent-up, and now, with the housing bubble near its final inning, I am positioning my portfolio in a number of shorts in companies that have relied on expanding turnover of the existing housing stock and rising home prices. What makes things even worse than many realize is that record refinancing cash-outs have levered the consumer ever more to the housing markets.
Furnishing companies, lenders, originators, remodeling companies and specialty retailing serving real estate will likely face a torrid headwind as we conclude this decade.
At the core of my economic concerns for 2006–2008 is the swift and deep deterioration in the U.S. real estate market.
Housing has been—to paraphrase New York Yankee slugger Reggie Jackson's self-description—the straw that stirs the drink of the consumer and the economy.
The construction industry has been the most important catalyst for economic growth since 2001. The Fed took interest rates to unprecedented low levels, and mortgage lenders encouraged activity through creative mortgages that kept mortgage debt service even lower by requiring small monthly payments.
Indeed, economists at Merrill Lynch (and elsewhere) have pointed out that residential and nonresidential construction activity was responsible for nearly half of gross domestic product (GDP) and employment growth since 2001.
Equally important, the unprecedented rise in home prices (especially of a coastal nature) buoyed consumer confidence, allowed the consumption binge to be extended (through record refinancing cash-outs) and encouraged consumers to stop saving (comfortably relying instead on the appreciation of their homes).
I argued (prematurely) that the housing cycle was no different than past cyclical experiences, that the long boom forecast by industry participants (homebuilders and analysts) was fallacious and that, in the fullness of time, housing activity and prices were headed for a fall.
The major reasons for my forecast were twofold and differed from the declines of the past (which were influenced by job losses and other negative macroeconomic forces). Affordability (home prices divided by household incomes) had been stretched to levels never before seen, and a new class of buyers (speculators or day traders of homes) had artificially inspired rising home prices (very similar to day traders of stocks in the late 1990s).
Over the past nine months, the cyclical peak in housing activity has come and gone. Almost weekly, prior upward guidance by homebuilders has been replaced by the slashing of estimates, lower order rates and eroding backlogs. And the industry's inventory has mushroomed to multiyear highs.
The worst is yet to come for housing; it is moving toward a very hard landing. And with a further decline will be (important) attendant and adverse ramifications for consumer confidence and aggregate economic growth.
Housing led the economic recovery and will now lead the economy's contraction—a causal relationship far older than most hedge fund managers' (who have never seen a bear market) half-life of investing.
My home and my neighborhood illustrate how quickly real estate markets turn and how worrisome the downward trend in the housing market might become.
For five months of the year, I live in the tony town of East Hampton, New York. (I purchased the home three years ago.) I live in a nice 50-year-old home on a little more than an acre, which sits about five blocks from Georgica Beach.
When I left East Hampton for southern Florida (my winter residence) last October (which, coincidentally, was the statistical peak in housing), there were no homes for sale on my block (which consists of about 12 homes). However, upon returning to Long Island in late May 2006, four of the existing 12 houses had been demolished and replaced with new homes for sale. (I would estimate, on average, each home was about 7,000 square feet.)
All four homes have been for sale since May (by speculators/developers) with no bids. Moreover, three other existing homes on my block have been put on the market this summer. No bids there, either.
Real estate agents across the country routinely have Sunday open houses, and East Hampton is no exception. Those open houses on my street have come and gone; there has been no traffic.
East Hampton is symptomatic of many other coastal real estate markets. The hard landing in housing is upon us, and as usual, the cycle will be more extreme than expected—just as the climb was unexpectedly high.
During the halcyon times last spring, I participated in a CNBC town hall special titled “The Real Estate Boom,” in which Dr. Robert Shiller of Yale University and I debated with optimistic industry participants and housing economists about the slope of the cycle. We were in the distinct minority. Many industry insiders still see a soft landing in housing. They are wrong.
As I mentioned previously, the statistical peak in housing (measured by new-home sales) was October 2005, only nine months ago (and with a unit drop in new-home sales since the peak of less than 20%). By contrast, the average postwar cyclical downturn for housing has been between 26 and 52 months, which has averaged a 51% drop in units.
As I wrote earlier, the worst is yet to come for housing, and with it, the multiplier effect on the domestic economy will be felt widely.
“We do expect an adjustment in home prices to last several months, as we work through a buildup in the inventory of homes on the market.…This is the price correction we've been expecting–with sales stabilizing, we should go back to positive price growth early next year.”
—David Lereah, economist, National Association of Realtors (New York Times, September 2006)
Lereah, whom I debated on CNBC's “The Real Estate Boom” in April 2005, is a very nice man and a capable economist. I recently had a most pleasant conversation with him at CNBC studios two months ago prior to a special on housing hosted by Bill Griffeth.
Lereah is also the author of the book Are You Missing the Real Estate Boom? Why Home Values and Other Real Estate Investments Will Climb Through the End of the Decade—and How to Profit from Them (Crown Business, 2005).
Not the most timely publication, Lereah's book was published within four months of the statistical peak in housing activity and prices in 2005. In fact, the paperback version came out in February 2006, when the down cycle was beginning to escalate.
I am in no way trying to embarrass Lereah. I am just stating the facts and my opinions. Don't think for a minute that the National Association of Realtors' Lereah was expecting a price correction last year, as stated in this month's New York Times interview above.
Back in April 2005 (on the CNBC special), Lereah and the managements of Hovnanian, Prudential Realty, and LendingTree were fully convinced (you might say glib) that the housing market was destined for a long boom. They saw a new paradigm of uninterrupted, noncyclical growth. One month later, Lereah was quoted as saying, “We simply don't have enough homes on the market to meet demand.”
That was then, and it doesn't pay to dwell on the past. So let's look into the future. Unfortunately, many within the homebuilding business continue to talk their book despite clear trends that do not support their bullish view.
Forgive my preoccupation with the housing markets, but it has had a disproportionate role in economic growth since 2000 (and maybe before). This merits a continued discussion as to the possible slope of the decline and the nature of the inevitable recovery. The housing cycle, among other variables, is a key influence on aggregate economic activity.
I expect a hard landing, and I have roughly quantified my expectations as to when the housing market will bottom (2009). It is folly to think that an unprecedented rise in home prices (in real and nominal terms) will be over in relatively short order. Yet this has been suggested by Lereah and others.
Housing cycles are long, and they play out over many years. We have learned that the peaks are surprisingly high and the up cycles unexpectedly long. Unfortunately, so too are the depth and duration of the down cycles.
Days/months of inventory have only begun to rise as the glut of homes will be exacerbated by continued overbuilding, disposition of land, and the selloff of homes by flippers. And, as discussed previously, the consumer enters the current downturn in a weak position. Consumers are highly leveraged after the overconsumption binge of the last decade and after massive cash-outs of home equity.
Consider the dramatic sale of D. R. Horton homes in the Daytona Beach market in Florida. A message at the bottom of its advertisement reads: “Realtors Warmly Welcomed!” That's never a good sign.
These discounts include up to $90,000 a unit, or as much as 30% (plus a free washer/dryer and refrigerator). This is not unusual: Most homebuilders have offered large price discounts and/or large incentives (vacations, car leases, reduced mortgage rates, etc.) for several months.
For a moment, let's suppose that you were a flipper in the Daytona Beach D. R. Horton community who owned and speculated on a few homes without the intention of moving in. You just took a 30% haircut on your inventory, not to mention carrying costs of a mortgage, real estate taxes, and expenses to keep up the property (landscaping, utilities, etc.).
And when the unit is finally sold, you have to pay a real estate agent a 6% commission. That speculator likely put up less than 20% up front (probably far less), and is now out, by my calculation, about 50%. But making the situation worse is this: who wants to buy a used home when you can get a new one?
The ramifications of an extended housing downturn are broad—far broader than many realize. For example, the apartment real estate investment trusts (REITs), a sector I am short, argue that there has been no new construction, so supply/demand favors an escalation in rents. But just wait until speculators, unable to sell their condominiums and homes, resort to renting the units.
Or consider the implications for building materials companies like Eagle Materials, which warned on Tuesday. What about the sale of pickup trucks, which are often used on the construction trade? What does an extended downturn portend for carpet, gypsum, lumber and appliance manufacturers? Or for subprime and some prime lenders? And what do you suppose happens to the plethora of real estate agents and mortgage brokers? (Do they become day traders again?)
You get the point: The housing decline is just beginning to be felt. The fixed-income market recognizes this. But for now, equity market participants don't. Common sense has taken a sabbatical.
Don't believe the housing soft-landing advocates, and do recognize the broad economic impact that a protracted downturn will have on our economy.
The worst is yet to come.
The nearly uninterrupted and intoxicating rise in equities over the past four months has caused many normally sober market participants to underestimate the severity of housing's downturn and to ignore the likely broad multiplier effect of housing's hard landing on the economy.
The arm of the housing market is long, and the cycles (up and down) tend to be long, too. Importantly, the lag of housing's negative influence (from the statistical peak in housing) is typically long, too.
At first, furniture retailers are immediately affected by the slowdown in residential activity.
Then home remodeling retailers and appliance manufacturers falter.
Ultimately, the effect that a hard landing in housing has on economic activity—and the lower home prices that it portends—broadens and causes a deep retrenchment in consumption, and its scope and impact becomes all-inclusive.
By historical standards, the recent up cycle in housing was atypically strong (topping 6% of GDP for the first time since the post–World War II expansion). We are from a bottom in residential fixed investment and facing likely economic slowdown.
Earlier this month, Richard Fisher, the Dallas Federal Reserve's president, explained the factors that contributed to the unprecedented boom in housing over the past six years.
In retrospect, the real fed funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer that it should have been. In this case, poor data led to a policy action that amplified speculative activity in the housing and other markets. Today, as anybody not from the former planet of Pluto knows, the housing market is undergoing a substantial correction and inflicting real costs to millions of homeowners across the country. It is complicating the task of achieving our monetary objective of creating the conditions for sustainable non-inflationary growth.
Stated simply, too-low interest rates fueled the speculative activity in housing and stretched affordability, which has resulted in an ever-expanding inventory of unsold homes. Today, a record level of builders' unsold inventory (including homes not started, homes started but not completed and completed home inventory) coupled with the residue of speculators' unsold homes speaks to a hard landing in housing, despite the protestations of many.
It is no wonder the Bureau of Labor Statistics reported a near 10% decline in home prices last month and that many homebuilders are reporting cancellation rates in excess of 40%.
Over the past 60 years, whenever residential fixed investment tops 5.5% of GDP and subsequently falls by at least 10%, a recession occurs. Already the ratio of residential fixed income to GDP (which peaked at 6.3% in late 2005) has now dropped by more than 10%. According to Guerite Advisors, the ratio has declined by another 17.4% in the fourth quarter of 2006.
Needless to say, there are other housing-related influences that will weigh negatively on forward consumption levels—adjustable option ARM interest rate resets; a clamping down on creative/aggressive financing (as defaults/delinquencies grow); the absence of personal savings; still-stretched affordability ratios of home prices to household incomes, etc.—that suggest the housing landing will be hard, serving as a strong headwind to economic growth by weighing on the consumer and countering the relatively stronger position of the corporate sector.
Last night, HSBC Holdings and New Century Financial—two of the three largest subprime mortgage lenders in the United States—reported disastrous credit losses stemming from their real estate origination businesses.
HSBC announced that its allowance for bad debts will rise to $10.6 billion (more than $1.75 billion above estimates) and New Century (whose stock fell nearly 20% on the news on Wednesday evening) projected a fourth-quarter loss and the need to restate its prior quarters because it materially understated subprime delinquencies and foreclosures.
Nationwide, the subprime default rate soared to 10.09% in November 2006—it stood at only 6.62% a year earlier. Despite a growing economy in early 2007, November's industry default rate exceeded the level of November 2001, which was recorded at the bottom of the last recession. The problem runs deeper than five and a half years ago, however, because nearly 15% of the mortgages made in 2006 were subprime. That is almost triple the penetration of subprime compared to 2000–2001.
Making matters worse:
Before the extraordinary start in home-price appreciation six years ago, bank charge-offs for home mortgages peaked at 45 basis points. If we simply move to that level again—and considering the preceding three factors, this seems reasonable—that would imply more than $40 billion in charge-offs.
Given the alarming swiftness in recent foreclosures and delinquencies, debt downgrades of subprime pools, and looser standards that accompany mortgage loan innovation, however, it is hard to believe that charge-offs won't exceed 2001 levels.
Many have dismissed the subprime risk, even though originators such as Sebring Capital and Ownit Mortgage Solutions were filing bankruptcy in late 2006 faster than you could say “five-year balloon mortgage.”
For that matter, many other economic risks also have been dismissed, including the bubble in credit availability, a spent-up consumer, tightening labor markets and lower productivity, the rising CRB RIND Index and the attendant cost-push inflation.
Also dismissed are the bubble in emerging markets, the levered and vulnerable (long-biased) hedge fund and fund of funds (especially of a Swiss kind) industries, the broad and negative tax implications of the Democratic tsunami, and a more hawkish Fed than many expect.
After all, the current investor base sees no evil and hears no evil, as the market just chugs along ever higher.
That fungus of subprime credit is now clearly not only among us but is now upon us, and the implications for a tightening in mortgage credit will likely serve to contribute to the second leg down in housing over the balance of 2007.
The tidal wave of liquidity and cheap borrowing over the past seven years—which has permeated the mortgage, private-equity and stock markets—has created an attitude toward risk-taking unlike almost anything ever seen before.
Except for a brief period in late 1999–early 2000, the spread of risk-taking to risk-aversion has never been wider. Similar to eight years ago, this condition has produced a market that is currently priced for perfection and poorly positioned for any unpleasant surprises.
We entered 2006 with most investors holding the highest degree of confidence in rising prices for their homes. As it turns out, homeowners were materially disappointed last year.
We enter 2007 with investors having the highest degree of confidence in rising prices for their stock holdings. They, too, might be disappointed as the year progresses when the hidden fragility of an overpriced, overleveraged world will soon be revealed.
I have written that “in time we will undoubtedly see a mean reversion in home prices, interest rates, credit spreads (and losses), corporate profit margins…and in the world's equity prices.”
Last night's subprime mortgage news that credit losses are skyrocketing is the first shot across the bow of the boat called market optimism.
The little-known secret in the subprime market is that the ratings agencies have been lax in their downgrades of subprime paper. The recalcitrant agencies (Moody's, Fitch, and Standard & Poor's) have quietly abetted the mushrooming of very aggressive subprime lending that has allowed the Wall Street firms selling these mortgage products to prosper.
According to Jim Grant, the number of downgrades at Moody's, for example, was even with upgrades in 2005. Last year, the downgrades/upgrades ratio rose slightly to 1.19:1. The problem is that the historical downgrade/upgrade ratio stands at 2.5:1.
Up to now, lenders (and borrowers) have greased the subprime market, making it the swiftest-growing portion of residential real estate lending from 2001 to 2007. Lenders relied on the candor of the borrowers, as nearly half of the subprime mortgages originated last year were no- or low-documented.
This week's Grant's Interest Rate Observer calls attention to a 13-month-old, $350 million asset-backed pool of mortgages, MABS 2006-FRE1. Foreclosures now stand at 9%, delinquencies at 10.5% and real-estate-owned at 3.5%. In other words, about 23% of the loans are problematic—and neither Fitch nor S&P has downgraded the issue. No doubt investors in MABS 2006-FRE1 (hedge funds, brokerages, institutions, etc.) mark the issuance to par (since it has not been downgraded).
But what will happen when the ratings agencies finally downgrade MABS 2006-FRE1? Answer: Investors will sell.
Anyone for a 60-bid?
The subprime fungus has only recently been uncovered, and the seriousness of the problem for the housing sector has only recently been uncovered in the “see no evil, hear no evil” capital markets of 2007.
What is astonishing is the almost universal view that the prime market is in good shape and that the weakness in subprime will be contained.
It will not be isolated, as nearly as half of all the mortgages made over the past 12 months—even those made to prime customers—are nontraditional, creative loans (interest-only, adjustable option ARMS, negative amortization, etc.). These, too, are vulnerable. At the very least, today's lemmings (a.k.a., mortgage lenders) will begin to restrict lending and will dramatically tighten standards. And Katy bar the door if this economy doesn't perform in a Goldilocks fashion.
Throughout the balance of 2007 and into 2008, mortgage defaults will accelerate into the prime market, as a result of a moderating economy, too-leveraged mortgage instruments, rising interest rates and ARM resets.
Credit is about to be less plentiful.
Wednesday saw another large mortgage bank, Silver State Mortgage, cease originating subprime loans. Silver State Mortgage was, according to National Mortgage News, one of the fastest-growing wholesale lenders in the country.
The relatively healthy subprime originators, such as Washington Mutual's Long Beach Mortgage, are downsizing around the country faster than you can say BBB-minus.
In a related note, Standard & Poor's might have been reading my story from last week as it downgraded ratings on 18 securities from 11 mortgage-backed bond issues and put on review a number of other bonds sold by units of Goldman Sachs, Lehman Brothers, Barclays Capital, Countrywide Financial, and New Century Financial on Wednesday.
Many in the media have opined that the bears don't understand the conditions under which real estate markets collapse and that these conditions (suggestive of a broadening credit problem) are not present. And in a series of perfunctory conference calls over the past week, the leading brokerages have supported their case that there will not be a credit contagion emanating from subprime lending and that the brokerage exposure will be contained and limited, even though none of the banks disclosed their involvement in the subprime market (as agents and as principals).
It appears that the principal reason these observers are ignoring the subprime problem and its ramifications is that the equity markets are ignoring them. Ergo, it must not be a problem. This is the definition of a Goldilocks mind-set (see no evil, hear no evil) not a Goldilocks scenario.
The subprime carnage (such as HSBC's nearly $2 billion addition to subprime loan losses in the fourth quarter 2006) is ignored as is the commentary from merchant builders such as KB Home and others (perhaps because their stock prices are also rising).
“We began 2006 with a strong backlog that produced record deliveries. As the year progressed, however, market conditions worsened, cancellations increased, net orders declined and margins came under pressure. The result was a 2006 year-end backlog substantially below the year-earlier level. At a minimum this will likely result in a year-over-year decrease in our unit deliveries through the first half of 2007 and potentially longer.”
—KB Home CEO Jeffrey Mezger (February 13, 2007)
The credit containment argument ignores the parabolic growth and rising role of subprime lending (relative to total mortgage industry loans)—never before have lenders relied more on the candor and integrity of borrowers, and never before have underwriting terms been so lax. These are two toxic reagents, especially within the context of the biggest housing boom in history, in which real estate mortgage receivables have mushroomed to all-time records at the major (and minor) banks.
The “dot condo” CondoFlip website that encouraged investors/speculators to day trade condominiums (and proudly declared that “Bubbles Are for Bathtubs”) has been dismantled and is no longer operational, replaced by a Condo Super Center. The site now admits, in a mea culpa, that “the condo boom was driven by overly ambitious speculators, many of whom had been successful in flipping condos in the past. As condo inventories grew and prices rose, many speculators realized that further purchasing was increasingly risky. So buyers just stopped buying.”
There is an emerging credit crisis, and it will lead to rapidly rising charge-offs. Construction lending on land and condominium loans are the next area to implode. (Examples of exposed intermediaries are Fulton Financial, National City and Corus Bancshares.)
As night follows day, the enormous securitization markets will shortly begin to demonstrate the same sort of delinquencies we have witnessed in subprime mortgage lending. Then a continued acceleration of subprime loan problems will creep into the prime market (where equally creative mortgage loans have been made to prime borrowers).
Restrictive credit practices are just beginning to unfold as a consequence of the poor underwriting standards applied over the last decade. The more things change, the more they stay the same.
Maybe Jim Cramer is right when he writes “get over subprime's collapse” and in his view that the brokerage companies will be relatively immune from the subprime carnage.
But I doubt it.
It is far too easy and convenient to dismiss the subprime woes based on the notion that because it is on the cover of the New York Times or on the tongue of many market commentators, it is either discounted or not as bad as it seems. Rather than listen to the comments of others on the Street and in the media, I prefer to deal in facts as opposed to simple and glib sound bites.
Here is a tidbit from page 132—yes, I do read every page in these filings!—of Goldman Sachs's 10-K dated Nov. 24, 2006.
Securitization Activities
The firm securitizes commercial and residential mortgages, home equity and auto loans, government and corporate bonds and other types of financial assets. The firm acts as underwriter of the beneficial interests that are sold to investors. The firm derecognizes financial assets transferred in securitizations provided it has relinquished control over such assets. Transferred assets are accounted for at fair value prior to securitization. Net revenues related to these underwriting activities are recognized in connection with the sales of the underlying beneficial interests to investors.
The firm may retain interests in securitized financial assets, primarily in the form of senior or subordinated securities, including residual interests. Retained interests are accounted for at fair value and are included in “Total financial instruments owned, at fair value” in the consolidated statements of financial condition.
During the years ended November 2006 and November 2005, the firm securitized $103.92 billion and $92.00 billion, respectively, of financial assets, including $67.73 billion and $65.18 billion, respectively, of residential mortgage loans and securities. Cash flows received on retained interests were approximately $801 million and $908 million for the years ended November 2006 and November 2005, respectively. As of November 2006 and November 2005, the firm held $7.08 billion and $6.07 billion of retained interests, respectively, including $5.18 billion and $5.62 billion, respectively, held in QSPEs.
Note to Cramer: I am officially ordering a Code Red!
“I guess we are a bit surprised at how fast this (subprime) has unraveled.”
—Tom Zimmerman, head of asset-backed securities research at UBS, in a recent conference call for institutional investors
The fungus of subprime credits has grown in scope and in economic consequence over the past three months. We are now beginning to experience a full-blown bursting of the latest asset bubble, which could prove even more devastating than the piercing of the Nasdaq stock bubble in 2000. The impact of the subprime collapse on the availability of mortgage credit—and, in turn, consumer spending—is the primary reason why I believe the U.S. economy and corporate profits will materially disappoint and why the equity markets remain vulnerable.
Many readily dismiss the potential spending consequences of substantially less capacity in the subprime mortgage-lending market and the emerging trend by mainstream originators and lenders to reduce lending in the primary mortgage market and for refinancing cash-outs.
Indeed, Jim takes the subprime issue one step further, noting that the mortgage house of pain will have a salutary market and economic result, as it will hasten the Fed's path toward monetary ease. Shockingly, many others can't comprehend the link between mortgage availability and consumer spending, claiming that the correlation between the two variables is unclear.
I have not touched on the outlook for considerably higher credit losses at the financial intermediaries that address the housing market, but I will underscore the perfunctory conference calls and the generally disingenuous role of Wall Street rating agencies that continue to hide the damage for owners of collateralized product paper as it relates to the collapse of the subprime market. It seems that at the end of every cycle's excesses, the investment community rationalizes the indefensible, owing to the enormous profitability of the products that are being peddled. The higher a market surges, the easier the product is to sell, but the less straightforward the pitch becomes.
Time and time again—whether it be junk bonds, tax shelters, technology stocks, high-priced initial public offerings (IPOs), glowing research reports—Wall Street (despite former New York Attorney General Spitzer's noble initiatives) continues to exist for the purpose of raising capital (i.e., selling stocks and bonds) and not for the purpose of producing objective research and making clients money.
The brokerages' ties (in packaging and trading mortgage products) and earnings exposure to the subprime collapse—they have 60% of the market share of the mortgage financing market—were covered in depth in yesterday's New York Times article by Gretchen Morgenson.
From my perch, the collapse of the subprime markets—delinquencies now stand at 12.6% for subprime and 4.7% for the overall mortgage market—within the context of the $6.5 trillion mortgage securities market will have a broad and negative multiplier effect on mortgage activity (housing turnover) and retail spending. It will also serve to further grease the current slide in new residential construction activity and hasten the drop in home prices.
It is important to understand housing's disproportionate role in terms of buoying employment and industrial production from 2000 to 2006 in order to appreciate how violent the reversal's effect might be on aggregate economic growth.
Not only did new-home construction embark on an era of unprecedented growth, but the broad rise in national home prices gave way to the concept of the “home as an ATM”—a source of cash, a substitute for savings and an enabler of the consumption binge (which was above and beyond the income means of the average consumer).
During the 1990s, mortgage equity withdrawals averaged between $20 billion and $80 billion per year, or only about 0.50% of GDP. By contrast, average yearly mortgage equity withdrawals climbed to about $230 billion, or 2% of GDP, over the past five years and peaked at nearly 3% of GDP in the second quarter of 2006—or at an annualized yearly rate of almost $400 billion.
Several months ago, Freddie Mac forecast that mortgage equity withdrawals will drop by 20% this year and by another 30% in 2008. These projections were done before the subprime fungus spread, and I think its estimates are too high.
In 2006, subprime mortgage loans trebled (to 36%) as a percentage of all mortgages issued. “Liar loans,” or non- and low-documented loans that relied on the candor of homebuyers (never an intelligent loan strategy) doubled (to 40%) over the same time frame. Creative loans (characterized by teaser rates, negative amortization, interest-only, etc.) became the new big thing in real estate and dominated the mortgages issued in 2006. Refinancing cash-outs proliferated, and, according to BankAmerica Securities, the average loan to a subprime borrower rose from 48% of the property's value in 2000 to 82% last year.
While the media have been focused on the D. R. Horton CEO's bleak forecast, every quarterly conference call with leading homebuilders last quarter confirmed the mounting restrictions of credit by mortgage lenders. Stated simply, it is growing harder and harder to get mortgages. In the interim interval, the subprime market's health has worsened and so has, on a daily basis, the availability of mortgage credit (the lifeblood of our economy's well-being).
In light of the recent adverse loan experience and bad publicity, most originators are avoiding these loans like the plague. Today, no mortgage lending officer at any bank or thrift will dare stretch lending standards to homebuyers, as the mandate of tightened loan-to-values and higher FICO scores are increasingly the directive from financial companies' management.
Moreover, the fixed-income market has a diminished appetite for packaged subprime loans and a diminished appetite for any collateralized product that includes subprime loans. It is unlikely that the institutional investors will hunger for this product for some time to come and originators will be faced with the hard reality that subprime loans will face more limited demand in the primary and secondary markets.
With financial intermediaries turning off the mortgage loan spigot, first-time homebuyers and trade-up buyers—who already are pressed by the lack of affordability (home prices divided by household incomes)—will have markedly reduced access to the residential real estate markets. As a result, the cyclical decline in housing will be forced into another down leg, just at a time when inventories of unsold homes remain elevated and the volume of ARM resets peaks (in third-quarter 2007). As a consequence, the gradual decline in home prices seen over the past 12 months runs the risk of becoming a full-fledged waterslide.
The mortgage market's new reality will serve to immediately (and adversely) affect housing turnover and reduce the demand for expenditures on many products. Exacerbating the decline in personal consumption expenditures will be the virtual disappearance of mortgage equity withdrawals.
Spending on everything from appliances, furniture, flooring, roofing, paint, televisions, telephones, and tools will suffer from the lower housing turnover and activity. The cessation of refinancing cash-outs could have an even broader effect, constraining discretionary spending on restaurants, apparel, vacations, remodeling projects, automobiles and other durables.
With the demand for a broad array of consumer goods and services moderating, corporate profits are at risk and will quickly disappoint relative to expectations. Up until now, the service sector has remained healthy (even while housing and autos weakened), but even the buoyancy in services will be pressured and put to the test in the months to come. In the fullness of time, the rate of job growth will decelerate even more markedly than we have seen over the past several months as construction unemployment accelerates and the contagion permeates the broader job market.
More tepid top-line sales growth will weigh on corporate profit margins (one of the cornerstones to my bearish case for equities and valuations) as operating leverage will be difficult to come by. Unfortunately, all this will occur at the same time cost pressures remain high.
The CRB RIND Index—an index of spot raw material prices—just made a multiyear high last week, while unit labor costs have upticked to levels not seen in years.
In summary, the credit contagion that started with the fungus of subprime lending will hit an already weakened housing market and could spread to other securitized markets. Its impact will be felt broadly and should have a pronounced negative effect on personal consumption, corporate profits, and stock prices. It will suck.
There are four main culprits responsible for the expanding subprime debacle that threatens to upset the Goldilocks scenario that so many are trumpeting. I've listed them in descending order of importance:
First, the former Fed chairman took interest rates far too low and maintained those levels for far too long a period in the early 2000s, well after the stock market's bubble was pierced. (Stated simply, he panicked.)
The Fed's very loose monetary policy served to encourage the new, marginal and nontraditional homebuyer—the speculator and the investor not the dweller—to embark on a speculative orgy in home purchases not seen in nearly a century.
Over time, home prices, especially on the coasts, were elevated to levels that stretched affordability well beyond the means of most buyers. Ultimately, despite relatively strong employment and low interest rates, the residential housing market crashed hard.
Second, Greenspan suggested—at just the wrong time and at the very bottom of the interest rate cycle—that homeowners retreat from traditional, fixed-rate mortgages and turn to more creative and floating rate mortgages (interest only, adjustable option ARMs, negative amortization, etc.).
He said this in February 2004 at a Credit Union National Association 2004 Governmental Affairs Conference:
American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest-rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.
One year later Greenspan continued the same mantra and cited the social benefits of the financial industry's innovation as reflected in the proliferation of the subprime mortgage market.
A brief look back at the evolution of the consumer finance market reveals that the financial services industry has long been competitive, innovative and resilient. Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. Such developments are representative of the market responses that have driven the financial services industry throughout the history of our country. With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. The widespread adoption of these models has reduced the costs of evaluating the creditworthiness of borrowers, and in competitive markets, cost reductions tend to be passed through to borrowers. Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending; indeed, today subprime mortgages account for roughly 10% of the number of all mortgages outstanding, up from just 1% or 2% in the early 1990s.…We must conclude that innovation and structural change in the financial services industry has been critical in providing expanded access to credit for the vast majority of consumers, including those of limited means. Without these forces, it would have been impossible for lower-income consumers to have the degree of access to credit markets that they now have. This fact underscores the importance of our roles as policymakers, researchers, bankers and consumer advocates in fostering constructive innovation that is both responsive to market demand and beneficial to consumers.
But even as Greenspan was taking interest rates to levels that encouraged the egregious use of mortgage debt and exhorting the opportunities in creative and variable mortgage financing, there were some smart cookies out there who recognized the risks; here are quotes from two of the smartest who warned of the danger in the mortgage market.
When I took economics in World War II, and we were studying the Great Depression, one of the reasons given was all the interest-only loans that came due. They were an indication of an economy getting into unsound lending. Ever since then it's been a rule that when you go into interest-only loans, you're very substantially increasing the risk of default.
—L. William Seidman, former chairman of the Federal Deposit Insurance Corporation and chairman of the Resolution Trust Corporation
Our own Robert Marcin put it even more precisely (and vividly) in his prescient warning back in mid-2005.
If Greenspan had a clue (remember, he didn't have one in the tech bubble, or maybe he did), he would jawbone the banking industry to tighten or even strangle lending standards for residential real estate. He should not kill the entire economy to slow the real estate markets. Now that bag people can buy condos in Phoenix with no down payments, maybe the Fed should get involved. You can't expect mortgage bankers to do anything; they get paid to lend money. But like Greenspan's unwillingness to raise margin rates in 1999, I expect him to do nothing until the market declines. Then, the taxpayers will be on the hook for the stupidities of the real estate speculators. Remember, I expect a sequel to the RTC in the future.
—Robert Marcin, “Making Money before Housing Crumbles”
Greenspan will go untouched and will continue to give speeches at $200,000 a pop.
Their rush to lend and helter-skelter growth relied on the candor of the mortgagees and not on common sense, prudent lending or reasonable underwriting standards.
The growth in subprime-only originators was irrational, but the industry will now be rationalized and the marginal lenders will go bankrupt. And in the fullness of time, the more diversified lenders will benefit from their demise.
After tax shelter abuses in the early 1980s, junk(y) bonds in the late 1980s, overpriced technology stocks and ludicrous IPOs and disingenuous research reports in the late 1990s, one would think that Wall Street had learned its lesson.
It has not.
The higher a market surges, the easier it is for Wall Street to peddle and package junk.
The magnitude of the potential gains are always too attractive and tempting, particularly as product demand swells into another cycle excess, as it did in subprime. Astonishingly, even the obligatory emergency conference calls intended to persuade investors that all is well were superficial and failed to disclose the inherent conflicts that each and every multiline brokerage has.
The major brokerages will be litigated against, again. They will pay large fines but will proceed in business until the next bubble, which they will also capitalize on.
This should not be considered a surprise, because like their Wall Street brethren, they prosper from the rising tide of credit issuances. In doing so, similar to a teacher who has turned his back on a boisterous and disobedient class, those recalcitrant agencies (Moody's, Fitch, and S&P) have ignored the erosion in credit quality and abetted the rush and market share taking of subprime lending.
Importantly, until downgrades are issued by the agencies, investors routinely carry their investments at cost, or par—downgrades force investments to mark to market and sell.
The rating agencies will likely go unscathed because they always do.
Bullish observers have increasingly been making the case that the growing fungus of subprime credit problems will force the Fed into a loosening of monetary conditions sooner rather than later.
These days, the private-equity put doesn't seem to be working, so it appears that the struggling bulls now must hold on to the notion of a Bernanke put to counter the currently troubling and tenuous stock market conditions.
After all, lower interest rates always reverse investor sentiment and adverse financial conditions, right?
My view is that with the level of inflation remaining stubbornly high, coming to the aid of a bunch of reckless and overly aggressive mortgage bankers is not necessarily seen by Chairman Ben Bernanke & Co. as an immediate responsibility of the Fed.
They might deem it too early in the crisis or think there is no crisis at all.
In fact, consider the cheerleading of Treasury Secretary Henry Paulson in Tokyo last week and remarks made recently by Federal Reserve Governor Susan Bies, both of whom have downplayed the subprime problems:
“Credit issues are there, but they are contained. I don't think it (subprime) has, at this point, implications for the aggregate economy in terms of the ongoing expansion.”
—U.S. Treasury Secretary Henry Paulson
“Based on some recent observations, mortgage lending certainly is an area in which we believe financial institutions and supervisors have learned some key lessons about risk management.”
—Federal Reserve Governor Susan Schmidt Bies
Also, consider this quote from another Fed official on what he sees as the Fed's true role.
Ultimately, though, ex ante judgments about leverage, concentrations and liquidity risk will continue to prove elusive. Our principal focus should therefore be not in the search for the capacity to preemptively diffuse conditions of excess leverage or liquidity, but in improving the capacity of the core of the financial system to withstand shocks and on mitigating the impact of those shocks.
And, as always, central banks need to stand prepared to make appropriate monetary policy adjustments if changes in financial conditions would otherwise threaten the achievement of the goals of price stability and sustainable economic growth.
—Timothy Geithner, president of the New York Federal Reserve Bank, February 28, 2007
Now even if the Fed did lower interest rates in March or April, the markets could interpret the move more negatively than the bulls realize by calling attention to the magnitude of the mortgage crisis and by fueling inflationary fears, serving to pull the capital markets into a tailspin.
As we move into the summer or fall, there will be better visibility of the subprime problems. By that time, it will be abundantly clear to even the bulls that an inventory-swollen housing market is back on the sick bed as the two most important marginal buyers—the first-time and trade-up buyers—have lost access to home-financing. And, by then, the multiplier effect of the housing downturn should be in full force, causing the economy to sputter and for corporate profit expectations to fall to more realistic levels.
The upheaval in the subprime mortgage industry is in its middle stages, but the broad impact on the U.S. economy is in its infancy. To paraphrase, Frankenstein's Dr. Waldman, the credit markets and Wall Street have created a monster—subprime—and it will destroy the economy.
I am not looking for a depression in housing or for the economy, but those who look for housing to stabilize and for an increasingly restrictive mortgage credit market to be anything other than a substantive drag on 2007–2008 aggregate economic growth are just plain wrong.
It's worrisome to look at the state of housing demand and supply today.
The explosion in mortgage delinquencies in the second half of 2006 has only recently begun to be converted from delinquencies to foreclosures (and for-sale signs). Currently, the housing market's foreclosures stand at a 40-year peak.
Economy.com estimates that there were about 400,000 foreclosures in 2006. With signs of continued rising delinquency rates thus far this year, 2007 foreclosures should be considerably higher than last year's figures. I would estimate that foreclosures in 2006–2007 will add nearly 1 million units (or 26.5%) to the current level of 3.75 million homes for sale. Stated simply, most are underestimating the massive supply of homes that will be dumped on the market over the next year to two years.
While record foreclosures will assuredly lead to a rapid rise in the supply of homes available to be sold in 2007 and 2008, tougher lending standards (particularly in the subprime category that is the lifeblood of first-time buyers) will squelch housing demand. Historically, creative lending (option ARMs, interest-only, negative amortization, etc.) shored up the housing markets by allowing (indeed encouraging) otherwise unqualified borrowers to participate in the roaring residential market of the last few years.
First-time buyers and speculators, who, before delinquencies mushroomed, were qualified for high (95% or more!) loan-to-value mortgages at below-market interest rates (80% of subprime loans over the past three years were 2/28 ARMs) based on teaser interest rates are now being qualified increasingly by the mortgage interest rate charged after reset.
This is serving to effectively price out a major demand source for homes as they are no longer eligible for low down-payment, non-documented loans that were previously granted with below-market or teaser interest rates. Indeed, subprime mortgages have been the only source for a large amount of homebuyers in the last three years. No more.
I would conservatively estimate that about 55% of the subprime borrowers, 25% of the Alt-A borrowers and 15% of the prime mortgage lending borrowers will no longer be able to secure financing for new homes because of tightened conditions. (This will produce about a 25% drop in housing demand.)
Speculators and investors (who were responsible for nearly 20% of all home purchases in 2004–2006) also will find it more difficult to secure borrowings, and it is likely that this buying category will revert close to its historical demand role of about 5% of all homes. (This will result in another 10% to 15% drop in housing demand.) Finally, end-of-economic-cycle conditions (lower consumer confidence, slowing economic growth and moderating job growth) should contribute to another 10% drop in housing demand, which is as it has done historically.
Adding together the above three influences, new home demand should fall off by almost 50% (vs. the rolling 12-month average showing a 17% drop off in 2007) even before the effect of a market inundated by record foreclosures is considered.
Precipitated by the subprime mess, the entire daisy chain of home demand is deteriorating. With the first-time buyer out of the market and increased demands of higher collateral, better credit and loan documentation, the trade-up market is also in trouble. So is the Alt-A market. And in the fullness of time, as Nouriel Roubini surmises, a more general credit crunch remains possible.
Credit Suisse projects that about $500 billion of mortgages will reset this year (60% of these are subprime loans). According to First American CoreLogic's recent study, “Mortgage Payment Reset: The Issue and the Impact,” resets will produce 1.1 million additional foreclosures (and more than $100 billion of losses) over the next six years. That's nearly another 185,000 homes per year coming into supply, on top of the nearly 1 million homes foreclosed on in 2006–2007!
What is particularly worrisome to me is that home prices remain inflated relative to household incomes (Merrill's Rosenberg did a good analysis on this topic last week; Today's home prices stand at the highest multiple to disposable incomes in history.) We have still not resolved the high price of homes by either prices moving lower or incomes moving higher. Affordability (or the lack thereof) will provide another headwind to the housing recovery.
There remains too much land and finished product inventory owned by the homebuilders. The publicly held companies are positioned to weather the storm, but the more levered private companies will be a continued liquidator of land and homes. Indeed, new home-price incentives look to be on the ascent, another headwind to supply.
With housing activity dropping and resets rising, consumer confidence should dive in the months ahead, construction employment will plummet and a cessation of mortgage equity withdrawals will further grease an already weakening slide in personal consumption expenditures.
From my perch, investing on the basis that the subprime carnage and exploding ARMs will not affect the consumer, the economy, and our equity market is a risky proposition.
Here is the economic equation as I see it: restrained mortgage credit plus reset mortgage rates equals more money needed to finance homes and less money available to purchase goods, which in turn equals a slowing economy.
The next down leg in housing is upon us. Employment, consumer confidence, and retail spending will be the next victims of housing's retreat.
The odds favoring a housing-induced recession are now increasing. My bearish preoccupation with the health of the housing markets appears to be justified by history.
The slow-motion drop in consumption seen in the last 12 months will likely accelerate, aided by growing evidence of a second housing downturn this year and possibly another downswing next year, which will be exacerbated by ever-increasing supplies of unsold homes served up, in part, by mortgage resets in 2007 and 2008.
The bullish crowd contends that there is no evidence that the real economy has been affected by the housing market and subprime collapse, rising energy prices or geopolitical threats. Nor, according to them, has the economy been affected by a host of other varied microeconomic and macroeconomic issues.
Today, liquidity is a catchphrase in support of continued economic growth and stock market appreciation, just at a time that collateral and interest rate terms in private-equity deals have begun to tighten.
The same things were said in the late 1980s.
During that period, unprecedented land and housing speculation followed the erosion in lending standards that were a byproduct of the deregulation of the savings and loan industry and the liquidity introduced by Michael Milken's Drexel Burnham, which brought an unprecedented increase in takeover activity.
Ultimately, the economic progress of the early and mid-1980s gave way to an implosion in the high-yield debt markets, an economic downturn and a horrific housing depression (and the loss of the previous decade's liquidity). In the early 1990s, the economic contraction was severe in both magnitude and duration (continuing for three years), even though the federal funds rate was reduced by 500 basis points, to 3%, and stayed there for over 20 months.
(As a result of the recession's severity, several money center banks, such as Citigroup and Bank of Boston, were almost insolvent and had to be saved by the Tisch family.)
Fast-forward to the present.
In 2007, the economy is nearly two-thirds larger than it was 16 years ago, a period in which the downturn in real estate produced nearly $300 billion in losses. But not only is the residential mortgage market much larger now but so are subprime delinquencies and the ultimate losses they will deliver.
Moreover, home mortgage borrowing, home ownership (69% of families vs. only 64% in 1991) and the impact of housing on aggregate economic activity have never been higher. Equally important, household debt as a percentage of GDP is dramatically higher, and home equity as a percentage of home market values has never been lower.
Once again, as in the late 1980s, lax lending standards have become the mainstay of our markets and now are a contributor to the real estate and subprime mess. Also, liquidity is the most often quoted term to explain the market's buoyancy, takeover activity and rising stock prices.
Given the extraordinary creation of wealth—in part because of the ongoing strength of the equity markets and, until recently, the large price appreciation in home prices and breathtaking mortgage equity withdrawals—one should not be surprised by a delayed or slow-motion response, particularly by consumers.
Nevertheless, there is an obvious chain of real estate-related jobs (mortgage brokers, landscapers, title searchers, real estate lawyers, mortgage bankers, realtors, contractors, etc.) that will suddenly be lost at breakneck speed over the near term.
The worst is yet to come—the housing's multiplier effect is starting to kick in.
The consumer has never been more levered, homeownership as a percentage of household net worth has never been higher, the issue of home affordability has yet to be resolved, the inventory of unsold homes is at record levels, homeowner vacancy rates are at an all-time high (2.8% vs. 1.2% in the early 1990s), foreclosures and delinquencies are skyrocketing, and mortgage interest resets are just beginning to further pressure household incomes.
The damage associated with the housing problems will be long-lasting—and, as in the early 1990s, lower interest rates will not readily jump-start growth and rescue the economy.
The downside of the leveraged and carried trade, mainly through the Bear Stearns High-Grade Structured Credit Strategies Fund, has been opened up like a Pandora's Box of inflated hedge fund valuations, impotent credit ratings and other risk issues.
It all started with the erosion in subprime credits, as delinquencies and foreclosures in late 2005 skyrocketed after housing affordability was stretched by a sustained period of low interest rates, which encouraged housing's speculative activity (the outgrowth of which was record buying of non-owner-occupied investment properties) and the insensibilities of lenders.
The culprits and sinners of this cycle are plentiful. They include a too-easy Fed, loosely regulated and heedless housing lenders, avaricious home speculators, funds of funds that encouraged hedge fund investors to leverage, greedy hedge fund investors—you would have thought that they learned from the demise of John Meriwether's Long Term Capital Management—irresponsible ratings agencies that were reluctant or ill-equipped to downgrade credits, brokerages that packaged these complicated products and, of course, hedge fund managers who have the temptation of large compensation incentives to take undue risk. (They participate in at least 20% of the fund's profitability.)
Reckless lending and the egregious use of leveraged capital have permeated our financial system, raising the risk that the subprime disaster is the leading edge of a deteriorating credit cycle and that its effect will be chilling.
The key to the ultimate impact will be the slope of the economic cycle. If the bulls are correct and a sustained period of economic growth (free of inflationary pressures) is in the cards, credit problems will likely be contained. If I am correct that we are moving toward a recession in early 2008, the subprime mess will be only the tip of the iceberg, and problems will move up the credit ladder.
On a different note, a lot of hedge funds are now trembling—and I don't mean because Congress wants to raise the tax rate on general partners' carried interest. The big hedge fund secret is that, barring credit downgrades, many leveraged and esoteric investments (such as the collateralized debt obligations that inhabited the Bear Stearns hedge fund) aren't marked to market.
This creates the illusion of profits in a hedge fund, until an outsized event (the subprime mess, Russia's refusal to pay its debt, a terrorist event) occurs. Then the proverbial excrement hits the cooling device.
Regardless, there is likely a large amount of undistributed senior risk sitting in dealers' hands today.
The lessons to be learned from this crisis are that:
And portfolios should be marked to market.
Other stocks that may have mark-to-market issues include private equity funds turned public powerhouses Fortress Investment Group and Blackstone as well as other banks that mix their own proprietary trading with their banking services, including firms such as Goldman Sachs, Lehman Brothers, and JPMorgan Chase.
The market is approaching an unprecedented and dangerous crossroads: not only is there enormous confidence in the notion of another long worldwide economic boom abetted by non-U.S. influences, but similar to in the late 1980s, there is a bubble in credit availability, credit costs and in investor activism—i.e., buy stock, make a 13-D filing (à la Icahn), make waves and make a boatload of money.
It can't be that easy. (Remember the aborted United Airlines takeover in the late 1980s that brought an end to the speculation surrounding junk-bond financings?)
Moreover, leverage, as in past cycles, is playing a much more active role in today's hijinks. But, leverage is always the monster that kills, and it will likely have a primary role in upsetting this cycle as it has had historically.
Of course, in the last stages of an accelerating trend in prices, the consensus view always seems to look smart. Think back to the last two bubbles: the housing bubble that was formed in the early 2000s, and the stock market bubble emanating from the late 1990s.
To paraphrase Broadway hoofer Ethel Merman in Gypsy, “everything was coming up roses” for home prices and for Internet stocks.
Rose-colored glasses were the fashion du jour as the investment community was convinced of the new paradigm and long boom in home prices (and activity), in the unparalleled prospects for technology/Internet and in almost a zombie-like trance in listening to the proselytizing by Wired magazine's Peter Schwartz and Peter Leyden that a long and uninterrupted economic boom was inevitable. “We're facing 25 years of prosperity, freedom, and a better environment for the whole world. You got a problem with that?”
In evaluating the past housing cycle, however, investors ignored, up until the very end, the growing mortgage credit abuses that would undermine the cycle by stretching affordability to unfathomable levels. In the late 1990s, pie-in-the-sky valuations and day trading's speculative excesses were ignored because, in the long run, stocks always rose and a Dow Jones Industrial Average (DJIA) target of 36,000 was the exclamation point in James Glassman's book for all of us to read in late 1999—just prior to the Nasdaq's 75% decline.
In the prior two bubbles/booms, prices were extended and exaggerated by borrowed funds or excess liquidity. Subsequently, the bubbles' bursting of falling prices were exaggerated by the calling in of the credit-financed liquidity.
It is no different today. Credit availability is unprecedented, and activism and private-equity activity are bubbly. Deals are being executed using ever-increasing leverage as credit spreads remain narrow and disbelief has been suspended. At the same time, fundamentals are not as sturdy as is generally accepted.
Grandma Koufax used to say, “Dougie, forewarnings are on your forearm. But for the time being, the joke is on you.”
Consider the following:
In bubble-like market conditions, when many fundamental threats and headwinds are increasingly ignored, stocks tend to overshoot reasonable levels of value until the worriers are totally discredited.
That time might be growing near.
It's time to panic.
Why?
I'll tell you.
To be sure, the economic and investment world does not face Armageddon. But often—especially when market momentum takes over and new paradigms emerge—people simply ignore reality, and in this case the reality has been ugly, and stocks are finally wising up to that.
I've believed for some time that the leverage in the world's financial system would lead to the inevitable end of a halcyon period of plentiful and cheap money. After all, leverage is always the monster that kills and historically has upset the credit cycle.
We are now seeing the beginning of the downside to the mounting leverage in private equity, credit markets, and the consumer segments of our economy, creating the potential for a more volatile backdrop and, in all likelihood, unaccustomed market headwinds.
While the meltdown in subprime mortgage values has been the most publicized of jitters in the credit markets recently, concerns are now growing about risky loans everywhere.
The appetite for high-yield credit has begun to dry up, with issuance of low-quality debt staying below $1 billion for the third successive week.
Prices of bank debt, which is integral to the buyout boom, fell dramatically this week, as many segments of the credit market seized up on Thursday and Friday.
The spread between the average yield of the Lehman U.S. High-Yield Corporate Bond Index and Treasuries, which narrowed to a record-thin 2.33 percentage points in late May (or less than half of the average spread over the last 20 years), has recently widened to around 3.25 percentage points in the last one and a half months.
Other headwinds are mounting:
Also, banking credit losses are expanding rapidly, private equity debt and bank loans are getting revised or are unsold, securitization losses are rising, the U.S. dollar is in a near-free-fall, and the rate of growth in June's headline CPI is at record levels.
The CRB RIND Index (a measure of industrial spot raw material prices) is at an all-time high, oil refinery bottlenecks around the country have pushed gasoline prices to 12-month highs, U.S. corporate profit quality is low (aided by foreign-exchange translation, lower tax rates and buyback benefits), and there is growing evidence of corporate profit margin vulnerability that has surfaced in second-quarter earnings releases.
Caught up in the momentum of price, investors have barely been concerned with the likely impact that a continued Democratic tsunami in 2008 would have on trade policy and on legislation raising individual and corporate tax rates. Moreover, investors seem little troubled by the mounting geopolitical tensions around the world.
Surprisingly, this eroding fundamental backdrop is occurring as worldwide equity prices are within 1.5% of multiyear highs.
Regardless, just as credit spreads have moved from being priced to perfection to being priced to reality since late May 2007, stocks will likely move lower as well.
Again, it's time to panic.
Since the housing market's collapse, cheerleading government officials, audaciously bullish strategists, investment bankers, commercial bankers and money managers, extrapolating economists and even irresponsible ratings agencies have felt the economy would not be affected. Skeptics were discredited because, in large measure, worldwide share prices continued to trace a pattern of nearly uninterrupted advances. They were all wrong; the economy has not been unaffected.
Many of those same observers have felt that the subprime disaster would not infect other parts of the credit market. They were wrong there, too, as the credit markets around the world have seized up and have been forced to rely on the injection of liquidity by central bankers in order to temporarily halt a full-fledged credit crunch.
The bullish cabal is now again arguing containment—that a combination of potential policy decisions, such as allowing Fannie Mae and Freddie Mac to expand their lending ability, Fed easing and central bank liquidity adds, will be the ticket to a return to stability.
They will be wrong again.
The cleansing process will take time. There is no short-term fix. The pendulum of the credit cycle is only in its early stage in what appears to be a swing back to normalcy. And the magnitude of the leveraging of the worldwide economy and of hedge fund investors will not allow for normalcy overnight.
The worldwide helicopter drop of money last week (through central bank injections of liquidity) was in response to the banking industry's demand for cash. Over here, fed funds were boosted to a panicky 6.00% in early Friday trading, well above the target level of 5.25%. Over there, it was even worse as market participants have been late in responding to and understanding the magnitude of the subprime problem. (It was only last week that three European funds and Bank Paribas acknowledged losses.)
Unfortunately, these (de facto easing) moves will likely serve only as a Band-Aid to a system that has dined at the trough of leverage for years.
We have not even begun to feel the economic effects of rising delinquency and foreclosure rates, to say nothing of the broadening crisis in credit. It was only in late 2006 that these rates began to climb.
Consumer and, more importantly, business confidence is about to hit the skids as the credit event morphs into an economic event. And the private-equity model of leveraging up Corporate America is now in jeopardy. Consider the near-$300-billion backlog of nonsyndicated bridge loans and unsold junk bonds in the pipeline. With interest rates for levered transactions shooting up in recent weeks (if those sort of loans are even available at all), many of these deals are in jeopardy to be completed.
For example, how in the world does J. C. Flowers finance the more than $16 billion of debt to acquire Sallie Mae? The answer? It doesn't, and the company will likely cite the “adverse event” defense in an attempt to walk away from the near-$1-billion breakup fee obligation.
The commercial banking and investment banking industry is overconfident, overleveraged and under-reserved. And so, too, are the dominant investors of the new millennium (i.e., hedge funds and the fund of funds community). Recklessness will be replaced by conservatism in the months (and possibly years) to come.
The government-sponsored entities are still bruising from more than $10 billion of fraud/losses and the associated political fallout. Given the recent histrionics, Fannie Mae and Freddie Mac are likely to stay limited in their ability to support the housing markets outside of conforming mortgages.
What is needed is a more permanent fix, a comprehensive housing Marshall Plan aimed at clearing up the housing mess over the next one to three years. Unsold inventories, stretched affordability and reticent mortgage lenders seem unlikely to be importantly affected by a cut in the fed funds rate.
A full-fledged credit crunch will be the mainstay of housing for at least another year. In periods of stress, fear is amplified. This helps to explain why mortgage rates for jumbo loans (even to creditworthy borrowers) are skyrocketing without a concomitant rise in the general level of interest rates—in fact, the opposite is occurring—and why mortgages are so difficult to come by. The purchase and refinance mortgage market is effectively shut down.
What we have learned from the last month is that in a period in which nearly every asset class rises in unison, disbelief tends to be suspended. When all investors are doing the same thing and making money, the hard questions are never asked because skepticism goes on holiday. And, importantly, when risk is hijacked, models misbehave.
Investors should be looking less closely at put/call ratios and investor sentiment surveys and instead should be reading the investment books that intelligently put credit and speculative market cycles in perspective. They should be reading books like Roger Lowenstein's When Genius Failed: The Rise and Fall of Long-Term Capital Management, Charles Mackay's Extraordinary Popular Delusions & the Madness of Crowds, and James Grant's Money of the Mind: Borrowing and Lending in America from the Civil War to Michael Milken.
In our tightly wound and levered financial system, investors today might be advised to concern themselves with return of capital; it is likely too early to be concerned with return on capital.
With corporate profit margins vulnerable to a regression back to the mean, price-to-earnings multiples still high—until recently the median P/E on the S&P 500 was about 20×—and the many noninvestment threats (political and geopolitical), the outlook for equities has turned sour.
We will have vicious rallies in the bear market that I envision, but they will be fake-outs. Buy on the dip? Not with my investors' money. Sell or short the rips, as (you can bet your bottom dollar that) “the sun will not come out tomorrow.”
The longs view the brokerage stocks, at roughly 9× earnings and trading at historically modest premiums to book value, as statistically cheap.
Though the shares are oversold for the short term, both cyclical and secular forces are conspiring to put the brokerage industry's profits in jeopardy. A moderation or contraction in credit products, private equity and hedge fund industry growth, when combined with mark-to-market and prime brokerage liabilities, suggest that the risks of ownership of brokerage stocks outweigh the rewards.
As a result of these conditions, earnings expectations remain far too bold, and company profit warnings are expected to begin posthaste.
The brokerage industry's fortunes are joined at the hip with the bubbles in credit (and derivatives) expansion and private equity, two correlated and intertwined asset classes. Unfortunately, these two bubbles have recently been pierced, marking a clear first-half 2007 peak in industry profitability. (This peak will not likely be reversed for at least another two years.)
Over the past decade, brokerages have feasted at the trough of credit availability. The current credit crunch leading to a temporary cessation of private-equity deals, however, is clearly changing that tailwind into a headwind. Brokerages' returns on investments have been goosed by the rapid growth in all types of fixed-income (and derivative) products, and the cycle's reversal spells lower securitization packaging fees and lower secondary credit market trading volume of the many credit and derivative products.
Moreover, the $8 billion-plus in first-half advisory fees—principally merger and acquisition, which is importantly influenced by private-equity deals—will decline dramatically in 2007's second half and seems destined to moderate further into 2008.
The hedge fund industry's woes (i.e., poor results and disintermediation) will begin to weigh on brokerage industry profits in the current quarter. Similar to the explosion in credit products, the mushrooming of growth of hedge funds has been a key contributor to brokerage profitability.
For example, it has been estimated that nearly one-third of Goldman Sachs' income has been derived from the prime brokerage and trading with hedge funds. In a more choppy and trendless trading environment and a less hospitable credit market, hedge funds will be increasingly vulnerable to a contraction in the number of hedge funds and to a moderation in inflows, or even disintermediation. Prime brokerage and equity and fixed-income trading volume seems destined to moderate in the next few years.
Besides the loss of fee income from lower trading and prime brokerage, the industry is exposed to mark-to-market risks in collateralized debt obligations, continuous linked settlements, mortgage-backed securities and private-equity bridge loans (owned in fee) that it is obligated to fund. Moreover, many brokerage firms' money market funds exposed themselves to subprime packaged products in an attempt to enhance yield. This is the next big shoe to drop.
The proprietary desks at Goldman and at other brokerages have fueled earnings growth; they have been the gravy on top of the main course of credit and hedge funds. Importantly, they have benefited from a simultaneous and steadily trending move upward in almost every asset class (commodities, equities, bonds, and real estate).
The 2002–2006 prop desk profitability will not be replicated in a more uneven market in commodities, equities, and fixed income. (Consider that it is likely that Goldman's prop desks took some of the same risks as its customer-based and broken Alpha Fund.)
To this observer, it is clear that the Democratic tsunami of 2006 will likely be extended into 2008's presidential election. The Democrats' agenda and initiatives are clearly aimed at reducing the schism between America's haves and have-nots. It is being manifested in attempts to change the taxation of private-equity profits and in other challenges to Republican policy.
And in reading between the lines of President Bush and Treasury Secretary Paulson's responses to the credit crisis, it is clear that even the Republican Party is moving toward the Democrats on this issue, as they both seem to be saying that Wall Street and the mortgage-lending communities should take the hits to their income statements without the benefit of government intervention.
Private-equity players such as Blackstone are starting to develop a vertically integrated organization by building up their own in-house M&A capabilities so that they can bypass the brokerages' fee apparatus. Or as Grandma Koufax used to say, “Dougie, why buy the cow when you can get the milk for free?”
Over the past 5 to 10 years, a surplus of cash has led to a shortage of common sense in the credit markets.
The outgrowth has included the following:
The ability to leverage in all facets of our economy and in financial instruments multiplied in a world where investors overreached for yield. As credit got easier and leverage was ever-more accepted, investors took their collective guards down by accepting abnormally low returns by taking abnormally high risks.
There was, until recently, an absence of risk-awareness, leaving few investors prepared for the morphing of the subprime mess into an early-summer black swan of credit as the aggregate leverage employed in our financial system provided little margin for error. In swift order, concerns of return on capital shifted to return of capital in many asset classes as risk aversion replaced risk taking.
Private equity's merger and acquisition activity stopped on a dime as hundreds of billions of bridge loans became hung and are still unsold by commercial and investment banks. Leveraged “quant” hedge funds reported awful returns, and many have gone or will go out of business.
The lack of availability of mortgage credit hit home sales, and those hedge funds/investment firms/money market funds that owned or inventoried mortgage-backed securities and collateralized debt obligations saw financing pressure intensify due to their dependency on the commercial paper market, and so on and so forth.
Stated simply, anyone who had previously bet that “the good times would (continue to) roll,” with the status quo of low volatility and an increasing appetite for risk, suffered (and continues to suffer).
The list of victims of the credit unwind should grow longer in the months ahead.
I think it's unwise to believe that the summer of 2007 is simply a bump in the credit road. The excesses were long in the making, and given their magnitude, the ensuing unwind will not be resolved in short order—regardless of the Fed's actions.
Though it rarely pays to invest for a full-scale meltdown or disaster, at the very least, one should steel oneself for a mean regression in credit that will dampen growth for some time to come as markets typically swing for a longer period of time than is generally expected. They did so on the upside to credit creation, and they will likely do so on the downside of credit contraction.
The pendulum swing back to normalcy in the availability-of-credit market and in credit losses is by no means the only factor contributing to what I believe will be, at the very least, a limited upside to equities.
Away from a deteriorating credit cycle, an all-time high in oil futures, ripping grain prices, a plunging U.S. dollar and the likelihood of political change are some additional headwinds facing investors over the next few months.
My long-held view of a period of blahflation (i.e., uneven and lumpy economic growth that both investment managers and corporate managers will find hard to navigate) remains my investment mantra.
In such a setting, unpredictable roller-coaster moves should be the market's mainstay, not a sustained uptrend.
We live in a brave new investment world. With the explosion of hedge funds—the newest and most aggressive and dominant investor—riches beyond the highest degree of avarice can be only a year away.
The industries of America's business icons (Ford, Carnegie, Rockefeller, etc.) are no longer the leaders, nor are the kids of the dot-com boom (Bezos, Yang, Case, etc.); today, the masters of the universe are hedge fund managers (Ed Lampert, Stevie Cohen, Paul Tudor Jones, etc.).
And there are many hedgies who are, understandably, wannabes—and who sometimes (arguably) misuse other people's money by worshiping at the altar of momentum in the pursuit of happiness. In the process, negatives are also sometimes ignored or, even worse, dismissed.
As such, in the pursuit of George Soros–like riches, momentum has taken a peculiarly more important role than ever. It has been almost unbridled as investors have often taken abnormal risks for normal returns in the low-interest world of 2000–2007. This is true not only in the equity markets but especially true in the credit markets.
And, as a result, over the past five to seven years, following the stock market bubble of the late 1990s and the easing in monetary policy around the world in the 2000s, we entered a period in which a surplus of cash led to a shortage of good sense in the capital markets. Investors prospered in the ensuing synchronized advance in almost every asset class—equities, private equity, fixed-income, commodities, gold and real estate.
As a consequence of the broad-based financial and economic prosperity, another new paradigm emerged—namely, the notion that a long and uninterrupted economic boom was believed by many to lie ahead. That promise, abetted by the low cost of capital and interest rates, stimulated the straw that stirred the drink of growth and speculation—namely, the financial derivatives markets.
That market mushroomed, in an unquestioning atmosphere in which t's were not crossed and i's were not dotted, to the point where the derivative market eclipsed the actual size of the markets it served. (In a generally unregulated market, this was easy.)
The appetite for derivative products creation grew almost boundlessly and was brought to us by that wonderful brokerage community that brought us the dot-com IPOs and biased research, stoking all asset classes and revving up the real estate market in particular.
Layers of different sorts of assets were securitized by the Street and packaged into one, and the generally unregulated asset-backed securities, collateralized debt obligations, structured investment vehicles and so on were given their birth. The new securities gave way to their cousins; levered hedge fund pools of capital emerged to take advantage of the availability of borrowed money (“the carry trade”) supporting those ABC and XYZ assets. They could, in theory, produce alpha (or excess returns).
In time, the need for speed had as its outgrowth the loss of common sense, particularly in lending. Subprime and no-/low-documentation lending gained share of the total mortgage market, and speculators/investors, drawn to those riches of flipping and day trading homes, began to stretch home prices to levels well beyond affordability and reason.
In time, the unintended consequence was literally a very shaky foundation to the residential real estate market and to the derivative products into which the subprime loans were dumped.
Over in equities, a new breed of stocks (energy, infrastructure, metals, emerging markets, etc.) flourished and took center stage during the synchronized worldwide economic growth boom and personal consumption binge, and these sectors were capable of making the sort of broad and parabolic moves that rivaled the AOLs and Amazons of the last decade.
Meanwhile, other secondary deleterious influences were emerging, too. Although, prima facie, these influences were positive for the markets—that is, as investors easily marginalized the United States' loss of its competitive edge in producing goods for worldwide consumption—they were destined to hold some negative consequences down the road.
The most important was the emergence of India and China as world economic powers and the concomitant dive in the U.S. economy's currency and economic standing, which buoyed the demand for basic materials as those countries' infrastructure developments began to take hold.
That rising demand served to have the adverse consequence of raising commodity prices around the world—and with it, attendant inflation and higher costs for manufacturers. Other influences during this period, such as the U.S.'s reliance on imported oil, sowed the seeds for higher noncore inflation.
In summary, the momentum of asset-price appreciation and the rewards that were a byproduct of those gains have been intoxicating and virtually unquestioned, even as headwinds mounted, in a world in which the dominant investors (hedge fund managers) get a carried participation in their growth.
And so the cocktail of derivatives, leverage and credit creation buoyed consumption in both the industrialized and emerging economies. What has recently intensified the problem is recognition that the derivative markets have bypassed the traditional conduit—namely, the commercial banking system (governed by capital and reserve requirements and audits).
In the absence of oversight, accountability has been weakened and, at times, eliminated. And then, almost overnight, conduits worth tens of billions of dollars are revealed. And so are tens of billions of dollars of debt securities and loans the market is unable to value.
Surprise, surprise. It was especially a surprise to the money center banks, which are at the forefront of the dance of write-offs—a marathon, not a two-minute fast step.
The problem with the aforementioned momentum and the exuberance that follows is that it does not last forever. Equally important (and often enigmatic) is that you never know what should end it—nor what will end it.
Today, there are a number of obvious problems/casualties that suggest that a more problematic and uneven stock market might be surfacing.
I am not saying the end of the world is near. It appears, however, that there are solid reasons to be increasingly concerned.
Most of my concerns are fundamental not technical. I would add, however, that the negativity bubble you read about could not be further from the truth; just look at the Investors Intelligence sentiment studies, the high level of margin debt, and/or the consistent raft of uninterrupted bullishness in the media.
Importantly, a confluence of a number of events is occurring at or near the conclusion of mature economies in the United States, Japan, and Europe.
Without further ado, below are some (but not all) of my concerns.
The pile of levered pools of capital that hold the extraordinary (in size and quality) amount of derivative assets are now in disarray. Mark-to-market issues and an acceleration in nonearning assets run deep and are endangering large bodies of market participants and their capital bases. This includes the domestic money center banks, investment brokerage firms, and, importantly, the unregulated and monstrous special interests vehicles, collateralized debt obligations and levered hedge funds that play in that water.
The destabilizing effect of the impaired financial institutions cannot be understated or underestimated; just ask those investors who have overweighted financials (20% of the S&P) on the basis of value, only to see the sector drop on a daily basis. Banking problems tend to have a long tail and historically are not resolved in a quarter or two (e.g., the less-developed-country debacle, the junk bond fiasco and the early 1990s housing depression, all of which crippled the banking community for years).
Arguably, the problems in housing and leveraged derivatives in 2007 run deeper than the prior adverse cyclical issues. Finally, we should not lose sight of the fact that the money center banks, which are this cycle's (and nearly every cycle's) dolt, entered 2007 ill-equipped to deal with losses. (They were at a historically low level of reserves as a percentage of earning assets.) The banks, too, were momentum players, believing in the new paradigm and believing (incorrectly) in their own credit standards and (lack of?) analysis.
Recognizing that the level of credit losses virtually hit an all-time low in 2006, only to be reversed markedly through the first three quarters of 2007, a likely mean-reversion-of-loss experience augurs poorly for a capital-depleted and off-balance-sheet-dependent U.S. commercial banking system that has experienced a two-decade drop in loan-loss reserves just as the economy matures and the consumer falters.
To an important degree, the Fed has lost control of the capital markets. These are situations that cannot be arrested by somewhat lower interest rates. Many problems reside abroad and outside of the Fed's influence. And much that is domestic lies in unregulated territory.
Capital-weakened financial intermediaries spell an important retardant to the financing of growth. The era of unbridled lending is over. Just try to get a mortgage for a second home. Just try to get a jumbo mortgage. Just try to borrow with little or nothing down—on anything. Or just try to get a nondocumented mortgage loan, motorcycle loan, furniture loan, or automobile loan today.
The next shoe to drop will be the failure of a public homebuilder and a private mortgage insurer. The latter concerns me more than the former, as the markets are not aware of the economic implications.
The domestic, nonexport economy is in recession. The Fed gets it and will likely lower interest rates by another 50 basis points next week. But the adoption of a Japanese solution of supporting bad debts will have, as an adverse consequence, further drops in our currency and competitiveness and higher prices for consumer products.
Based on my recent trip, I can assure you all that the western European economies are falling faster than is generally realized for many of the same influences behind the U.S. weakness.
The dual impact of a higher real rate of inflation and climbing oil prices are a tax on the consumer and will weigh on corporate profit margins, which will be hurt by slowing top-line growth. Importantly, these are occurring at a time in which the consumer's debt load has never been higher based on nearly any measure. With declining home prices, however, the burden on maintaining financial net worth has never been more on the shoulders of stock prices, and that's a slippery slope.
An all-time high in debt service and in the debt load of the consumer and, importantly, the message of the market from the Retail HOLDRs' (RTH) steady demise and the equally steady drop in bond yields are precursors to the obvious slowdown.
The excess capacity in housing holds far-greater economic import than the excess capacity in technology six years ago.
Meager job and income growth and the squeeze on the lower- and middle-income classes at the tail end of a maturing economic cycle bodes especially poorly as the consumer's dependency on asset appreciation (stocks and houses) remains elevated.
The next five years in the capital markets seem destined to be unlike the past five years. The most significant difference is that the egregious use, generation and packaging of debt will not be repeated, and the consequences of that leverage will be adversely seen in areas of the world economies that we had never contemplated.
There will always be winners in the markets, just as there are always losers in the markets. The winners appear to be narrowing in scope, however, representing a classic sign of a maturing equity market. And, in more difficult markets, those babies are often taken out with the bath water.
The equity market is now on the brink, as rising inflationary pressures and slowing economic growth have increased the possibility of stagflation, a condition that has historically led to a contraction in P/E ratios and poor equity returns.
The core of my concerns remains the U.S. housing market, the future of which is inexorably linked to the current credit bubble's piercing.
Economic bulls have thought that the housing market's problems would be ring-fenced. After all, residential housing activity accounts for only about 6% of GDP—somewhat less than the 12% to GDP role of business fixed investment, which was responsible for a shallow recession five years ago.
Economic bears, such as myself, focus on the more important role of consumer spending, accounting for a record 71% of GDP, and its likely retrenchment, which is the outgrowth of lower home prices (for the first time since the Great Depression), restrictive mortgage credit and the absence of the home as an ATM for consumption.
Importantly, the days (1995–2006) of relying on the asset appreciation of homes and equities as savings conduits have been reversed.
Since the mid-1980s, the Fed has sanctioned bubble after bubble by stimulating and then ignoring them. Fed members have, up until recently, ignored real inflationary pressures, preferring instead to recognize the artificiality of core inflation. In addition, the Fed has ignored the causality between the credit market's earthquake and economic growth.
Frankly, it is almost comical to watch free market capitalists complain that the Fed did not do enough last Tuesday. From my perch, the Fed is acting responsibly; the critics of monetary policy, on the other hand, are acting irresponsibly by asking for higher and higher concentrations of interest rate opiates.
The only hope for our domestic economy is a protracted downturn to break the accumulated economic excesses and the lethal chain of endless asset bubbles of the last two decades.
Morgan Stanley and Merrill Lynch are now calling for a recession.
I will touch on some of the factors that indicate a move toward recessionary conditions.
There are other problems to worry about as well, mostly emanating from the last decade of overconsumption (i.e., the lack of due diligence in lending and the disregard of risk in borrowing) and the structured products that permeate the markets today.
The outgrowth of the aforementioned variables suggests that corporate profit (and profit margin), business spending and personal consumption forecasts remain far too optimistic.
There are some offsets to my fundamental concerns, but they are principally statistical and/or sentiment-based. Most prominent:
It has become increasingly difficult to gain an edge on the short-term market outlook. Quite frankly, anyone who thinks that he has one is lying to himself and to others. The near term is too unpredictable and too volatile and contains too many crosscurrents.
I remain more confident than ever in my intermediate view that a period of uneven and disappointing economic and profit growth augurs for substandard stock market returns.
From that context, the market is on the brink.
Yesterday, the Fed cut its funds and discount rates by 75 basis points, the largest fed funds cut since October 1984 (when Volcker's Fed bailed out Continental Bank) and the largest discount rate cut since December 1991 (when Greenspan's Fed feared the failure of Citibank).
While the Fed's actions will have a salutary impact on the U.S. banking industry's net interest margins, throwing cheap money into the markets will do nothing to address a dysfunctional credit market and the dangerous systemic risks associated with the monoline insurance industry. Nor will dead-at-birth home mortgage market fiscal policy relief (the Paulson plan) and cheap money provide any meaningful short-term relief to the current housing depression—or to the foreclosed or delinquent mortgages providing much of the current pain.
Policy aimed at providing solutions to the deep-rooted problems of credit and housing must, by definition, be more imaginative—something that, to date, a timid and tardy Fed and executive branch seem unable to grasp. This is particularly true given the already levered state of our maturing economy, in general, and consumers, in particular.
The investment community remains hungry for a solution to the following:
Historically, investors are experienced in economic/profit recessions and their impact on equities in terms of timing, magnitude and duration. Investors' experience with credit dislocations, however, is less clear, and it is the associated counterparty risk fears that seem to be the proximate cause for the pronounced weakness in world equities markets.
The source of the financial system's Achilles' heel lies in the monoline insurance companies.
The bond insurers, MBIA and Ambac, were originally formed to insure bond defaults of municipalities. Though there would be a cost to that insurance, the municipalities saved more in interest expenses than the insurance cost as the insurance with which MBIA and Ambac provided those municipal bonds held the same AAA credit rating of the insurers.
So far so good.
But the bond insurers, intoxicated by the profitability of other instruments, diversified away from municipal bonds in the late 1990s into the real estate markets. Unfortunately, at the same time, mortgage originators began to make too many loans to homeowners and commercial owners who could not afford to pay in all but the most optimistic interest rate, economic and real estate assumptions.
And too many of those ill-fated loans were packaged into structured credit products: Residential mortgage-backed securities (RMBSs) and commercial mortgage-backed securities (CMBSs) begat collateralized loan obligations (CLOs) that morphed into collateralized debt obligations (CDOs) and CDOs-squared. In the fullness of time, even more complex instruments—including variable-interest entities, structured investment vehicles and qualified special purpose vehicles—entered the picture.
Many of these securities and the credit default swaps that fortified those credit markets were ultimately insured by the incredibly levered monoline insurance industry. The monoline insurance industry's top line grew exponentially coincident with the boom in structured finance. Wall Street embraced the shares of MBIA and Ambac, and in 2007 the stocks reached record levels.
The risks that MBIA and Ambac were taking on were clearly not recognized by investors or by the companies. Last week, for example, MBIA disclosed that it has over $30 billion of insured mortgage-backed bonds, which includes over $8 billion of CDOs that own other CDOs (i.e., CDO-squareds).
The private mortgage insurance companies such as PMI Group, Radian Group, and MGIC Investment took a similar route and have suffered as delinquencies and foreclosures have spiked.
The solution to the emerging failure of the monoline insurers that hold insurance on homes, mortgages, bonds and derivatives is straightforward but requires bold initiatives and imagination. It is a public/private permutation of a Resolution Trust Corporation–type facility that will somehow acquire the equity of the leading monoline insurers and will, with or without private-sector partners, retain their portfolios of financial asbestos and sell them over time.
This solution will, importantly, serve to retain the AAA ratings of the individual bonds—the U.S. government has the highest bond rating extant—and the portfolios insured by MBIA, Ambac, MGIC Investment, Radian Group and PMI Group. In turn, this would prevent the domino effect of bond and mortgage downgrades and further forced selling and price markdowns at the world's leading financial institutions.
This program will, however, require a degree of financial creativity that has yet to be apparent from a thus far noncreative executive branch nor from an equally timid and tardy Fed, which seems to be behaving like Milton Friedman's “fool in the shower.” It will, if enacted, immediately alleviate the concerns with regard to counterparty risks that have cast a pall over the world's equity markets and wreaked havoc with some of the world's largest financial institutions.
I would note that I have already drawn a clear parallel between the S&L crisis of the 1980s and the current credit crisis. So, not surprisingly, the solutions could be similar.
Again, the equities of the monoline insurers have declined by an average in excess of 85% from 2007's highs. The existing industry equity value of under $4 billion is de minimis against the size of the problem and low relative to the cost of a government acquisition of these companies.
Suppose the government acquires these companies en masse at a 50% premium to current prices: At a cost of only $6 billion, the U.S. government will own the majority of the companies that insure mortgages, plain vanilla municipal bonds and structured investment vehicles. More importantly, the total value of the toxic portion of the structured products insured that the government would inherit is manageable and modest relative to the cost of acquisition. For example, MBIA, the largest bond insurer has “only” about $30 billion of insured mortgage-backed bonds.
The credit problems facing the world started with housing and moved up the credit ladder. For more than a decade, the normal/historical rigor of lending was abandoned in the residential and nonresidential real estate markets. The problems were exacerbated by the ratings agencies, which abrogated their responsibility of providing accurate assessments of risk.
As such, the solution to our currently dysfunctional credit markets lies squarely on the shoulders of housing. Policy must be immediately enacted that provides the framework that will specifically allow homeowners who are now unable to service their mortgages to become current on that payment. We have to stop foreclosures and begin to whittle down the inventory of unsold homes. This will serve to begin to remedy what ails the RMBS, CMBS, CLO, and CDO markets and aid the monoline insurance companies as, in the fullness of time, banking industry financial writedowns could turn into write-ups.
As Punk Ziegel's Dick Bove reminded me over the weekend, the mechanism and solution for turning around the housing markets is already on the books and requires no new legislation: It is Section 8 of the Housing and Community Development Act of 1974.
The solution could take several steps:
Voila!
I am absolutely positive that these two solutions would have a momentous, immediate and profound impact on equities. Stocks would literally rise by 10% overnight.
“But these waves we are battling, caused by the biggest hurricane in 20 years, had been pounding the shore relentlessly. Although I wouldn't admit it to George (Soros), it was very clear to me that something unusual was going on.”
—Victor Niederhoffer, The Education of a Speculator
The sale of Bear Stearns at a price of $2 per share to JPMorgan Chase will have short-term negative reverberations around the world as the credit quality of the leading financial institutions will come into question. While it was an illiquid balance sheet and the lack of institutional confidence that brought Bear Stearns down (as panic and margin clerks are today's voting machines), the price tag of $2 per share could raise more questions than it answers. After all, the general impression was that the company's headquarters were worth over $1 billion and that the prime brokerage business was worth at least $2 billion, or 4× last year's cash flow of $550 million. These factors suggest that there must be more to the story.
It's different this time. Stated simply, the housing and credit bubbles have been unprecedented in scope and duration—and so has the novel and astonishingly large increase in debt (especially of a consumer kind), as all elements of risk control and due diligence were abandoned in the quest for yield enhancement. Meanwhile, amidst these bent secular influences, the reckless proliferation of unregulated and unwieldy derivatives continued, seemingly limited only by the imagination of man.
There is no single policy that will politely eradicate the egregious and out-of-control buildup in debt and the proliferation of unregulated derivatives in our shadow banking system. The natural forces of a business downturn seem the only solution to what ails the equity and credit markets.
Piecemeal and oldfangled policy responses to newfangled problems will no longer work and, in many cases, will lead to adverse and unintended consequences. Deleveraging out of the most recent cycle will be a rabid bitch. There will be many more currency, economic and hedge fund casualties. The Fed can only do so much—any more could jeopardize the world's view of its creditworthiness, which would serve to put even more pressure on our currency.
Stocks are now tumbling back toward the lows established in mid-January.
“Charlie (Munger) and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both with the parties that deal with them and the economic system.”
—Warren Buffett, 2002 Berkshire Hathaway letter
At the core of the equity market's and economy's problems are:
To get some sense of the complexity of the derivative threat, I strongly suggest that subscribers consider reading pages 12–14 of Warren Buffett's 2002 letter to shareholders of Berkshire Hathaway for a fuller understanding. I may continue to be short his stock, but, once again, his wisdom and insights run true—well before the issue became au courant.
Most of the time, it does not pay to invest on the basis of the view that “it's different this time”—after all, multiple sigma events are just that, and, by definition, they occur infrequently. Victor Neiderhoffer, who I quoted at the start of this column, devotes his website, Daily Speculations, to applying historic reasoning in order to understand the current state of the market—and how to respond tactically.
Unfortunately, a two- to three-sigma event occurred in the housing market by 2005–2006, when housing affordability was stretched to unfathomable levels, and a black swan event is now in full force in the credit markets, thanks to many of the aforementioned secular developments.
The ultimate question is whether a small cabal of ne'er-do-wells at the banks and brokerages have infected the entire financial system with such large amounts of toxic paper so that traditional analysis of business/market cycles, the stock market's historical role of discounting an economic upturn after a recession and other factors lose their relevance as issues of liquidity, contagion and solvency gain center stage.
If so, the 1930s could be repeated—and so could the Nasdaq's 75% swoon of 2000–2002.
But I doubt it.
History might not repeat itself, but it sure rhymes. Or as Yogi Berra once said, “It's like déjà vu all over again.”
The decade of the 1980s gave birth (and death) to an upstart brokerage firm, Drexel Burnham, which created, sold and traded high-yield junk bonds—the turbo debt and foundation of the previous decade of greed. After the insider trading indictment of Drexel's Denis Levine was followed by Michael Milken's demise, junk bond liquidity dried up, recession befell the U.S. economy, and, by 1990, default rates on high-yield debt more than doubled to over 10%. Drexel, forced to buy the bonds of its junk bond clients, depleted its capital and filed bankruptcy.
In much the same manner as Drexel did in the junk bond market, Bear Stearns emerged as a leader in a parabolic growing market—mortgages. As we are now witnessing at Bear Stearns (as we did during the Drexel era), a brokerage's well-being relies, in large measure, on the kindness and confidence of strangers to accept its collateral and accept counterparty risks. That confidence is impaired swiftly when price discovery unveils a diseased portfolio of assets, which is further exacerbated by a high degree of leverage employed. This is especially true when the brokerage's business is not diversified and is narrow in scope—Drexel (junk bonds) and Bear Stearns (mortgages).
Following the Drexel bankruptcy and a real estate-led recession, the equity market regained its footing in late 1990. It didn't take much time—the same could hold true in 2008–2009.
The principal investment question at hand is whether Bear Stearns was a one-off situation—whether its business was so levered and narrow in focus (mortgages) that, with its revenue base collapsing, operating losses would quickly have eaten up its $85-plus per share book value.
I would argue that, in the main, Bear Stearns (similar to Drexel Burnham) is indeed a one-off situation—very similar to when Penn Central shocked the financial system 28 years ago.
While the credit conditions suggest that it is different this time, my investment conclusion is that we are likely at the beginning of the end. As was the case of the Drexel bankruptcy, however, we are not at the end of the current crisis (as the deleveraging process will take more time).
The infinity of political, economic and psychological factors that influence the investment mosaic overloads the senses—more so today than in most prior periods.
Following are some (weighing not voting) considerations that could buttress the markets and/or suggest that the current issues could be in the process of being discounted in the markets, forming the basis for the potential for a more constructive view in the days/weeks/months ahead after the panic subsides:
Most should continue to maintain below-average sized positions in order to take advantage of what Mr. Market presents, as an opportunistic approach to trading/investing remains my mantra. Erring on the side of conservatism remains an appropriate strategy for individual investors.
Frankly, it's time to let the market do its talking, not the pundits. My guess is that we will know the answer sooner than later and that the outcome will be more positive than most appear to believe this morning.
I am now making the hardest decision—again, only for the most facile traders/investors—as I am getting more constructive (mildly bullish) on my intermediate-term market outlook on the basis that we are now at the beginning of the end of the credit crisis.
“I used to be Snow White—but I drifted.”
—Mae West
For over two decades, with the possible exception of the aftermath of the speculative bubble of the late 1990s, equity investors have been comforted by the notion that nearly every dip has been a buying opportunity, as the U.S. economy has typically recovered relatively swiftly from economic and credit, geopolitical, systemic and assorted exogenous shocks. And for over two decades, fixed-income investors have been comforted by the tailwind of disinflationary influences, which provided excellent absolute and relative returns in bonds.
Stated simply, stocks and bonds were no-brainers to most. After all, investors' intermediate- to longer-term experiences in the capital markets were universally solid.
The media insisted that investors buy stocks and bonds for the long run as the sky was the limit. Even James Glassman and Kevin Hassett's Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market seemed within reach.
“Here's another fine mess you have gotten me into.”
—Ollie (Laurel and Hardy)
As we entered the new millennium, the U.S.'s economic moorings became unanchored as unprecedented low levels of interest rates produced a second wave of speculation in housing and day trading in homes replaced the day trading in stocks. The generous availability of low-cost capital and debt formed the foundation of an unprecedented boom in consumer borrowing, a massive spending binge and a desperate institutional search for yields.
A shadow banking industry emerged as the helter-skelter move into derivative products (which were unregulated, unwieldy and intentionally seemed to circumvent banking capital requirements) rapidly materialized. And an eager hedge fund community joined the happy hour of leveraging while unquestioning investors seemed to sanction the generation of common returns that were produced by taking uncommon risks.
At the epicenter of the leverage was the housing market, which was confidently embraced by owner nonoccupied investors, who stretched housing prices and affordability (home prices divided by household incomes) to unsustainable levels. Expectations of a long, uninterrupted boom in residential real estate became the newest paradigm.
Generally speaking, the availability of cheap credit made the notion of debt more acceptable and institutionalized leverage, serving to enrich a small cabal of originators who sliced and diced housing mortgage products. With the benefit of hindsight, however, it is clear that the mass marketing of debt began to poison the world's financial system.
“All for one! One for all! Every man for himself!”
—The Three Stooges: “Restless Knights” (1935)
That was then and this is now.
Last week, we saw a tsunami of selling, which was in marked contrast to my expectations for some stability.
We now face the aftermath of a bygone credit cycle gone ballistic. The world's financial system is, to some important degree, crippled and in a workout mode now. In all likelihood, the pendulum of credit will swing to an opposite extreme, and availability (the lifeblood of economic growth) will become dear, which is in marked contrast to the freewheeling decade of the past.
Regardless of short-term direction, we continue to be in an investing environment that argues in favor of erring on the side of conservatism. Most should maintain smaller-than-typical investing/trading positions and should keep conviction on the back burner.
The experience of the past 12 months has exacted a toll on investors. The average household net worth has taken a hit from the depreciation in stock and home values, confidence in our politicians and corporations (especially of a financial kind) have rarely been lower, and, importantly, investors' innocence has been lost.
While, at some point (maybe sooner than later), the equity markets will rally from the current oversold readings, an extended period of investor disinterest and apathy seems likely to follow.
With so many cross-currents, it is hard to have a conviction regarding the short-term trends in the equity market, but it is easy to have an economic view. It is only with the benefit of hindsight that we will know whether Thursday's market lows will hold. At some point after the initial thrust higher from the new SEC ban on short-selling and our government's $700 billion rescue package, hedge fund and mutual fund redemptions and an uncertain profit picture could lead to an absence of buying power and a vulnerable equity market.
I feel safe in saying that the market has limited upside.
The frequency of the recent bailouts—Bear Stearns, Fannie Mae, Freddie Mac, and AIG—and the scale of the policy initiatives needed to plug up a seized credit market underscore the fragility of the world's financial system.
It will take years, not months, for the world's economies and financial system to adjust and normalize to more reasonable levels of risk taking.
There will be more casualties.
Last month, I made an op-ed contribution to the Financial Times, entitled “This Blame Game Is Short on Logic,” in which I addressed why the blame being thrust upon the short-sellers of financial stocks is misplaced.
Today, I direct my energies toward exposing the true culprit—namely, the Wall Street firms and their executives.
The current nightmare has exposed the players on Wall Street, who, in their packaging, slicing and dicing of mortgage products, have proven themselves to be most destructive.
The words of a mentor of mine ring out loud: As he recently said in an interview, the way to riches on Wall Street is being a part of that community not by investing in Wall Street shares.
Aggressive use of leverage, the risks associated with short-term funding (and long-term lending) of brokerage balance sheets and the subpar level of secular profitability (return on assets) on Wall Street have combined to expose an over-rated industry whose engineers—namely, a small cabal of the firms' traders and executives—bear full responsibility for the credit fiasco and its economic ramifications.
It was an accident waiting to happen.
Wall Street firms take uncommon risk in producing normal returns for their shareholders.
In the process of leveraging up, the financial benefits were bestowed upon a privileged few, but the systemic risks were passed on to the many.
Let me frame the math: A broker/dealer index that includes Bear Stearns, Goldman Sachs, Merrill Lynch and Paine Webber demonstrates that the average return on equity for the industry has averaged 15.9% over the last 23 years. (Return on equity peaked in 2006 to 2007 at about 26% and, taking out the last year, troughed at about 5% in 1990 to 1991). During the same period, leverage has ranged from about 30× to approximately 15×, depending on where the industry is in the cycle.
In other words, Wall Street's return on average assets has averaged roughly 1% over several profit cycles! I don't use leverage in my partnership, but I am certain if I returned only the 1% that Wall Street has achieved on average, I would have very few (if any) investors left.
A “heads I win, tails I win” compensation culture on Wall Street extracts capital and necessitates continued high degrees of leverage and its attendant risk.
Over the past decade, Wall Street's compensation was no longer calculated on multiple years of contribution/performance but rather became a short-term (meritocracy) calculation based on a one-year profit-and-loss statement. The extraordinary compensation at hedge funds, private equity and in the investment and commercial banks became a “heads I win, tails I win” proposition, as a star system emerged that was based on contributions calculated within reduced time frames rather than an assessment of the value-added contributions over lengthy periods of time (subject to high water marks and claw backs).
Importantly, outsized annual compensation packages were typically not retained but rather were allowed to exit Wall Street every year—in part, helping to explain the appreciation in home prices between 1995 and 2005 on the East and West Coasts and the willingness to take risks.
Wall Street has sold out America.
Fortunately, for the U.S. economy, Wall Street will never be the same until these lessons learned above are forgotten.
As investors, we now face a dystopian future.
Our future has been purchased from the past. My vision of the future does not preclude a stable/better stock market over the next several months but it does make the argument that disappointing or substandard investment returns seem the most likely outcome over the next three to five years in an economy that has suffered a massive coronary and that lacks future clarity.
I expressed concerns regarding an imminent depression in housing three years ago, and then, two years ago, I began to cite the alarming use of credit that could have dire consequences. When the excrement started hitting the fan, I wrote that the outlook for the highly levered consumer (and for the economy as a whole) sat squarely on the shoulders of stock prices, which is the other significant household asset that, up to mid-2007, had held price. I opined that a dependency on steady or improving equities was a slippery slope because so much can and usually does go wrong in the stock market.
Unfortunately, my housing, credit, and stock market concerns were realized in the extreme.
Our hand has now been dealt, and it's a weak hand, with reduced promises and possibly even worse investment returns.
As we approach the next decade, our social, economic and political future has materially changed, owing to the deep and muddy financial ditch in which we are now squarely stuck. Moreover, the scope and duration of the financial meltdown has placed our economy well past the tipping point, and it will have an enduring and negative effect. Consider that U.S. home prices have dropped by over $5 trillion in the last one and a half years and that, during the month of October alone, nearly $10 trillion has been lost in the global equity markets. Quite frankly, that ditch is so deep right now that we are in big trouble if our policymakers get it wrong over the next 12 months. My concern is that we might even be in trouble for a long period of time if they get it right.
My secondary (but no less significant) concern, which has an important bearing on stock prices, is that our economic future can be seen with far less clarity than in past cycles when the United States has ventured out of recession. That future has been purchased by our past policies of overindulgence, disregard for risk, and lack of forethought.
Not surprisingly, the economic perma-bulls prefer dreams of the future to the history of the past, but the fault I see in using previous recessionary examples is that history (and those charts) fails to recognize that it is different this time on so many fronts but particularly as it relates to the accumulation of debt and credit. By contrast, the realists see the aforementioned past policies and argue (perhaps more correctly) that the past is gone, the present is full of confusion and that the future scares the hell out of them.
For decades, U.S. investors have seen the hereafter as an expected gift, but, in reality, the future is earned—it is based on achievement. Unfortunately, never has a generation spent so much of our children's wealth in such a short period of time with so little to show for it.
There will be broad-based social, political, credit, economic and stock market ramifications from the economic and market jolts of the last 18 months, some of which are enumerated below. Few of these are P/E-multiple-elevating developments, and the emerging trends (if accurate) will likely produce an uncertainty of outcomes that make it difficult to glibly conclude that the market's dramatic decline has now been fully discounted and almost certainly questions the market's intermediate-term upside.
In summary, my vision of the next three to five years is one of less economic clarity, more economic conservatism, rising populism, a more youthful government and muted investment expectations and returns.
It is a vision not of utopia but of dystopia.
The natural rhythm of the markets has been disrupted since, sometime in September 2008, investors came to the realization that the current economic downturn was not going to be of a garden variety.
It was at that point in time that the decline in equities gained speed in the face of the failure of Lehman Brothers, along with growing recognition of an abrupt deterioration in business activity around the world. As a result of Lehman's demise and the accelerating economic downturn, credit eroded, junk bond spreads widened further, and the price of bank loans plummeted.
The magnitude of policy relief that has been heaped on our current condition in order to reinflate the domestic economy underscores how different it was this time, as we attempted to deflate out of the previous credit binge.
In the old days, recessions were anticipated by the stock market. But in late 2008, as George Soros related in The Alchemy of Finance, market participants seem to be shaping the slope of economic activity as the decline in equities is serving to deepen the downturn. Indeed, the swift drop in stock prices on top (and into a continuation) of lower nationwide home prices has recently fed a negative feedback loop as the acceleration has had a materially adverse impact on consumer and business confidence. As a result, the outlook for personal consumption expenditures and business fixed equipment has dimmed over the balance of 2008 and into next year.
Though share prices seemingly discount anything short of a Great Recession, visibility remains ever more clouded and a wide range of S&P 500 profit outcomes from 2009 to 2011 seems, to this observer, to be an important contributor to an unprecedented degree of volatility not seen in our professional careers. And that volatility is being exaggerated by a trigger-happy and rapidly consolidating hedge fund community that seems to accentuate both upside and downside market movements.
A description of what has happened in the past and what is now happening is easy; how to respond tactically and how to adopt a reasonably accurate vision of the future are much more difficult.
The largest positive is that most now believe that the Fed and Treasury are pushing on a string as investment, economic and profit expectations have begun to adjust to reality:
The largest negative is that stocks are still reacting poorly to weakening results, and those negative but lagging fundamentals will likely be with us for some time to come.
We all recognize that, in the fullness of time, an unprecedented amount of stimulus will, well, stimulate! The only question is when.
My view is that it is simply too hard to have conviction until we meet the following conditions:
Until the above three conditions get resolved, we are likely to be stuck in a broad trading range of plus/minus 10% to 15% for the short term.
We remain in an exquisite backdrop for traders but a difficult and frustrating setting for investors, in which it may be too late to sell and too early to invest for the long term.
At some time in the future (possibly sooner than later), a historic buy-and-hold opportunity will be in front of us.
The current test for investors is to remain solvent until that time is near.