Update On the Real Estate Debacle

First I wanted to share a significant personal announcement. I took the California Bar Exam last week after a couple months of preparing and doing practice exams. I will find out my results this November, so there will be quite a wait. I found the exam very difficult, especially the multiple choice component. We will see - as they say.

Second, I hope that everyone has been watching the imploding of real estate markets and most of the credit markets associated with different types of securitized home loans / mortgage backed securities. We are seeing a huge flight to quality with credit spreads between treasuries and these riskier assets widening substantially.

Third, the real estate spreadsheet strategy is finally beginning to pay dividends. I wish that I had not blown my portfolio up last fall so that I could actually being speculating with my own money on this down market. That said I have helped some people set up portfolios of longer dated put options on real estate related stocks in order to hedge their actual real estate holdings. The results so far have been very encouraging. The biggest surprises for me at least as far as the violence of their downside action is concerned are the Mortgage Insurers. Several of them are down 40-50% over the PAST 2 WEEKS!

The fallout from the recent Bear Stearns hedge fund meltdown and the dissemination of the information that the mortgage backed securities or CDOs were not worth anywhere near what they were marked at has had a significant impact on market action.

I am not convinced that we have commenced a new bear market yet. I think that dollar weakness overseas can continue to boost overseas operations of the major Dow companies and at least create the illusion of market strength in the Dow for the rest of the year. That said - there is a bear market underway in the homebuilders and mortgage lenders, and it is quickly spreading to many of the other financials that seemed immune even three months ago.

Let's keep our eyes open and fingers on the sell triggers. There are some fantastic implications for the precious metals markets out two to three years once the Government bailout of the banks and real estate sector begins, just don't jump too soon. The short to intermediate term action could actually drive gold prices down as investors flee to "risk-free" treasuries increasing the demand for dollars in the short term.

-BG

Economics of the Bailout

The scope / implications of the real estate meltdown underway in San Diego and soon spreading to the rest of California, yes - including Los Angeles, and San Francisco are surprising me. I really can't think of any better example of George Soros' reflexive framework used to analyze boom / bust cycles than the real estate cycle we have experienced from 2001-2002 to present.

Initially long term interest rates at half of normal averages allowed buyers to bid home prices up to twice the previous level based on approximately the same mortgage payment they were making previously. After the initial doubling of prices, loan underwriting guidelines were essentially eliminated in order to grant loans to anyone with a pulse. Traditional methods of gauging borrower's ability to pay back loans such as audits of assets and income were no longer expected to be needed based on the tremendous amounts of "equity" in the homes that were being lent on. This produced another 50% increase in price at put prices throughout San Diego at a minimum of 3 times the previous price just 3-4 years earlier.

The common viewpoint among the public and EVEN the professionals - re: bankers, realtors, etc. - was quite typical of human hubris - that is - the home prices increases were a testament to our own greatness. Asset price inflation made us all "wealthier" and allowed a further development of the "ownership" society - and I use that term loosely. ;)

Which brings us to present day San Diego. Foreclosures and REOS are hitting historic highs and we are only six months into the bust. Home prices in several areas (think Chula Vista) are already down 20-30% from peak 2005 pricing. The ability of any sub-prime borrowers to refinance their option ARMS has basically been eliminated due to the disappearance of any "equity" they had in the property as well the inability to make a fully amortizing mortgage payment anyways.

The new lending guidelines released by the Government basically require all ARMs to be underwritten based on a borrower's ability to make the loan payment AFTER the loan adjusts. This takes even more propsective buyers off of the market. How far will prices drop during this bust? I am guessing a minimum of 50% from 2005 peak numbers in nominal values. That would still leave us with a 50% increase in price from the beginning of the cycle in 2000-2001. As the $200K home would essentially be worth $300K up 50% but down 50% from the $600K peak.

So the above statement will probably be controversial to a lot of people, but lets just take it as an assumption for argument's sake. A price drop of that magnitude over the next 2-3 years is going to require multiple government bailouts. Not because those bailouts will actually "fix" the problem, but the Government for political reasons needs to make it clear that they are trying to help out the little guy.

Additional tax deductions are not likely to be helpful as there is no gain when the properties would be sold. A tax CREDIT would be interesting as it could basically allow the government to GIVE directly to homeowners an additional say $3K-10K a year back in their pockets. Again this will not "fix" anything - but it has to be seen in the context of what Government will do to try and stabilize the issue.

I think another probable measure will be some relaxation of the rules for discharge of indebtedness income when it relates to your principal residence. Mainly the current rule may be changed so that if your home is sold for less than you owe on the property and the difference when charged off could be attributed to you as ordinary income / discharge of indebtedness income those charges could be eliminated if you can prove that the property was your primary residence. This would allow people to quickly move out of their home either through foreclosure or short sale, beginning renting, and then transition back into home ownership when the finances were more appropriate.

How ironic is it, that in attempt to make homeownership available to everyone through the enormous tax subsidies of mortgage interest deduction on principal up to $1M, exclusion of up to $500K tax on sale of home, and additional mortgage interest deduction for home equity up to 100K - the Government has instead created a huge economic incentive for speculation.

The dream of home ownership has been put so far out of reach of the "average joe" that they essentially have to borrow such huge amounts of money to invest in housing that the housing related expenditures may reach higher than 50% of disposal income. If the potential of home price appreciation disappeared would homeowners see things the same way?

I guess Im just saying that if the end goal is "affordable housing" - why should we provide subsidies to homeowners that will likely inflate housing prices? I guess in some ways it is the short term versus long term issue. Over the short term the subsidies decrease the cost for a homeowner but for another prospective buyers - and national welfare as a whole - the subsidies drive up the prices for citizens as a whole.

On that note - look at who is writing this piece - a non-homeowner. :)

Before this cycle is done, I'm guessing five years or more till we reach the boom in "real" terms of decline, we should see an actual aversion to both housing and debt levels re-assert itself among the American public. This will initially kill economic growth as we know it which is so dependent on our own internal consumption growth / expectations. Still this adjustment will be important because it will allow the country to rebuild our domestic savings levels in an attempt to make investments increasing welfare over long term and not just going to fund current consumption preferences.

Let's just pray that the Federal Reserve and Government do not attempt to cut rates to 1% again in order to attempt to restart the consumption engine of growth. This time around I don't fear for a reinflation of real estate prices or even stock prices. I fear a destruction of the value of our currency and a hyperinflation.

Ill leave off with that and maybe if time next weekend I will discuss a bit "The paradox of inflation." I read about this concept in Marc Faber's book "Tomorrow's Gold" and I found it very useful / interesting for identifying undervalued investment opportunities.

-BG

Thoughts on WAMU and Bull / Bear Markets

I had an interesting interchange with another follower of the WAMU stock earlier today. I thought people might find it interesting. Here was the basic exchange:

I posted:

Wikipedia defines insolvency as follows: "Insolvency is a financial condition experienced by a person or business entity when their assets no longer exceed their liabilities, commonly referred to as 'balance-sheet' insolvency, or when the person or entity can no longer meet its debt obligations when they come due, commonly referred to as 'cash-flow' insolvency."

WAMU is certainly not "cash-flow" insolvent as they have proven time and again their ability to raise capital in the market via debt issuance, regardless of their actual cash operating performance. The important question then is whether or not WAMU is "balance sheet" insolvent.The recent issues in the Bear Stearns hedge funds concerning their "mark to model" accounting raise some important issues for WAMU. Although WAMU does not own CDOs in its investment portfolio (it is instead usually selling its own loans to Wallstreet so they can make the CDOs or MBS or also sometimes instead retaining the loans for its own portfolio).......the question arises of how does WAMU come up with the value of the loans that it does retain and hold on its balance sheet.

Based on the Q1 2007 financial disclosure table and balance sheet information that WAMU provided back in April 2007. They currently hold over $58 Billion Option ARMs in their portfolio as well as $56 Billion Home Equity loans. In addition to this they own over $20 Billion in Subprime Loans.According to their own balance sheet they have net shareholders equity / book value of $25 billion.

So the next question is how much of WAMU's $134 billion in risky mortgages have to implode in order to wipe out the entire book value. Easy - just $25 billion or a mere 18%.Keep in mind - I am not talking about DEFAULTS of $25 billion - I am talking about a drop in market value of $25 billion in th retained loan portfolio. Considering the http://www.markit.com/ readings that many of these types of mortgages once securitized already trade around $0.50 on the dollar in th secondary market - the correct answer is that WAMU is ALREADY balance sheet insolvent.

The reply to my comment was as follows: "LMAO! That erroneous case can be made for a whole lot of mortgage lenders. Short some more dummy, and I'll guarantee that you'll be insolvent long before WaMu."
Forgetting for a second this person's cunning ability to assess my probable future, :) let's look at my reply to that.

Ben: The fact that "everyone is doing it" does not make it right. If we trace the logic of the Bulls' argument over the past 6 months it started like this:

Fall of 2006: The loans on the balance sheet are worth more than face value - they are in high demand from Wall Street

Spring of 2007: Who cares if there are a few defaults? The underlying value of the collateral (re: the home) is more than enough to offset and cover any principal amount on the loan as well as past due interest.

Now Summer of 2007: Bear Stearns controversy makes it evident that these types of loans are not worth anyhthing close to what WAMU is carrying them at on the balance sheet. We also know that with home prices falling nationwide that the collateral of the loans is quickly disappearing. Bulls are essentially saying: who cares the collateral value is eroding, and that WAMU is misrepresenting on its balance sheet the market value of its loan portfolio - in essence because ALL banks are doing this - this is OK.

Rather than try to wrap my mind around such difficult to grasp concepts as "huge retail footprint" or "large accounts growth" - I would prefer to stick to the statistics that have traditionally mattered during a credit crunch. Namely - liquidity. If the secondary market for securitization of both Option ARMs and Home Equity Loans is drying up or at least offering substantially lower amounts for these types of loans - it suggests that WAMU will have hard times ahead of it.The fact that a Ponzi scheme can go on for a long time and fool many people does not make it a sound business plan. WAMU is no exception.

Follow up thoughts: aside from the obvious bias that I feel towards WAMU, I had some thoughts today about being long the market versus shorting the market. More particularly I thought about the phrase - "There is always a bull market somewhere." Is the obvious corrollary - "There is always a bear market somewhere" - also true?

I have read that in the early days of hedge funds the simplistic model involved going long a certain percentage of stocks say (60% of portfolio) and go short (40% of portfolio) - it is not 50/50 in order to account for the long term upward bias in the market. The idea behind this approach was that by picking the best companies and the worst companies - market risk would be eliminated and the fund could generate "alpha" due to its superior stock picking.

I am not so interested specifically in this idea but an analogous one - mainly - are there entire bear markets going on in certain sectors even during a primary bull market such as we have experienced over the past four years? Im not sure - although it should be easy enough to check.

I am still tracking the real estate sector spreadsheet and currently only ONE sector is in a primary bear market (the homebuilders). Some sub-sectors are still making new 52 week highs (Title Insurance companies) and other sectors are in slight corrections but still bull markets (re: REITs, Mortgage Companies, and Brokers).

The final thought I had is how do I define bear market or bull market? Is the test just a simple - "I know it when I see it." or is there a better quantitative method to apply that actually could hold true. I have seen some people argue that nominal drops in stock prices represent a bear market if the fall is enough, while others argue that regardless of price movement a bear market occurs mainly as a result of falling valuations re: PE multiples as was the case during the 1970s in the US.

More questions than answers but it was nice to get a few ideas off my chest.

-BG